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I feel strongly that this is an important time for asset allocators to take a fresh look at how and where they are accessing growth across their investment portfolio, given the backdrop of richly valued equities and the sharp increase we’ve seen in rates year to date. One way I see allocators rethinking growth exposure is via long/short directional strategies.
To put some data behind this observation, I’ll share three brief takeaways from a recent alternatives allocator survey1:
In my alternatives evaluation framework, my “best fit” criteria for long/short directional strategies include:
One example of an area that I believe checks these boxes is tech-enabled innovation within financials. While the term “fintech” has been around for years, I think it’s worth taking a fresh look at the industry in the face of rapidly advancing technology and a multitude of new players.
Startup companies are creating products and services to penetrate new areas of the financial system and to change the competitive landscape. Meanwhile, big data and cloud computing are rewiring the existing financial infrastructure, and consumer demand for digital assets is evolving, creating haves and have-nots among the incumbents.
With so much disruption, dislocation, and innovation in the financials space, we have seen meaningful dispersion when looking at intra-stock correlations. In fact, financials broadly rank at the top of our dispersion dashboard given the complexity of the segment. The complexity and rapid pace of change in the sector can also create inefficiencies that may yield alpha opportunity on both the long and the short side. Figure 1 highlights the dispersion we’ve seen in the sector over time.
Given the challenges the financial sector has faced, many portfolios have had a persistent underweight to it. We analyzed the eVestment global equity manager universe and found an average underweight to financials of 2.5% – 3% over the five years ended in December 2020. In other words, generalist strategies may be missing the dynamic changes in fintech and the opportunities they present.
Finally, this is one of a number of sectors in which I think the convergence between public and private markets is especially relevant. I’ll touch briefly on this convergence here, and more in a future publication.
Since the number of publicly listed US companies peaked at more than 8,000 in the late 1990s, it has steadily declined. This trend has notably impacted the composition of the public small-cap universe. In 2001, 55% of the Russell 2000 Index had a sub-US$1 billion market cap. This decreased to 44% in 2011 and just 12% in 2021. Over this period, the private ecosystem matured, with additional options to fund growth outside of an IPO resulting in companies going public later and at a larger size than in the past.3
As a result, some allocators are recalibrating how they access growth and are increasingly using hedge funds to access private markets. Crossover investors seek to apply the breadth of their public markets investing acumen to private opportunities and to identify superior growth prospects across the public and private competitive landscape. These hybrid structures may also alleviate certain governance challenges facing investors. The liquidity profile of open-ended vehicles facilitates more frequent rebalancing than closed-end funds. The evergreen structure may also reduce the due diligence load for subsequent fundraises and allows investors to be fully exposed at inception, potentially minimizing J curve drag4 in the portfolio.
1Source: Goldman Sachs, 2021. 2Source: HFRI, based on Equity Hedge Index, January 2021. Past results are not necessarily indicative of future results. Indices are unmanaged and cannot be invested in directly. 3Source: PitchBook, January 2021. 4In private equity, the J curve is a phenomenon in which a period of unfavorable returns is followed by a period of increasing returns in later years when the investments mature.
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Fintech market overview: The intersection of disruption and dispersion
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