A new paradigm for equity long-short alpha?

The last two years have been very difficult for global equity long-short alpha strategies, compared to the previous decade. Dramatic shifts in the macroeconomic environment have challenged long-held microeconomic assumptions and global equity long-short strategies have struggled.

Inflation has moved up to levels not seen since the 1980s and central banks have aggressively tightened monetary policy. As a result, higher valued companies have been disproportionately impacted as they are typically the higher growth or higher quality companies that equity investors are positively biased towards. A sustained and persistent increase in interest rate volatility has also led to higher factor volatility, influencing equity prices more frequently and heavily, which is not something fundamental equity long-short managers are accustomed to.

'Chart 1' shows data from Morgan Stanley Prime Brokerage, illustrating the average global alpha generated by their hedge fund client base during the 2010-2020 period compared to 2021 and 2022 YTD.

Source: Morgan Stanley Prime Brokerage, data as of 30 September 2022.

Cyclically, we could see some mean reversion from here given the scope for rate volatility to move lower from an elevated starting point. Historically, this has been positive for relative value long-short equity investing.

'Chart 2' shows the MOVE Index – which looks at near-term implied volatility across different US Treasury maturities – reached levels during October last seen during the global financial crisis of 2007-2008.

Source: ICE BofAML MOVE Index, to 10 November 2022

Many inflation data points have surprised to the upside this year, leading the US Federal Reserve to hike interest rates aggressively and rate volatility to spike. However, regardless of your view on inflation and central bank policy from here, it is difficult to see rate volatility staying this elevated in 2023.

Something has changed structurally, though. Years of accommodative central bank policy and supportive demographics from emerging markets have led to a structurally low interest rate and inflation environment. This helped support a backdrop of backing high growth companies regardless of valuation, and arguably diluted the skillset of focusing on relative valuation and capital structure differences.

We believe that this potential new paradigm favors teams with: experience through past cycles; a focus on bottom-up fundamental analysis combined with a strong relative value framework; and collaboration between teams across asset classes. There are also areas with structural alpha tailwinds relating to regulatory, policy, geopolitical and thematic change, which relate less to variables like interest rates and inflation. These are areas like China, private credit, event-driven situations, energy transition and trade finance.

In China we see four supportive factors operating together – high retail participation, low institutional investor interest, low research analyst coverage relative to other major markets, and improving liquidity for institutional investors. We believe this will create a conducive environment for long-short investing regardless of the market environment.

Equity long-short alpha has indeed been more challenging of late, and will require capabilities that not all investors are equipped with. Yet there are cyclical and structural reasons for investors to be more constructive on the opportunity set as we move into 2023 and beyond.