Stock Markets Too Volatile? Get the Long and Short of It
Point of View With Raffaele Savi, Kevin Franklin and Paul Ebner
- Investors remain fearful of market volatility and hold fewer stocks than they should, given the need for meaningful growth and returns.
- A major reason for this reluctance is the exposure portfolios have to stock market volatility; reducing that risk can enhance the ownership experience for stock investors.
- A solution is to employ an investment strategy that seeks to take advantage of global stock market inefficiencies to profit in both up and down markets.
- A professionally managed stock portfolio that employs an active strategy to manage risks can help reduce volatility and enhance returns.
Why have investors moved out of stocks?
It's not hard to understand why investors remain cautious and underweight equities given the extreme volatility caused by the global credit crisis and subsequent European debt crisis. The chart [below] shows the significant maximum losses that investors endured from the global credit crisis, which led to a significant flow out of equities into bonds. It seems pretty clear that despite the recent stock market rally, investors are still looking for a better, less volatile, solution for the stock component of their portfolio.
Is there a better way to manage stock market volatility?
Many investors have been asking that question. Part of the problem has been that the stock portfolio strategies currently available are not built to manage market volatility. In fact, most equity funds are set up in a way that the investor ends up being exposed to all of the ups and downs of the market, with little to buffer the extremes. In addition, since 1997, equity sectors have moved together in bull or bear markets (see chart below), so what was thought to be diversity really was not. So what investors need is a stock portfolio that behaves differently than the broader market by taking a different approach. As a solution, we believe investors should consider a long/short equity strategy to help reduce volatility.
What do you mean by a long/short strategy?
A long/short equity investment strategy means that we buy (long) stocks that we believe will appreciate in price, and at the same time sell (short) borrowed stocks we believe will go down in price. The intention of shorting is to buy the same stocks back at a future date for a lower price, profiting from the difference. Whether markets are rising or falling, this kind of portfolio strategy is designed to profit from stocks that go up and down, providing results that are different from traditional US and international equity markets.
A dedicated long/short approach is an effective strategy to try to take advantage of the inefficiencies of global stock markets. By matching both long and short equity positions, we have the ability to dial up or down our exposure to market risk from 0% ("market neutral") up to 40% exposure. This means we seek to deliver excess returns out of our investments, while minimizing our exposure to broader market movements, and the related volatility. Investors should note that long/short strategies present the possibility of significant or total losses, and that the long and short strategies may not perform, potentially adding to volatility and losses.
What are the benefits of this approach?
A key benefit of a dedicated long/short approach is the increased number of opportunities available to us. In so doing, we are able to pinpoint precisely the companies we believe will perform well, even if we don't favor the industry they participate in. It's that herd mentality that we're working to defend against. We believe this kind of strategy can offer portfolio growth with less volatility.
Conventional wisdom is that developed stock markets efficiently and quickly price stocks based on fundamentals. The reality is that pricing inefficiencies occur all the time.
You suggest developed stock markets are inefficient. How?
Inefficiencies exist in every market. Conventional wisdom is that developed stock markets efficiently and quickly price stocks based on fundamentals. The reality is that pricing inefficiencies occur all the time; they just don't stay around for very long in developed stock markets. But opportunities exist--frequently when the connections aren't obvious or direct. So investors must find ways to enhance their understanding of the fundamentals and relationships surrounding companies to uncover those opportunities and stay ahead. The way we look at it is when a balloon is squeezed smaller at one end, it expands somewhere else. We see that in stock markets: when one inefficiency is eliminated, somewhere else a new opportunity arises.
Ultimately, what we're trying to do is capture the ripple after a stone drops in the water. Although we may not be able to predict where the stone drops, we can forecast how we think the ripples will play out.
What advantages do you have to capture these opportunities?
