June 2016
Equity long/short: Are your
Dennis H. Kim, CFA
Director of Wellington Alternative
Investments, US
Dennis serves as a senior resource
for Wellington Management’s Global
Relationship Group in engaging with
clients on a variety of alternatives-
related topics, including both thematic
and product-specific discussions across
the firm’s range of alternative invest-
ment strategies.
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shorts delivering alpha?
The period from the global financial crisis through 2014
was characterised by strong market performance across most asset classes, with
equity prices consistently trending up and credit spreads continuing to tighten.
Not surprisingly, long/short, risk-managed (hedged) strategies found it hard to
keep pace with their long-only counterparts in that environment.
More recently, several factors — such as uncertainty about the effectiveness
and consequences of global central bank policy and declining trend growth
in China — have contributed to a more challenging backdrop for asset prices.
Nominal return expectations have become more conservative, and expectations
for market-price volatility have meaningfully increased.
Looking forward, this environment should be more constructive for long/short
strategies, particularly relative to traditional, long-only investments. Certainly,
last year produced a fair amount of alpha generation on both the long and the
short side for better-performing long/short managers.
However, the performance dispersion across managers and strategies remains
wide and has steadily increased over the past couple of years. So is there a reli-
able way of assessing the skill of long/short managers?
There is no uniform market standard for evaluating manager skill, especially
on the short side. However, this paper provides a framework for assessing long/
short managers, which may serve as a guide for investors considering the role of
long/short strategies in a broader portfolio.
First, we believe that context is crucial. Some investors will simply look at
whether the manager has generated positive returns from the short book.
If returns are negative, their presumption is that the manager is not good
at shorting.
Key points
Assessing managers’ skill on the short side is complex and multi-dimensional and
goes far beyond simply measuring the absolute performance of the short portfolio.
We propose a framework that sets the alpha generation in the context of the role
short positions play in long/short equity portfolios, market conditions, capital
allocation to the short book and market timing, as well as the upside/downside
capture relative to an appropriate index.
We also observe that certain sectors — such as financials, information
technology and health care — inherently offer richer opportunity sets for active
long/short management.
June 2016 2 Wellington Management Funds

In our view, the analysis is far more complex. The market environment is
critical to evaluating short skill, but probably more important still is what
role the shorts are intended to play within broader portfolios.

Four roles of shorts

Perhaps the simplest example is alpha shorts, where the manager shorts
The market issuers that may be fundamentally challenged or have excessive valuations
that are not consistent with the company’s market position or future pros-
environment pects. As a result, the manager expects the market value of that company
to decline. In this case, looking at whether these alpha shorts have pro-
is critical to duced a positive contribution to the portfolio is a fair assessment of skill.
Another application is relative-value trades, where the manager may
evaluating short be long structural winners and short structural losers within a partic-
ular sector. In theory, implementing a pair trade hedges away much of
skill, but probably the sector or market risk and better isolates the stock-picking skill of
the manager.
more important Shorts are also used as dampeners of portfolio volatility — effectively,
macro/index hedges or tail-risk protection. In recent years, for example,
still is what role some of our portfolio managers have used out-of-the-money put positions
in various equity indexes, to smooth the ride and protect portfolios during
the shorts are risk-off episodes.

intended to play
In addition and more broadly, shorts allow managers to increase expo-
sure to high-conviction ideas on the long side. They have exposure in

within broader
excess of the portfolio’s market value, in order to amplify the potential
returns from the long side, but they use shorts to reduce the overall direc-
tional market exposure. In many instances, the short book will produce
portfolios. a loss. However, it should still be viewed in the context of the broader
portfolio and should be considered successful if any losses are more than
offset by the increased gain the manager is able to generate on the long
book because of the extra comfort level provided by the short exposure.
In summary, a short position’s purpose within the portfolio impacts how
we evaluate the short’s overall effectiveness.

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June 2016 3 Wellington Management Funds

Multiple layers of assessment

Shorting well is a complex skill, and we think it should therefore be eval-
uated on several levels. An illustrative example can serve to outline our
evaluation framework.
First, we can assess ability at shorting single stocks (see Figure 1), as
opposed to a broader short book including some of the macro hedges
mentioned above. In this case, we’re simply trying to understand whether
individual equity shorts have created value for the portfolio.

Figure 1
Assessment level 1: Stock picking
Do your long positions Assessing stock-shorting skill
outperform your (Individual equity positions only)
short positions? 60

Long/short spread (illustrative, %)

Up Down 40
market market

Long portfolio return +10 -5

20
Short portfolio return +5 -10

Long-short spread (%)

Long/short spread +5 +5
0

Do you generate alpha

from your short portfolio?
-20
Short alpha vs index (illustrative, %)

Up Down
market market -40

Short portfolio return +5 -10

Index return +10 -5 -60

-60 -40 -20 0 20 40 60
Short alpha vs index +5 +5 Short alpha vs index (%)

Data from 1 January 2003 – 31 December 2015 | The charts are provided as illustrative
examples only and are intended to demonstrate certain data that could be used when analysing
a manager’s shorting skill. The returns of the long and short portfolios are not intended to be
representative of any actual portfolio returns and are included for illustrative purposes only. Past
performance is not necessarily indicative of future results and characteristics of a long/short
portfolio could vary significantly.

