COVID-19 is creating long-term winners and losers across sectors and has accelerated trends like work from home, rebuilding a U.S. supply chain, e-commerce, cable cord cutting, etc.
COVID-19 is creating long-term winners and losers across sectors; it has also changed the narrative on healthcare from a focus on drug pricing to strategic security.
Long/short equity funds protected capital when COVID-19 emerged in February and into March. More recently, there has been meaningful dispersion in the returns of long/short equity managers, with several sub-strategies like technology, healthcare and activists having some meaningful outperformers. In general, long/short managers came into this period running fairly low net exposures which helped them protect capital in the March sell-off. Their low net exposures were less of a macro call (i.e. they were not bearish) and more the result of them finding more short opportunities even in a market where the strong beta rally was expected to continue.
Beta-focused strategy popularity
For years now, managers who were able to produce short alpha were often overlooked, as the beta call (or market direction call) was more important. Long-only strategies won the day as the short books of long/short equity managers proved challenging since the Global Financial Crisis (GFC). In a low rate environment, it was easy for companies to refinance their way to growth which challenged short sellers.
Today, we are less comfortable making a call on the direction of the markets, but we are very comfortable making a call on alpha and dispersion. COVID-19 has accelerated and cemented several trends that were already in place. Traditional business models are rapidly being upended. The result, we believe, is an environment where there will be more winners and losers or said another way – dispersion. This should be a fertile environment for long/short stock picking.
What will drive dispersion? We believe that differences in debt levels will matter more today as fewer companies will be able to refinance their way to growth and eventually revenues will not sustain their debt structures. Zombie companies may not get another bailout. Furthermore, we have yet to see what the implications of fiscal stimulus across the globe will be — it will vary greatly across countries and regionsand will create inefficiencies. Where money flows post-COVID will be uneven and will benefit some and may miss others..
The pandemic has accelerated many trends that had already been underway, which is going to lay bare the differences between winners and losers. For example, stability in supply chains will allow some companies and industries to get ahead, while others with less-stable pipelines may not fare as well. Moreover, demand trends are truly changing.
We can’t ignore the fact that COVID-19 has possibly permanently changed consumer behavior — for example e-commerce and e-payments are here to stay.
We see opportunities with managers who are strong on the short side of their portfolio — the decade-plus long beta rally is being called into question now more than ever. Sector-focused managers within technology and healthcare are also attractive to us — these are two sectors that historically have had wide dispersion, and we expect will have even more dispersion moving forward.
We’re also constructive on generalists who are more active in moving their portfolios to opportunities, as well as long/short managers who have high hit rates and can benefit from increased volatility to capture larger returns.
Below are two charts explaining where we see “winners and losers” in the technology and healthcare sectors specifically:
Meeting investor needs
We’re currently seeing a change in investor preferences like we haven’t seen since the global financial crisis. After the crisis, investors wanted low beta, defensive strategies. Unfortunately, during this time period there was also low alpha, so investors shifted to wanting a yield. But as yields fell, investors were forced to capture yield in less liquid parts of the markets.
Following the liquidity pain trade in March, investors have begun to return to long/short equity, both from their equity allocations (where long short equity is a defensive alternative) to their long-only allocations, and from their other hedge fund allocations as equity dispersion should improve the alpha environment and the strategy is liquid.
The long/short equity universe (and even hedge funds in general, to an extent) has reacted to investor concerns about fees, so many managers can be accessed with more favorable terms than in the past.
We see the greatest benefit in long-short equity’s ability to generate alpha in both long and short positions. Active management should benefit investors, as the surface of investing is no longer smooth. Money is going to flow differently as we emerge from a global quarantine — the one-way, “don’t fight the Fed” approach is over. And, the ultimate expression of active management is long/short equity investing.