2022 has been a depressing year so far for many investors, as global equity markets completed the worst first half of a calendar year since the 1970s. With inflation remaining stubbornly high and interest rates continuing to rise, the contagion has spread to even those asset classes that had initially done well - many commodities have reversed their previously strong upward trends in recent weeks.
With veteran investors like Terry Smith, manager of Fundsmith Equity, saying that they believe further capitulation of stock prices is yet to come and consumers feeling more pessimistic about their personal financial situation, it’s therefore perhaps not surprising that investor sentiment is lower today than it was during the first months of the pandemic*.
In such uncertain environments, absolute return funds are a possible solution, particularly those that can both ‘long’ and ‘short’ stocks. In other words, funds that can profit from both rising and falling share prices.
“The objective of an allocation to long/short equity is to pursue a consistent, positive return over time, with performance drivers that are differentiated from the underlying equity market,” explained Luke Newman, co-manager of Janus Henderson Absolute Return fund, which is on the Chelsea Selection.
“These strategies are not designed to compete with the performance of long-only funds (stocks held specifically to benefit from any rise in value over time) in a strongly rising market, but they should aim to deliver a lower level of volatility during periods of market uncertainty.”
A flexible long/short strategy should be as comfortable in bear markets as bull ones, with a short book capable of operating as a profit-centre as much as a hedging tool,” continued Luke.
“Every investment should be made with consideration of the downside risk. Such strategies, if managed correctly, should help to reduce the risk to capital during initial periods of macro uncertainty, and then shift to a position to capitalise from the subsequent market rebound – or variations in performance between different parts of the market.”
Over the past ten years or so, as central banks have pumped money into the global economy, quantitative easing acted like a tide that rose all boats, meaning bad companies as well as good were saved. This made it difficult for long/short strategies to do their jobs properly.
But now monetary policy is reversing, pricing dispersion between stocks is increasing, providing opportunities to make a positive return from investing on both the long and short sides.
“There are so many unknowns at present with COVID continuing to impact economies and supply chains, and the conflict in Ukraine adding to inflationary pressures (primarily energy and food),” said Luke. “Expectations for growth have fallen, and the risk is that central banks could be too aggressive in their decisions on interest rates, adding to the risk of recession.
He concluded, “Were that scenario to prove true, long/short strategies have tools to hand capable of generating a return for investors throughout the market cycle, regardless of corporate earnings. In that environment, the emphasis will land squarely on stock selection at a tactical and core level, conditions that we consider well-suited to equity long/short investing.”
The co-managers of this pan-European fund, Stefan Gries and Stephanie Bothwell, employ a fully flexible investment approach to try and create positive returns regardless of market conditions. They have a key focus on capital preservation and low levels of volatility, which is achieved by investing in companies whose share prices they think will rise (longs) and by ‘shorting’ stocks where they believe the share price will fall.
Janus Henderson Absolute Return aims to deliver a positive absolute return over rolling 12-month periods. It can invest in companies listed all over the world but has a bias towards UK equities. The managers look to identify stocks that will either exceed or fall short of analysts' expectations and construct a portfolio of both long and short positions. There are limits on the overall market exposure, which serves to reduce the volatility of the fund.
This fund sits in the IA Global sector and is a quality growth fund that buys high return on capital businesses experiencing sustainable structural growth. However, it has a 130/30 structure, which allows the manager Neil Robson to extend investors’ potential returns by buying stocks he expects to do well and looking to make money on stocks he expects to do badly (shorting). Neil describes this as “lining up on the starting grid for a motor race with an engine 50% bigger than everyone else’s”.
*Source: Boring Money, survey of 1,500 fund investors between the end of June 2022 and start of July.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the fund manager and author and do not constitute financial advice.