BBH s Approach to Long/Short Equity Investing

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1 Investing BBH s Approach to Long/Short Equity Investing Authors Brian Nelson, CFA Investment Analyst Thomas Martin, CFA Investment Strategy Analyst In order to create and sustain a successful investment program for our clients across multiple asset classes, it is necessary to have a deeply-rooted investment philosophy, a rigorous investment process supported by a set of manager selection and asset allocation criteria that flow logically from this philosophy and the right team in place to identify and select our investment partners. Our Q InvestorView article, BBH s Approach to Manager Selection, provides a detailed overview of our approach to allocating capital, our stringent set of criteria used in evaluating managers and our long-term objectives for our investment program. This piece serves as a solid backdrop to our approach to long/short investing. We also believe it is critical to develop a well defined framework for investing in specific categories like long/short equity, and the investment team responsible for allocating our clients capital has endeavored to do this across other categories in the past. We hope that clearly communicating this framework and our approach to the long/short space will provide useful context about this complex area of the market, as well as our commitment to maintaining the same stringent standards we have for our more traditional managers. What Is Long/Short Equity? Long/short equity is the oldest, most prevalent alternative portfolio management strategy. The concept dates back to 1949, when Alfred Winslow Jones established the world s first hedge fund. The most basic definition of a long/short equity hedge fund is an investing strategy, used primarily by limited partnerships, that involves taking long positions in stocks that are expected to increase in value and short positions in those that are expected to decrease in value. Taking a long position in a stock simply means buying it if the stock increases in value, the buyer will make money. On the other hand, taking a short position in a stock involves borrowing a stock one doesn t own (usually from his or her broker), selling it, then hoping it declines in value, at which time one can buy it back at a lower price than he or she sold it for and subsequently return the borrowed shares. The goal of any equity long/ short strategy is to minimize market exposure, generate alpha (risk-adjusted return over an applicable benchmark) on both the long and short side 1, protect capital during large market drawdowns due to the lower exposure and compound capital at attractive absolute rates of return over market cycles. 1 Brown Brothers Harriman Quarterly Investment Journal

2 InvestorView The Long/Short Landscape Today In the first quarter of 2015, total hedge fund assets set a new record, surging to $2.94 trillion. For some perspective on the growth in the asset class, this total was a modest $30 billion in When isolating the equity hedged (long/short) space, overall assets have reached $820 billion today and represent the largest component of total hedge fund capital. 2 Based on the exponential growth of the market in terms of assets, number of managers and overall popularity, one can deduce that the space is much more competitive now than it was 25 years ago. Many knowledgeable participants in the long/short investing community would agree, with some even acknowledging that the growth in assets and talent has resulted in an overcapitalized market. This imbalance has led to significant challenges, most notably too many managers chasing too few ideas. As a result, there has been more crowding of names, particularly on the short side, leading to more correlated returns across managers, substandard returns relative to the past and inevitably overlapping trades eroding portfolio diversification benefits. Performance Dispersion - U.S. Long/Short vs. Long-Only Funds 25th - 75th Dispersion 16% 14% 12% 10% 8% 6% 4% 2% 0% 13.51% 6.50% 9.88% 6.81% 3.97% 3.58% 3.66% 2.92% 1-year Return 3-year Return 5-year Return 10-year Return U.S. Long-only Sources: Neuberger Berman, evestment U.S. Long/Short While the growth in the number of long/short managers has created real challenges for effectively executing a long/short strategy, it also has resulted in a wider talent gap between the exceptional manager and the average manager. In the case of long/short equity hedge funds, the average manager has underperformed comparable traditional asset classes during the 10-year period ending May 31, Over that period on an annualized basis, the HFRI Equity Hedge Index 3 returned 5.20% versus 8.12% for the S&P 500. Furthermore, the last year in which the HFRI Index beat the S&P was in 2008, which was a year that can be taken with some ambivalence: While the index outperformed the S&P by almost 10 percentage points, the average hedged strategy still lost 27% that year. 4 However, the dispersion of active management returns in long/short is substantial, as illustrated in the previous chart 5, and top-quartile full-cycle results are compelling. Therefore, long/short selection represents not only a risk but also an opportunity one that highlights the potential value exceptional managers can bring to our portfolios. What Are the Attractive Characteristics of Long/ Short Equity? We believe many of the best investors in the world have chosen to manage capital in long/short hedge funds, and it is primarily the skill of these managers that attracts us to the long/short space. We understand the desire of a talented investor to manage capital in a long/short structure because of the objective to protect capital on the downside in order to compound capital at attractive equity-like rates of return over the long term. We believe this aligns with our core principle of protecting capital first, growing it second. Long/short strategies have the ability to use various hedging strategies to reduce market exposure (single name shorts, options and market hedges, for example). In a fairly valued market like the one we face today, we believe our clients will benefit from more downside protected strategies such as long/short. In sum, our goal with respect to long/ short is quite simple: we are seeking to partner with highly experienced, exceptional stock pickers that have proven risk management capabilities and can generate equity-like returns (after taxes and after fees) over a full cycle while taking on less market risk. If executed correctly, a long/short investment enables us to maintain our equity positions in a wider range of market environments. Further, it is no secret that long/short funds have lagged the market since 2009, and have received a fair amount of negative press for it. Considering that, a key objective of long/shorts is to manage risk (as defined by drawdown protection and the reduction of market exposure), so it is not surprising that they have underperformed the market. However, as noted, top quartile long/shorts have historically outperformed market indices over a full cycle, so having the appropriate long-term lens is necessary to evaluate managers investment merits correctly. What Are the Challenges to Investing with Long/ Short Managers? There are two main challenges to partnering with a long/short manager: the difficult nature of shorting and the drag on returns from taxes and fees incurred by most long/short strategies. The Difficult Nature of Short Investing: Superficially, shorting sounds quite easy to do. Bet against a lousy company or overvalued stock, watch the stock price fall and make a profit. On the contrary, there is no shortage of challenges when it comes Brown Brothers Harriman Quarterly Investment Journal 2

3 to single name shorting. The practice is simply very hard to do well consistently, and has become more challenging over time as more capital has entered the shorting arena. A few specific challenges to shorting include risk-return asymmetry and complexities in borrowing. In terms of asymmetry, potential gains on a short position are mathematically limited to 100% and potential losses are limitless, whereas with longs, the potential upside is limitless and potential downside limited to 100%. In addition, there is asymmetry in terms of position sizes when an investor makes a mistake on the short side, the position grows and makes up a larger percentage of the portfolio, but when there is a mistake on the long side, the position size decreases. Another challenge relates to borrowing. When a long/short fund borrows a stock and sells it short, the fund provides the cash proceeds (plus a little extra) as collateral to the lender. The lender typically invests this cash and generates a return, and a portion of it is shared with the hedge fund. This short rebate is typically tied to the federal funds rate. With short-term interest rates so low, the rebates managers can earn on their short cash is extremely low, which make shares more expensive to borrow. 6 While part of this negative carry issue is a temporary phenomenon due to the low interest rate environment, the increased demand for borrowing shares and the crowding of shorts due to the overall growth in the long/ short space has proven to be more permanent. Additionally, a short investor can lose the terms of his or her borrow, meaning the counterparty can change the terms of borrowing during the manager s hold period. Since crowded shorts are more susceptible to squeezes 7, managers in these positions are forced to buy-in their shares if the loans on shares are called back. This tends to occur at the most inopportune time. Shorting today is both more competitive and expensive than it has been in the past. Further, shorting is an incredibly difficult process due to broad market forces 8, 9, as well as the highly technical nature of shorts. As successful hedge funds grow larger and larger, it becomes increasingly difficult for them to take large short positions in a security. Thus capacity constraints are an important consideration when partnering with a manager, as growing too large makes it challenging for managers to repeat past successes. Taxes and Fees: We are always conscious of and focused on after-tax and after-fee returns. For taxable investors, strong pre-tax returns are nice to see, but it s the money you take home after taxes that truly matters. The taxable nature of the gains is a key criterion as in other asset classes, but we pay particularly close attention to this dynamic with hedge funds because of how prevalent it is to find managers with high rates of turnover. A high turnover rate typically translates to high trading activity, a preponderance of short-term profits and consequentially higher tax rates on those gains. Generally speaking, the long/ short universe is dominated by shorter-term oriented investing strategies with the average long investment having three- to 12-month time horizons, and short investments having oneto three-month time horizons. Compounding this short-term orientation problem is the fact that it is industry standard for hedge fund managers to be compensated on pre-tax returns, which can act as an incentive to make decisions that may be suboptimal for taxable investors. Lastly, a short investment pays the short-term capital gains tax on profits, regardless of how long the position is held. We are always conscious of and focused on after-tax and after-fee returns. For taxable investors, strong pre-tax returns are nice to see, but it s the money you take home after taxes that truly matters. More often than not, long/short investors do not justify their fees and tend to accumulate wealth off their client base irrespective of results. The required alpha to justify the standard 2 and 20 compensation structure is substantial. For example: a 20% gross-of-fee annual return from a long/short manager, on average, translates into an after-tax, after-fee return of approximately 12.2%, assuming a 2% management fee and 20% performance fee and assuming a tax efficiency ratio of 80%. 10 For this reason, the bar is set higher with any potential long/ short partnership we evaluate. In terms of our approach to fees, we look for value net of fees when examining a manager s compensation structure. But, cheaper is not always better. We do believe there is a subset of long/short managers that have proven they justify their fees. While investment talent, process and returns are the obvious difference, other areas such as operational infrastructure, risk management and transparency combined can distinguish the best from the average. Additionally, as longterm investors, one way that we are open to reducing our fees is by taking advantage of fee concessions at the cost of reduced liquidity, generally in the form of a longer initial lock-up period. 3 Brown Brothers Harriman Quarterly Investment Journal

