Equity long/short and market neutral hedge funds - Can they improve in 2021?

The investment foundation for equity long/short or market neutral hedge funds is the manager having the ability to widen the opportunity set of choices. Long-only investing is limiting because, at best, poor companies can only be excluded from the set of opportunities. Long/short managers should have a decided advantage versus the long-only manager because they can both hold long and short positions and selectively decide to cut market exposure while still holding a set of attractive long positions. The market neutral manager can eliminate the market exposure and create a portfolio of firm-specific opportunities, a pure alpha opportunity fund. In theory, this widening of choice should be a great opportunity for both active managers who has skill and the investors who wants the broadest set of directional choices for their managers. 

Allowing managers to flex their skill over this broader opportunity set is the way these funds are marketed, yet in practice the results have been less compelling during this post GFC period. There can be a number of explanations for this failure, yet none have been studied too closely in order to provide definite answers. 

The explanation for low long/short or market neutral returns is wide-ranging. Clearly, if the long/short manager has a lower beta to the market their alpha production may not generate enough return to offset a one-way rising market. Alternatively, there is the view that competition in stock-picking may just be too great, so alpha has been eroded. Lower equity dispersion may have reduced the opportunities for stock picking. The classic value play used by many hedge funds managers has underperformed during this period. Small caps have not generated the expected premium seen in the past.

The current environment calls into question how managers are picking opportunities and whether there is active stock-picking or market timing skill by managers. Nevertheless, there are clear winners in this space, just not with the strategy averages. This discussion on the reason for a drag on performance is not about the great managers but the average manager represented in hedge fund indices. As measured by hedge fund indices of managers, performance has been strained relative to their skill at marketing. This is seen in 2020 and in the last year.

Nevertheless, there may be some hope for 2021. First, volatility has increased even with a decline from the highs in March. Second, stock dispersion has also increased versus earlier periods. Third, the overall market is considered overvalued which may allow short positions to profit. Overall, 2021 may be a better year through greater opportunities for shorting specific names and cutting market exposure.