US Equity Long-Short: The Case for Sector Specialization
US Equity Long-Short: The Case for Sector Specialization
US Equity Long-Short: The Case for Sector Specialization
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Investment Insights Series<br />
Alternative Thinking by<br />
Alternative Investments Group<br />
of Oppenheimer Asset Management<br />
<strong>US</strong> <strong>Equity</strong> <strong>Long</strong>-<strong>Short</strong>:<br />
<strong>The</strong> <strong>Case</strong> <strong>for</strong> <strong>Sector</strong><br />
<strong>Specialization</strong><br />
2013<br />
Volume 2<br />
March 2013
<strong>The</strong> case <strong>for</strong> specialization within U.S. equity long-short has increased over the last decade given<br />
the increased competition within the U.S. equity market among market participants seeking to<br />
extract risk premiums. <strong>The</strong> U.S. equity market is the most liquid and crowded equity market<br />
relative to other regions and countries. As a result, the crowding makes the U.S. market more<br />
efficient, and arguably the most efficient, relative to other equity markets. In our view, having a<br />
sustainable edge in security selection requires deep domain knowledge within a sector rather<br />
than being an all encompassing generalist investor.<br />
Furthermore, while we are strong believers in active management and view success in active<br />
management over time as being driven by skill, we also hold the view that the some portfolio<br />
managers do not add value, and may destroy value. Since the financial crisis in 2008, active<br />
managers in general, and equity long-short managers in particular, have faced significant<br />
headwinds driven predominantly by the fact that macro headwinds and tail-risks, combined<br />
with policy risk, have resulted in equities trading on macro factors rather micro factors.<br />
However, to extrapolate the outlook <strong>for</strong> active equity investing based on the last 5 years in our<br />
opinion would be an error, particularly since our investment philosophy is based on having a<br />
<strong>for</strong>ward-looking view based on the environment and opportunity set. We view the outlook <strong>for</strong><br />
active equity investing utilizing a long-short approach as being highly favorable <strong>for</strong> the following<br />
reasons:<br />
1. Central banks across the globe have provided a long-term level of accommodation<br />
which reduces the likelihood of tail-risk events<br />
2. <strong>The</strong> majority of macro risks and global imbalances are known amongst policymakers and<br />
market participants<br />
3. While governments may not be ahead of the issues and continue to provide band aid<br />
solutions, they are not significantly behind the curve<br />
4. <strong>The</strong> feedback loop between market participants and policymakers is functional<br />
5. <strong>The</strong>re is an increased acceptance in the private sector that we are in the New Paradigm<br />
of anemic growth, multi-year deleveraging, and increased government regulation,<br />
taxation and intervention. While these are clearly headwinds, the clarity and acceptance<br />
of these enables the private sector to act accordingly<br />
As we will show in the analysis below, over the last 5 years we have been in a period of elevated<br />
level of stock correlation and compression of equity valuations in an environment where there<br />
will likely be winners and losers within sectors as well as between sectors. We hold the view<br />
that over the next 5 years, macro and policy factors will become a secondary factor to corporate<br />
fundamental factors in determining equity valuations and there<strong>for</strong>e a premium will be placed on<br />
skill in security selection.<br />
We believe that investors can increase the probability of success in active equity investing if you<br />
pursue an unconstrained long-short approach rather than an index conscious long-only strategy<br />
where success is predicated on a positive outcome <strong>for</strong> equity markets. <strong>The</strong>se long-short<br />
portfolios should have the following attributes:<br />
1. Unconstrained portfolios<br />
2. Concentrated portfolios<br />
3. Absolute long and short investments<br />
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4. Moderate use of leverage<br />
5. Ability to manage tail-risks through the use of derivatives<br />
We are strong advocates of a sector-based approach to long-short investing and we believe that<br />
the optimal solution <strong>for</strong> investors looking to invest in U.S. equity markets is to build an actively<br />
managed diversified portfolio with investment teams that are specialized in the major sectors<br />
that comprise the S&P 500 Index. <strong>The</strong> chart below shows the current S&P 500 breakdown by<br />
sectors:<br />
S&P 500 <strong>Sector</strong> Breakdown - February 2013<br />
TELECOM SERV<br />
UTILITIES<br />
2.96%<br />
M ATERIALS<br />
3.42%<br />
3.44%<br />
IND<strong>US</strong>TRIALS<br />
10.25%<br />
INFO TECH<br />
18.25%<br />
CONS STAPLES<br />
10.94%<br />
FINANCIALS<br />
15.91%<br />
ENERGY<br />
11.11%<br />
CONS DISCRET<br />
11.45%<br />
HEALTH CARE<br />
12.27%<br />
Source: Bloomberg<br />
We believe in a sector-based approach to U.S. equity investing <strong>for</strong> the following reasons:<br />
