Rethinking growth and where long/short directional strategies fit in

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:

• There is broadly positive sentiment toward long/short equity strategies, given their performance in 2020 — the best in over a decade, against a challenging market backdrop.²
• There is appetite for raising allocations. Data shows that target allocations for long/short equity strategies increased over the past year with an additional 40% of allocators surveyed planning to increase allocations in 2021.
• There is also increased appetite for managers who invest across public and private markets. I think this is an acknowledgment of the growing importance of analyzing the entire competitive ecosystem in a sector or industry. It also recognizes shifting market dynamics, where companies are generally staying private longer and going public at a larger size.

An alternatives evaluation framework

In my alternatives evaluation framework, my “best fit” criteria for long/short directional strategies include:

• Focusing on areas of structural change with an attractive theme that may play out over multiple years 
• Leaning into areas with high dispersion
• Thinking about how particular strategies may help to recalibrate structural underweights and amplify themes when looking across an overall portfolio

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.

Focusing the framework on financials

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.

FIGURE 1

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.

The public/private equity market evolution

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.