Investor demand for downside protection drives surge in Australian shares long/short strategies

A prolonged bull run in equity markets and increased concerns about a possible market correction have underpinned a sharp rise in the use of long/short strategies in investor portfolios.

12 Jul 2018

Over the year to March 2018, the amount invested in Zenith’s rated Australian shares long/short strategies increased 43% to $8.7 billion. Over the past four years, this segment has grown 78% (up from $4.9 billion).

Long/short equity funds invest in shares like long-only equity funds, however, they are also equipped with the ability to “short sell” stocks. Short selling allows investors to profit when stocks or markets decline – hence their appeal to investors in times of market uncertainty.

Long/short outperforms, with lower risk

The surge in inflow has coincided with a good performance period for Australian shares long/short funds. In the five years to March 2018, Zenith’s rated fund managers returned 11.7% p.a., compared to the S&P/ASX 300 Accumulation Index return of 7.6% p.a. Risk volatility was also lower for long/short funds, with annualised standard deviation of 8.9% versus 11.2% for the Index.

Long/short delivering on their protection pledge

The basic premise of long/short investing is that in order to provide better protection on the downside, investors trade away some of the potential upside. Expressed differently, if share markets fall, the funds should fall by a lesser amount, and when markets rise, the funds should also rise – but to a lesser amount.

In its Research Report, Zenith assessed whether Australian shares long/short funds have delivered on this promise, comparing the results to traditional long-only funds.

In the five years to March 2018, long/short funds captured an impressive 92% of the market’s upside return, which is within close range of the 98% upside capture for long-only funds.

When markets fell, long/short funds provided a much higher degree of downside protection, suffering only 57% of the market’s decline, compared to 86% for long-only funds.

Jacob Smart, Zenith Investment Analyst summarised, “The results of our analysis provide clear evidence of the beneficial role that long/short strategies can potentially play in an investor’s portfolio. It is also important to recognise that short selling is a specialised skill set that we assess carefully when rating funds. The ability to short sell effectively is a key determinant of success in the overall strategy.”

Size is much more limiting in the long/short space

Zenith believes that short selling effectiveness is sensitive to strategy size, mainly because short selling requires stock borrow, which has limited supply. This supply shortage is reflected in the low volume of short sold stocks, with only 2% of the Australian equity market held sold short as at 31 March 2018.

Zenith believes the overall capacity of long/short strategies – which is limited by a fund manager’s short selling capacity – currently sits at approximately $1 billion for the shorting component. Smart concluded, “Our hypothetical capacity target provides a line of sight to guide optimal short selling effectiveness. Pleasingly, all our rated managers have leverage-adjusted short exposures that are below this figure, providing our financial adviser clients with confidence that capacity among our rated funds is prudently managed.”