Alternatives: What are Directional Strategies?
Directional strategies are more straightforward compared to other complex alternative investment strategies. Essentially, they enable fund managers to profit from stock movements, whether up or down. These strategies mirror those of traditional stock-picking funds but include short selling. Common directional strategies include long/short and short bias, which depend on the portfolio manager’s skill in selecting stocks that will outperform or, in the case of short selling, underperform the market.
Equity Long/Short Funds: A Blend of Long and Short Positions
Equity long/short funds combine long positions (buying stocks) and short positions (selling borrowed stocks) to potentially outperform market indices. For instance, a 130/30 fund typically holds 130% long and 30% short positions, aiming for superior stock selection over market returns. This approach aims to replicate the market’s “beta” while surpassing index performance through stock selection. By predicting the best and worst-performing stocks, the combination of short exposure and additional long leverage from short positions can enhance outperformance beyond a simple long-only strategy while maintaining comparable risk levels.
Short Bias Funds: Navigating Market Conditions
Short bias funds operate with a net short market exposure, adjusting positions based on current market conditions. These funds perform well in down markets, with managers increasing shorts in bear markets and decreasing them in bull markets. However, as equities generally rise over time, short bias funds face challenges generating positive returns in most market conditions. Their strength during falling markets makes them an attractive hedge against equity risk.
Challenges in Achieving Enhanced Returns
While the idea of achieving enhanced returns through superior long and short stock selection is appealing, the reality often falls short. Empirical research shows that managers consistently outperforming an index through stock selection are rare, and those who do often see their excess returns eroded by fees. Excessive trading and high fees create additional expenses, which seldom compensate for gains from security selection. Short bias funds are expected to lose money over the long term, challenging their role as a portfolio hedge compared to safer assets like fixed income.
For anyone with questions, contact Empirical Wealth Management. We are here to guide you through your investment options and help you achieve your financial goals.