We ask ourselves two key questions. The first — and, in our view, most
important — is whether the long positions outperform the shorts, a mea-
sure commonly referred to as the long/short spread. The table in the top
left-hand corner assesses absolute returns in up and down markets. In
this illustrative scenario, the long book generated a positive return of 10%
in an up market, while the short book generated a positive return of 5%,
giving a long/short spread of 5%. In a down market, the long portfolio
declined 5%, but the short portfolio declined 10%. Again, the long/short
spread was 5%. In both types of markets, the portfolio manager has been
able to differentiate the winners from the losers.
The second question is whether the manager generated alpha relative
to a reference index. The illustrative table in the bottom left-hand cor-
ner shows that, in an up market, the short book generated a return of 5%,
while an appropriate reference index was up 10%. We would view this as
a positive outcome, with short alpha of 5%. Similarly, in a down market
where the reference index declines 5% while the short portfolio declines
10%, it again produces positive short alpha of 5%.

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June 2016 4 Wellington Management Funds

The scatter graph on the right in Figure 1 combines the two measures.
The optimal box, shaded green in the top right-hand corner, would
include performance years when the manager has generated a positive
long/short spread and positive short alpha. Overall, the manager seems to
be exhibiting some skill.
This simple approach to evaluation ignores the manager’s ability to
choose when to allocate capital — and how much — to the short portfolio,
which we believe is essential to any thorough assessment. If a manager is
skilled at differentiating longs and shorts but consistently allocates insuf-
ficient capital to the shorts at key times, the manager’s skill at identifying
shorts will not be fully reflected in portfolio performance.
Figure 2 illustrates how these capital allocation decisions can materially
impact portfolio performance. In addition to the individual equity shorts,
this analysis also captures macro/index hedges and tail-risk protec-
tion, such as exchange-traded fund (ETF) shorts, derivatives and options
strategies. This approach provides a more holistic view of how the short
book performs.
The red dot is 2008, which was obviously a bad year for the financial sec-
tor (the reference index used in this example), with the index down 54%.
So the net result of being down 14% looks strong on a relative-value basis,
capturing less than a third of the total down side in the market. More
importantly for this analysis, partly because of the significant amount of
capital allocated to the short positions, the short book in total made a sig-
nificant positive contribution of 30%.
More broadly, Figure 2 also emphasises that, even in years when the
short contribution to return is negative, the gross portfolio return can be
significantly positive, thanks to the flexibility the short book gives manag-
ers to hold larger long positions in their highest-conviction ideas.

Figure 2
Assessment level 2: Capital allocation
Have you effectively Assessing capital allocation to
allocated capital to the short portfolio (Entire portfolio)
short portfolio at the 60
right time?

Gross portfolio return

(2008, %) 40

Long portfolio -44

contribution to return 20
Gross portfolio return (%)

Short portfolio +30

contribution to return
0
Gross portfolio return -14

Index return -54 -20

Contribution to return
includes impact of single -40

stocks, indexes, ETFs,

CDS and other derivative
instruments -60
-60 -40 -20 0 20 40 60
Short contribution-to-return (%)

Data from 1 January 2003 – 31 December 2015 | The charts are provided as illustrative examples
only and are intended to demonstrate certain data that could be used when analysing a manager’s
shorting skill. Past performance is not necessarily indicative of future results and characteristics of
a long/short portfolio could vary significantly.

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June 2016 5 Wellington Management Funds

So, in addition to differentiating the winners from the losers, it’s impor-
tant that the managers are effective at allocating capital to the short side
at the most relevant points in time and at choosing the appropriate mix of
individual shorts and market hedges within the short portfolio.
Another approach, which we believe is helpful for thinking more method-
ically about evaluating manager skill, is represented in Figure 3, where
we disaggregate the portfolio’s returns into three core pieces: market tail-
wind; market timing; and stock picking (of which short skill clearly is an
important driver).

Figure 3
Assessment level 3: Market tailwind and timing
Market tailwind (beta) 1 yr (%) Disaggregating portfolio returns
(Average monthly gross returns)
Average monthly index return -0.16
1.5
Portfolio net exposure range 66 – 99 Market tailwind

Return from beta -0.15 Market timing

Stock picking

Market timing (varying net 1.0

exposure) 1 yr (%)
Average net exposure 85

Portfolio net exposure range 66 – 99

0.5
Return from varying -0.09
net exposure

Market tailwind (beta) 0.0

+ Market timing (varying net exposure)

+ Stock picking

= Total return -0.5

1 year 3 years 5 years 10 years Since
inception

Data from 1 January 2003 – 31 December 2015 | The charts are provided as illustrative
examples only and are intended to demonstrate certain data that could be used when analysing
a manager’s shorting skill. Past performance is not necessarily indicative of future results and
characteristics of a long/short portfolio could vary significantly.