We believe information is our advantage: specifically our tools for accessing it, consuming it and analyzing it. That leads to better investing. To take advantage of the vast amount of publicly available information available, we believe a scientific approach is necessary to process it all and make sound trading decisions. The benefits of our scientific approach include being able to bring a technological edge as well as continuous evolution to our investment process.
For example, our access to information relies on cutting edge infrastructure to compile vast amounts of obvious and less-obvious sources of publicly available information. In fact, we consume a massive amount of data from more than 25 countries, with a storage capacity 4 times the Library of Congress and 8 times the size of Wikipedia. We take that vast quantity of publicly available information and filter and identify relevant pieces.
The numbers are big--new information is mapped to more than 1.7 million entities and 100 million connections--but it is how we synthesize it that is a key advantage. We analyze and interpret this vast array of data to provide daily rankings and updates on the over-2,500 companies we follow, allowing us to make high conviction investment decisions.
Can you give us an example?
One example is a case in which we tried to take advantage of the reviving housing market. (See example 1) We were interested in a less-obvious company that could present a stock buying opportunity. In this case, we relied on a map of relationships we built to understand the housing industry. Our mapping system led us to the less-obvious opportunity, but one that is central to a housing rebound: a company that produces titanium dioxide. Housing? Yes--titanium dioxide is primarily used to improve the whiteness of paint.
Can you provide another example?
Another example is when a for-profit education company was mentioned negatively in a Congressional hearing and US GAO report. (See example 2) Immediately the stock dropped. Few investors could take advantage of that surprise. But we believed there would be other connections that might take longer to be uncovered. We systematically uncovered the less-obvious education industry connection in a software company that sold its online content delivery system to several major for-profit firms, resulting in a successful short-sale opportunity that developed over a period of weeks following the initial news.
If inefficiencies disappear, how do you find new opportunities?
Evolution is central to our process. We maintain our edge by continuously evolving our investment research strategy. Because finding the less-obvious investment opportunity requires resources and skill, we are constantly investing in our technology, expertise and people to maintain our competitive advantage.
We continually are looking for more and better public information about companies, ways of knowing it sooner and improving our understanding of that information. Indeed, over the course of 16 years, our team has changed and evolved the inventory of hundreds of signals and investment classifications to stay ahead of market changes. For example, our ability to consume research reports, conference calls and filings has gone through three generations of improvements.
Can you describe your team's investment process?
The Scientific Active Equity team has managed long/short portfolios since 1996. We have team members in Asia, Europe, Australia and the US so the sun never sets on our ability to monitor and trade markets. Our investment process is built around this flexible global team and based upon a systematic application of our research based on three buckets: earnings quality, sentiment and relative valuation. Combining these factors offers us a comprehensive view of how likely it is that a given stock is going to outperform (or underperform) its peers over the next three to 12 months.
How should investors incorporate this strategy into a portfolio?
We believe this strategy is a great building block for meaningful diversity in a broader portfolio of stock funds, particularly in a tax-efficient account. The portfolio illustration to the left shows how this building block can be combined in a broader equity and fixed income portfolio. By incorporating a long/short strategy into a traditional equity portfolio, investors can help reduce volatility and enhance returns in their overall equity portfolio.
For investors looking to add more growth potential:
- Increases exposure to equity-like returns, but with low volatility
- Low correlation creates a nice complement to traditional equities
For investors under-allocated to international equities:
- Increases exposure to global equities, but with less exposure to global market risk
- Low correlation complements US equity holdings
Investors preparing for retirement:
- The higher potential returns of equities than what is currently offered by investing in bonds can enhance a retirement portfolio
- Increases exposure to the growth potential of equities, but with lower volatility
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Investment involves risks. Stock values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Long/short investing entails special risks. Short sales in securities that increase in value can cause a loss of principal. Any loss on short positions may or may not be offset by investing short sale proceeds in other investments. Long/short strategies present the possibility of significant or total losses, and that the long and short strategies may not perform, potentially adding to volatility and losses. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility.
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