Why it’s time to enhance portfolios with long-short strategies

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This is a sponsored article from Columbia Threadneedle Investments.

After an exceptional period in the history of financial markets, our analysis suggests that equity returns are likely to be more modest in the next 10 years and volatility higher. Central banks from the US to the UK and Europe are ending the era of quantitative easing that followed the financial crisis. As they do so, equities are beginning to perform in line with their fundamentals again and stock correlation has broken down, creating an ideal environment for stock pickers.

The US has led the way with seven interest rate hikes since late 2015 and quickening balance sheet shrinkage at its central bank. This means that the cost of capital for businesses is rising, fostering a tighter borrowing environment where businesses with high leverage and poor business models will not find generating returns so easy.

Such a return to normality presents rich pickings for long-short equity strategies. With their focus on fundamental stock picking, they benefit as companies’ fortunes diverge. At the same time, they can navigate the market volatility that tighter financial liquidity may trigger, through short selling and altering gross exposure to equities.

In the last decade when low-cost beta strategies in the form of ETFs have proliferated, long-short strategies have continued to offer investors a highly effective way to source alpha. In particular, investors gain the flexibility to dial up or down beta and alpha exposure in their client portfolios, depending on the market outlook and clients’ risk appetite.

At Columbia Threadneedle, we take a unique approach to long-short investing, managing two distinctive strategies – Extended Alpha and Absolute Alpha – with the same long-term investment philosophy and similar portfolios. The difference is that they are designed to provide a choice of either equity-type (extended) or absolute, cash-plus returns.

Unique combination of strategies
Taken together, the two strategies offer a unique combination that enriches the wealth manager’s opportunity set, particularly in current market conditions.

At the heart of the portfolio managers’ approach is a quest to identify US companies with the potential to achieve total operating earnings yields above 15%, where the compounding effect allows operating earnings to double every five years. As the top 10 long holdings make up more than half the portfolio, this concentrated approach can generate outsized gains.

The majority of the portfolio’s short book comprises relative pair trades, which are expected to underperform the corresponding long holdings in the same sector. The portfolio also has structural shorts and catalyst-driven shorts, where events such as disappointing earnings, competitive product launches, etc. are expected to trigger price falls.

Our focus on total operating earnings yield allows the fundamental research to be agnostic to value or growth styles. The top-performing stocks in the last five years have been a combination of both value (Berkshire Hathaway, Microsoft, Apple, JP Morgan) and growth (Google, Amazon, Visa, Lam Research).1

Absolute Alpha Extended Alpha
Approach Fundamental long/short Fundamental long/short
Portfolio managers Same team, 25+ years’ experience Same team, 25+ years’ experience
Number of stocks 40 long / 40 short 40 long / 40 short
Daily liquidity Yes Yes
Objective Capital preservation with low S&P 500 beta, and security selection driving total return Embedded S&P 500 beta, with dual sources of alpha from high-conviction extended long position stock picking, as well as shorts
Benchmark Cash (3-month Libor) S&P 500

(Source: Columbia Threadneedle Investments, 20.8.18)

But while the two strategies share the same approach, their differentes in objectives are reflected in risk appetite and benchmark. This leads to varying net market exposures: Extended Alpha has a range of 90% to 110% and Absolute Alpha -10% to +50%.

Fine tuning market exposure
The scarcity and appeal of high-alpha equity portfolios have increased with the rise of passive funds, making a strong case for long-short equity with high -alpha potential. Extended Alpha and Absolute Alpha strategies allow for a full range of market exposures, and can be used separately or combined to fine-tune client portfolios.

1 For illustrative purposes only. The mention of stocks is not a recommendation to deal.

Important Information:

For Professional and/or Qualified Investors only (not to be used with or passed on to retail clients).This material in this publication is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments to anyone in any jurisdiction in which such offer is not authorised, or to provide investment advice or services. Offerings may be made only on the basis of the information disclosed in the relevant offering documents and the terms and conditions under the relevant application forms. Investment involves risk. You are advised to exercise caution in relation to this material. Please refer to the relevant offering documents for details and the risk factors. Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this publication have been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. The mention of any specific shares or bonds should not be taken as a recommendation to deal. This document includes forward-looking statements, including projections of future economic and financial conditions. None of Columbia Threadneedle Investments, its directors, officers or employees make any representation, warranty, guarantee, or other assurance that any of these forward-looking statements will prove to be accurate. This document may not be reproduced in any form or passed on to any third party in whole or in parts without the express written permission of Columbia Threadneedle Investments. This document is not investment, legal, tax, or accounting advice. Investors should consult with their own professional advisors for advice on any investment, legal, tax, or accounting issues relating an investment with Columbia Threadneedle Investments. This document and its contents have not been reviewed by any regulatory authority.Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W.

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

This is a sponsored article from Columbia Threadneedle Investments.

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