Long/short equity strategies use a variety of approaches to managing

net exposure. Some tend to be more net long biased; others run lower net
positions or are market neutral; and some vary net exposure based on
market conditions.
We think about the net position in two ways. First, if a portfolio is con-
sistently running net exposure of 50% of the market (for example), broad
market performance is clearly impacting portfolio performance. The top
left-hand corner shows this “market tailwind” or beta. In this case, the
portfolio is running significantly net long, and the reference index was
down pretty consistently over the year, so the positive net bias overall
detracted from performance.

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June 2016 6 Wellington Management Funds

The second way is market timing, which is the manager’s ability to gen-
erate value by tactically managing the net exposure. This can be difficult
to get right consistently, but it can be a powerful contributor to returns
if executed well. In this case, we’ve set the reference point as the aver-
age net exposure for the rolling latest 12 months and then measured the
manager’s ability to alter positioning around that average point to assess
whether there has been any value creation. For this strategy, tactically
managing net exposure also detracted marginally from return for the
most recent one-year period. Both market tailwind and market timing
contributed significantly to this strategy over the period since inception.
Clearly, the market tailwind and market timing are important compo-
nents of the success of a long/short strategy. However, consistently the
most significant contributor to return in our example was stock selection.
Even if the portfolio’s longer-term beta management and shorter-term
net-exposure management around that beta aren’t significant contribu-
tors to performance, stock selection can continue to generate value for the
entire portfolio.
The bar charts on the right in Figure 3 represent variances of those com-
ponents over different periods, from one year to since inception. Clearly,
while all three of these drivers of return have contributed to the perfor-
mance of this portfolio, stock selection has consistently generated the
most value, and we consider it the most important component to focus on
when choosing a manager as it typically is the most systematically repeat-
able over time, in our opinion.
Finally, let’s look at the overall performance of the strategy to see how
much of the upside in markets it is capturing and how much downside
protection it is providing. Figure 4 shows the strategy’s performance ver-
sus the reference index. Since inception, it has captured about 48% of the
upside in the average positive month for the index, but only about 6% of
the downside in the average negative month for the index. That kind of
spread between upside and downside capture can help produce an attrac-
tive risk and return profile over time.

Figure 4
Assessment level 4: Strategy upside/downside capture
Upside/downside capture, average monthly return (portfolio, net %) 2001 – 2015
6
Average positive Average negative
index month index month
3.9

3
1.8

0
-0.3

-3

-4.8
-6
Portfolio Index Portfolio Index

This chart is provided as an illustrative example only and is intended to demonstrate certain data
that could be used when analysing a manager’s shorting skill. Past performance is not necessarily
indicative of future results and characteristics of a long/short portfolio could vary significantly.

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June 2016 7 Wellington Management Funds

Long/short opportunities in sector-specific strategies

With sector-specific strategies, many investors ask whether they need
to have a positive beta view on the sector before making an investment.
Obviously, for a net-long portfolio, it helps to have a market tailwind; but
we would argue that it’s not critical for long/short strategies. As Figure 5
shows, the index (the MSCI Finance, in this case) has generally not gener-
ated much value for investors over the past 14 years; at times, it has barely
beaten inflation. In addition, it has been very volatile. By contrast, a long/
short strategy, which allows managers to generate value in the three ways
we have discussed, has produced a strong risk-adjusted return, with a
Sharpe ratio above 1.0 and only a fraction of the downside.

Figure 5
The benefits of long/short sector investing
Long/short portfolio vs sector index

Key statistics Portfolio Index

Annualised net return 11.9 1.8
Cumulative net return 439.5 30.5
Annualised standard deviation (%) 9 21
Sharpe ratio 1.1 0.0
Max drawdown (%) -21 -73
Portfolio beta vs index – 0.2
Portfolio up capture ratio – 0.48
Portfolio down capture ratio – 0.06

This table is provided as an illustrative example only and is intended to demonstrate certain
data that could be used when analysing a manager’s shorting skill. Past performance is not
necessarily indicative of future results and characteristics of a long/short portfolio could vary
significantly.

We think certain sectors lend themselves well to long/short, including

financial services, information technology and health care. All these sec-
tors tend to have a wide dispersion of performance between stocks (with
differentiated winners and losers) and reasonably high volatility. They
may also undergo long periods of lacklustre beta. These factors can allow
active long/short managers to unlock the return potential of these sectors
in a way that may be more difficult for long-only managers. As always,
manager selection is critical. 

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