4 InvestorView BBH s Criteria for Long/Short Investing Investing in a long/short equity manager is not a declaration that we view the entire long/short space as attractive. While high-quality fundamental research and value orientation tends to be the standard within the long/short community, the overwhelming majority of long/short equity managers fall well short of the high bar we have established with our criteria. However, after expending significant attention and resources on this space, we believe we have found and will continue to find a very small minority of high-quality actors in the long/ short population that meet our criteria and, most importantly, can enhance our client portfolios by providing diversification benefits and after-tax, after-fee returns that are competitive with our long-only managers. Based on the goals we seek to achieve with our long/short investments, we favor long-biased long/short strategies as opposed to more market-neutral or short-biased strategies. The investors that utilize this approach tend to be more philosophically aligned with our core principles. Further, there have been significant developments in the single name shorting environment over the past 15 years that make the practice extremely challenging today, and we prefer strategies that have more long than short exposure. Lastly, we believe being net long, or being exposed to the market over the long run, provides a higher likelihood of generating attractive, absolute, equity-like returns after-tax and over a full cycle versus market neutral or short-biased strategies. The specific characteristics we look for in a long/short manager include: Long track records executing long/short strategy as a portfolio manager. Long-term oriented, business-owner mentality with time horizons compatible with our own and concentrated long books with multi-year holding periods. World-class investment research process with a proven ability to generate significant alpha on the long side while protecting capital in bear markets. 11 Exceptional operational processes and infrastructure. Short book consistent with skills and prior experience, such as 100% single name shorts or a flexible approach using single name shorts, options strategies and other securities to inexpensively hedge long book and large tail risks (unlikely, catastrophic risks). Limited use of leverage. 12 Focus on downside protection and limiting drawdowns, but not at the expense of compounding capital at attractive rates over the long term. Treatment of clients as partners, which includes being transparent into what they own and why they own it. Alignment with investors, characterized by the vast majority of their net worth invested in the strategy, a willingness to cap assets at appropriate levels and a focus on one strategy. Unquestionable integrity, hunger, competitiveness, intellect, honesty and passion. While long/short strategies have historically provided attractive diversification benefits to multi-asset portfolios, we view our allocations to the long/short space as entirely dependent on finding suitable long-term investment partners, largely due to the challenges in effectively executing a long/short strategy. Our default allocation to long/short equity is zero, whereas in the long-only world, we will have a permanent allocation. Because our team has the freedom to choose traditional investment structures over hedge fund structures, we also have the ability to wait for the best alternative managers to become available to our clients, as opposed to being forced to pick among the best managers available at a particular point in time. Although the best managers often have limited access for investors, they are most open to new capital when they see very attractive investment opportunities ahead. Other opportunities to partner with exceptional long/short managers are more special situation in nature, with the primary source coming from highly experienced portfolio managers spinning out of an existing firm or simply starting a new Brown Brothers Harriman Quarterly Investment Journal 4

5 Unlike many asset allocators who succumb to the pressure to deploy assets in the alternatives category in order to look sophisticated, we are prepared to be patient, waiting for managers who share our core investment principles, who meet additional criteria we have for long/short investing and who we deem as exceptional. firm. These types of occurrences tend to be rare, and we seek to identify these situations opportunistically by leveraging our network to make sure we are in a position to get the at-bat so that we have a chance to see the pitch. When we invest with a manager that fits all of our criteria, we expect it to be a long duration partnership. Since we are looking to partner with managers that can generate equity-like returns over a full cycle, we will not be trading in and out of long/shorts based on the market environment. Instead we may modestly flex the individual position size up or down depending on the opportunity set or for rebalancing purposes. In circumstances in which we identify an inconsistent application of a manager s process and approach ( style drift ), we will admit we made a mistake and exit the partnership without hesitation. We apply the same amount of rigor to the monitoring of our managers as we do to the underwriting of prospective managers. Final Thoughts We believe that partnering with select long/short managers who have the ability to compound capital at rates competitive with our long-only investment partners on an after-tax, after-fee basis can be attractive. While the population of managers that fit our criteria is exceedingly low, we have the ability to wait for the right managers at the right time, which is a key investing advantage. Unlike many asset allocators who succumb to the pressure to deploy assets in the alternatives category in order to look sophisticated, we are prepared to be patient, waiting for managers who share our core investment principles, who meet additional criteria we have for long/short investing and who we deem as exceptional. We believe today is such a period when one needs to be more fearful than greedy. With equity valuations elevated and the potential for rising rates to wipe out fixed income gains quickly, we believe an allocation to a long/short strategy that provides a more defensive equity position is prudent. 1 Short books can serve different roles for long/short managers. They can serve as alpha centers, profit centers, hedge centers or any combination of the three. Alpha center short books: managers have the explicit goal of generating alpha on all of their shorts, meaning they are looking for the securities they short to either 1) appreciate less than the increase in the market or 2) depreciate more than the decline in the market. Profit center short books: managers have the explicit goal of making profits on all single name shorts, meaning their goal is for each security they short to decline in value and for them to generate positive absolute returns on the short book. Hedge center short books: managers have the goal of removing specific risk factors out of their long positions (e.g. market risk, currency risk, commodity risk, customer concentration risk, etc.). 2 Statistics in this section from Hedge Fund Research, Inc, April, The HFRI Equity Hedged Index is not investable. While we would never be interested in investing in the HFRI Equity Hedge Index, we are not able to in the first place. 4 This ignores the biases inherent in many hedge fund indices, including self-reporting limitations. David Swensen, the Chief Investment Officer of Yale University s endowment, noted in his 2005 book, Unconventional Success, that one of the most utilized hedge fund indices at the time included Long Term Capital Management s spectacular returns of 32.4% annualized, but failed to include the last 12 months of the fund s existence (when LTCM stopped reporting its results to the index), during which it returned -92%. Based on the HFR databases, around 15% of funds cease reporting every year, while another 15% or more take their place. 5 Source: Neuberger Berman, evestment. Long/short data reflects a peer group of U.S. equity-focused long/short managers established by Neuberger Berman based upon information voluntarily reported to Neuberger Berman. Long-only data proxied by the evestment U.S. all-cap equity universe. Performance data through December To make matters worse, the short seller must pay the dividend of the stock they are short to the entity from whom they borrowed the shares. 7 Short squeeze is a rapid increase in the price of a stock that occurs when there is a lack of supply and an excess of demand for the stock. Short squeezes result when short sellers cover their positions on a stock. 8 As one manager we spoke described When you short, you are going up against every force behind the Wall Street machine. Short sellers are fighting the world. While there aren t many great companies with great management teams, there are likely no companies with management teams that don t want to see their share price go up. Governments, regulators, brokers and the vast majority of investors are all conspiring to make the global economy perform well, and to nurse the stock market to ever higher levels. 9 When shorting, the fact that markets tend to go up on average (over the long term) works against a short, instead of working for a long. A short investor needs to be right not only about the direction, but also about the timing. As a short seller waits for his or her thesis to play out, growth in the economy and forces such as inflation are causing the position to compound against them. 10 Tax Efficiency Ratio is calculated by taking the after-tax (net of all fees) return and dividing it by the pre-tax (net of all fees) return. A 100% Tax Efficient Ratio would mean that a manager s pre-tax returns are equal to its after-tax fee returns, or 0% tax drag. Based on our research, more tax efficient long/short managers generate tax efficiency ratios in the low 80 percent range versus more tax efficient long-only managers in the low 90 percent range. Our general rule is that a long/short equity manager with a tax efficiency ratio north of 85% is above average. 11 While managers may generate alpha on both their long and short books, absolute returns or making money typically is derived solely from the long books over a full cycle. Past performance is no guarantee of future results. 12 We subscribe to the adage that leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one. When an investor uses borrowed money to purchase securities, volatility, which is typically an overstated risk, becomes of paramount concern. The use of leverage may magnify losses. While we will not partner with managers who use excessive leverage on the long side, we do believe a moderate amount of leverage employed in the context of a robust risk management framework by investors who have a laser focus on avoiding the permanent impairment of capital can be acceptable. 5 Brown Brothers Harriman Quarterly Investment Journal

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