The long and short of absolute style

Rule changes and new tools challenge managers of absolute return funds, but with conviction about an established style and transparency over risk, the strong strategist will stand out.

Behavioural finance theorises that being contrarian when the world is either overly negative or overly positive is, on average, an outperforming strategy. Simple value investing is one of the areas that demonstrate this most clearly. Although value investors may underperform when the market has momentum the rewards they reap by buying when everyone else is heading for the exit are significant.

The world will work its way through the various systemic problems it faces and the best companies will prosper. Those that have taken advantage of cheap debt and distress will be well placed to take market share. Those that continue to increase efficiency and margins will fully participate when top line earnings start to grow. As systemic risks subside those companies that have been irrationally discounted the most will offer fantastic value and rewards for investors. An environment where investors have an idea of prospects will also be one where companies that can provide a good return for their shareholders are rewarded with higher share prices.

An examination of the record flows into bond funds and index trackers suggests that investors are more focused on asset allocation than stockpicking. Government bond yields are unlikely to stay as low as they are today and investors will eventually want to allocate to good companies more than bad ones. The agnostic approach to quality and value implied by tracker funds will not persist. At the very least an investor’s hunt for yield will draw them to the higher dividend paying stocks. These will outperform and lower or non-dividend paying stocks will suffer. Inevitably this is the beginning of a whole new cycle when value stocks will outperform, as will active managers.

Long-short managers are unconstrained equity investors. Weak managers bend their philosophy when it appears not to work. Experienced managers will recognise when they are trying to ’push water uphill’ and reduce their risk. They will also have the strength to keep applying their principles to take advantage when they are rewarded.

Helping investors understand what to expect from a fund is as important in the long-short world as it is in the long-only world. It may be that the industry should define long-short funds simply as flexible equity funds rather than absolute return funds. If it helps clarify the expected returns then this can only be a good thing. It would not make the investment case less compelling.

The bulk of long-short funds that were chastised for not having performed well in 2008 lost 10-20% when long-only funds lost more than 40%. Compounding from a year with a 20% fall rather than a 40% drop means that many of these long-short funds are already close to their all-time highs. Those unfortunate enough to have been allocated to long-only funds remain doggedly under water – many being still down over 20% from their peaks.