A Review Of Hedged Equity: Why It Makes Sense Now

As an investor, this may be one of the toughest environments to assemble a balanced portfolio. You might wonder how this can be, given that the stock and bond markets have done so well. Yet, that’s just the point. While we may be optimistic about the future of the stock market, no one’s total portfolio should be in stocks.

Today, those who want some of their portfolio in something other than stocks are faced with a real problem. Now, there’s nothing wrong with owning stocks, stock mutual funds or stock index funds. It’s just that the traditional options for the non-stock portion (like bonds) of a portfolio are not great.

It’s no secret that economists, investors, and market pundits rarely agree on anything. But, they seem to all currently agree that bonds yields are incredibly low, and at some point, will go higher. When they do, it will hurt the overall return of traditional bonds. So, we get little interest, and lose if yields go higher.

What else can we consider for the ‘non-stocks’ in the portfolio? As we outlined the criteria we were seeking: mid-to-high single digit long-term returns with half, or so, the risk of stocks, one strategy that intrigued us was long-short (or hedged) equity.

Most investors – whether they choose to invest in individual stocks, ETF’s, or index funds -participate in the full upside and downside of the stock market. A long-short strategy gives the manager the flexibility to choose stocks that he or she believes will go higher, and also choose stocks they believe will go lower and short them, potentially profiting as their prices fall.

There are extremes to long-short investing. Some managers attempt to keep volatility extremely low, while others use leverage, and those funds can be quite risky.

I encourage you to watch this video that explains the rationale to incorporate what we call “the stuff in between” to portfolios now, and why we chose the Robeco Boston Partners Long/Short Research Institutional Fund.

If, after you watch the video, you would like more detail on the mechanics of how a manager can short (or bet against) a stock. You can find more here: Shorting stocks, explained.

If you have questions about this strategy or want more information, please Contact Us.

Full Transcript

>>So interest rates are really low. They may stay low for the foreseeable future. In this kind of interest rate and investment environment, we think a strategy called long-short or hedged equity makes sense. We have it throughout virtually all of our client portfolios. Today we explain long-short and hedged equity.
>>Hi, I’m Barry Glassman, President of Glassman Wealth Services. And part of our role for clients is not only to invest their money, but to put together sophisticated strategies and explain how they work and why we have them in portfolios. Today, I want to dive into something called long-short or hedged equity that we have throughout virtually all of our client portfolios.
Now in today’s investment environment, cash is paying nothing. Interest rates on bonds are really low and they have inherent interest rate risk. If interest rates go up, we’ll lose money. And at the other end of the risk spectrums, stocks are — they have stock market risk. So I want to show you this strategy that I think has a better risk/ reward scenario than both of those extremes. And let me show you how it works.
So if you think about an investment advisor or mutual fund manager and think about the process that they go through, they look at the universe of stocks and every single one of them puts some sort of filter on them unless they’re an index fund, and they own the entire stock market. They put some kind of filter. Maybe it’s based on valuation, on management, on competitiveness. Everyone has some kind of filter, and they narrow down the universe of thousands of stocks down to anywhere from 40 to 100.
In essence, we’re used to this. We know how this works. If these stocks do well, we make money. If they come down in value, we lose money. What most people don’t know is these are called long holdings. We profit from the price increase. And if you’re a mutual fund or portfolio manager who only owns this kind of strategy, you only have 2 decisions to make. Do I own other stocks or do I build up cash? That’s it.
And at Glassman Wealth, we’ve asked our portfolio managers not to build up cash. We didn’t ask them to time the markets. We want them to stay fully invested. So while they’re going through this process, they happen to bump into stocks that are the opposite. They’re the antithesis of their filter. Maybe they’re overvalued. The price momentum’s coming down. Management is in chaos and from a competitive standpoint, they’re being bombarded from all sources. Most portfolio managers can only look at these and say well, I’m not buying them. Or, I can only imagine who’s buying them at these prices.
A long-short manager has the flexibility to actually bet against them and that’s called shorting stocks. Now, in our blog post we’ll have a link to explain how it is that they accomplish this but for this video’s purpose, just know that for long investments, we’re hoping that the price goes up in value. With short investments, we’re hoping that it comes down in value.
Well, let’s look at the long and short of it.
In a typical mutual fund where they might have 95% stocks and 5% cash, they have 95% net exposure to the overall stock market. This is what we’re used to seeing. With long-short, little nuance change. We’re 60 percent long in this example, and then this manager happens to have 40% short holdings. So the net exposure in this example is a 20% net long exposure to the overall stock market. So what do we expect from that? Well from a volatility standpoint, about 20% of the volatility of stocks.
In the risk spectrum of long-short, there are two real extremes to this. One extreme is market neutral where they match up almost exactly longs and shorts and have zero percent exposure to the overall stock market.
In this case, why would somebody want this? Maybe they look at Coke and Pepsi and they’re at completely different valuations, completely different trajectory as far as where the manager thinks they’re headed. They pair them up together and they’re just hoping that the price narrows. That the long outperforms the short, and they don’t even care if the stock market goes up or down, or the stocks go up or down in total, they just want the prices to narrow. What are they expecting from this? They’re expecting bond-like returns. Let’s say mid-single digits with no interest rate risk but zero net exposure to overall stocks.
At the other extreme, is what hedge funds can do? Hedge funds can go 100% long and 100% exposure to the market. And then the next day, they can go 100% short and bet completely against the market. They can also go 400% long or have 400% short exposure, and so forth. That can work extraordinarily well and people can make billions, but it can also implode very easily if they guess wrong.
So the strategy that we employ and have throughout just about all client portfolios is a no-load mutual fund called the Robeco Boston Partners Long-Short Research Fund. And they typically have 40% to 60% net exposure to the market. We’d actually worry if they had zero exposure or negative exposure, or they went 80% or 90% long.
And what do we expect from this? We’re looking for something like high single-digit returns, 7% to 9% over the long-term with about half the risk of stocks. With all of the investment options out there, why do we own something this complex? Well, in today’s investment environment, our clients own cash. They have some bonds. They have stocks. They’re very well diversified, but there’s very little out there that I believe can offer high single-digit returns with half or less the risk of stocks.
I think long-short equity, not all long-short equity, but this exposure of long-short equity can offer that kind of potential. If you have questions about this in your portfolio, please give us a call. We’re happy to help.

Legal disclosure: “This video is provided for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this video is to be construed as a solicitation to buy or sell a security or the rendering of personalized investment advice. All information is subject to change without notice and there can be no assurance that any of the views or opinions expressed herein will come to pass. Certain of the information contained in this video is derived from sources that Glassman Wealth Services, LLC (“GWS” or the “Firm”) believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio. A complete list of all recommendations rendered by the Firm during the last 12 months may be made available upon written request. For additional information about GWS, please consult the website of the U.S. Securities and Exchange Commission at www.adviserinfo.sec.gov. “

Barry Glassman, CFP®
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