While most long-only manag- ers are fully invested, save for frictional cash, long/
short managers vary greatly in both their
net exposures and their betas (which can
be substantially dissimilar from what
the net exposure may imply, because of
differing beta profiles for the long and
short books). Further, many long/short
managers vary their net exposures over
time. In some cases, substantially so.
Done well, that can be a meaningful
source of alpha. But let’s be honest, it’s a
form of market timing — or at least introduces the same risk — even if it’s a result
of the ever-changing opportunity sets
for the long and short books. Generating
alpha on the long book is hard. Generating
alpha on the short book is harder. And
generating alpha with any consistency by
varying net exposure might be the most
difficult thing a manager can do.
We were curious how many manag-
ers vary their net exposure in a material
way over time, and how funds tend to
be positioned at this stage of the cycle.
We looked at holdings-level data (from
Morningstar) for long/short equity
funds over the past 10 years, inclusive of
both existing and obsolete funds. While
we caution that the data set is spotty at
times, here’s what we found:
• Average net exposure across funds
over the 10-year period has been
60%, (median of 61%)
• Average minimum net exposure by
fund has been 32% (median of 34%)
• Average maximum net exposure by
fund has been 88% (median of 91%)
• Range between the minimum and
maximum exposures by fund over
time went from 1% to 253%
That last point gets to the heart of the
question, just how active are managers
in moving their net exposures around?
The answer: quite active.
We segmented funds according to their
min-max ranges in 20% increments. For
example, if Fund X had a minimum net
exposure of 47%, and a maximum exposure of 77%, it would go into the bin covering a 20-40% range. Here are the results:
No. of Funds Max–Min Range
35 In excess of 80%
Surprisingly, the data indicates that
funds that maintain a relatively static net
exposure are the exception, not the rule.
And this makes the life of asset allocators
difficult. How do you know what your
risk level is going to be when markets
take a turn if the net exposure can float
between 62% and 120%, for example?
Perhaps that is why allocations to long/
short funds tend to be small (often too
small to make any discernable impact),
and why investors frequently use multiple
managers. While these cautious behaviors
may be understandable, investors should
prefer managers that generate alpha con-
sistently on both the long and short books,
while maintaining a fairly tight net expo-
sure. This allows for fewer and larger
allocations (and less ongoing due dili-
gence costs). In this way they can make a
better assessment of what the risk profile
of a fund will be over various points in the
market cycle, eliminating the guesswork
that can make for sleepless nights.
Lastly, for those wondering if manag-
ers are positioning portfolios differently
because of concerns about valuation,
etc., the evidence is mixed. The average
net exposure across all existing funds
currently is around 64% — above the
long-term average of 60%. This suggests
that managers may be taking more risk
to keep up with long-only indices.
But the maximum exposure of 104% is
well below the average maximum expo-
sure of 135%, implying that managers
who can employ leverage are less excited
about doing so in this environment.
Regardless of how managers as a
group are acting, investors in long/
short funds should know exactly how
much equity exposure they are taking
to judge their true equity risk across
their diversified portfolios.
Cliff Stanton, CFA, is Co-Chief Investment
Officer of 361 Capital.
By Cliff Stanton
How Exposed is Your Long/Short Manager?
If you don’t know how much market exposure your long/short manager is
taking to generate returns, it’s time to take a closer look.