1. A sector specialist investor with deep domain knowledge through multiple years of<br />
experience in a sector will likely have a greater depth of knowledge relative to a generalist.<br />
2. <strong>The</strong> primary objective behind a sector-focused approach is to capture the dispersion in<br />
per<strong>for</strong>mance between winners and losers in a particular sector. Historically, investors have<br />
perceived sector specific long-short strategies as being a directional play on a particular sector.<br />
3. In our view, having exposure to any particular sector is a secondary consideration since we<br />
are not expressing a directional view on a sector and over time the sector exposure is driven by<br />
portfolio diversification considerations.<br />
4. Where we may take a strategic view, we are likely to focus on sectors and industry groups<br />
where there is significant change which specialists are able to analyze and determine the<br />
companies that will be winners and losers from change.<br />
Quantitative Analysis<br />
• A historical analysis of U.S. equity sub-sector returns since 2000 shows that no single<br />
sub-sector persistently dominated per<strong>for</strong>mance, thereby making the case <strong>for</strong> industry<br />
diversification.<br />
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S&P 500 Sub-<strong>Sector</strong> Historical Per<strong>for</strong>mance<br />
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012<br />
Energy Telecom Serv Info Tech Cons Discret Financials<br />
31.13% 35.98% 61.30% 27.57% 28.68%<br />
Utilities Energy Materials Industrials Cons Discret<br />
23.65% 24.05% 47.85% 26.37% 24.00%<br />
Telecom Serv Energy Utilities Energy Cons Discret Materials Telecom Serv<br />
19.47% 31.18% 20.53% 34.07% 40.77% 21.95% 17.93%<br />
Financials Cons Discret Utilities Health Care Materials Industrials Energy Utilities Health Care<br />
79.03% 17.82% 16.65% 18.92% 22.37% 20.19% 20.00% 19.44% 17.72%<br />
Utilities Info Tech Financials Info Tech Materials Utilities Health Care Telecom Serv Cons Staples Industrials<br />
56.01% 56.53% 13.17% 6.40% 18.69% 19.12% 19.32% 17.92% 13.74% 15.26%<br />
Health Care Cons Staples Materials Health Care Financials Cons Staples Financials Cons Staples Health Care Materials<br />
36.79% 45.40% 12.94% 6.30% 18.50% 16.25% 16.69% 13.85% 12.60% 15.05%<br />
Energy Cons Discret Health Care Materials Industrials Industrials Cons Staples Financials Cons Discret Info Tech<br />
25.33% 20.41% 10.70% 4.53% 14.39% 14.16% 14.43% 12.08% 6.17% 14.81%<br />
Info Tech Health Care Industrials Industrials Cons Discret Cons Discret Energy Info Tech Telecom Serv Cons Staples<br />
16.32% 19.97% 8.09% 3.55% 13.16% 11.99% 13.61% 10.11% 6.13% 10.99%<br />
Cons Discret Financials Industrials Cons Staples Cons Discret Cons Staples Telecom Serv Utilities Utilities Energy Energy<br />
15.46% 3.42% 11.62% 2.53% 2.24% 8.36% 11.83% 11.30% 5.19% 4.73% 4.59%<br />
Industrials Materials Utilities Info Tech Cons Staples Info Tech Info Tech Telecom Serv Health Care Info Tech Utilities<br />
5.80% 2.79% 2.30% 1.65% 0.97% 7.43% 7.28% 8.21% 2.81% 2.43% 1.30%<br />
Financials Industrials Info Tech Telecom Serv Telecom Serv Financials Health Care Industrials<br />
-15.83% -5.75% -4.12% -3.72% -5.33% -13.10% -29.11% -0.58%<br />
Materials Info Tech Financials Materials Financials Health Care Financials Materials<br />
-19.94% -6.44% -5.35% -10.07% -6.36% -18.14% -31.80% -9.53%<br />
Telecom Serv Energy Cons Discret Energy Industrials Financials<br />
-38.46% -8.93% -10.97% -28.51% -35.82% -16.90%<br />
Cons Staples Cons Discret Energy Cons Staples<br />
-40.86% -10.26% -14.50% -37.36%<br />
Health Care Health Care Telecom Serv<br />
-11.94% -18.73% -39.81%<br />
Telecom Serv Materials Utilities<br />
-12.06% -23.73% -40.77%<br />
Cons Staples Industrials Energy<br />
-25.86% -26.20% -41.08%<br />
Utilities Utilities Info Tech<br />
-30.03% -29.54% -47.64%<br />
Telecom Serv<br />
Materials<br />
-34.03% -50.72%<br />
Cons Staples<br />
Cons Discret<br />
-37.39% -55.55%<br />
Source: Bloomberg, Oppenheimer Alternative Investments Group<br />
• Evaluating the percentage of stocks in the S&P 500 moving in the same direction shows<br />
that there are meaningful periods when there is dispersion (per<strong>for</strong>mance differential<br />
between winners and losers) in per<strong>for</strong>mance among index constituents.<br />
90%<br />
Percentage of S&P 500 Stocks Moving in the Same Direction<br />
(6-Month Moving Average)<br />
85%<br />
80%<br />
75%<br />
70%<br />
65%<br />
60%<br />
55%<br />
50%<br />
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012<br />
Source: Bloomberg, Oppenheimer Alternative Investments Group<br />
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• While we have recently been in a period of compression in the dispersion of company<br />
valuations (due to the dominance of macro specific factors) as measured by the<br />
dispersion in P/E <strong>for</strong> the S&P 500 sectors, there have previously been periods of greater<br />
valuation differentials among sectors, driven by fundamental factors. <strong>The</strong> chart below<br />
shows the P/E dispersion among the 10 different S&P 500 sectors, calculated by the<br />
differences between the 3 rd and 1 st quartiles historically.<br />
16<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
S&P 500 <strong>Sector</strong>s P/E Dispersion<br />
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012<br />
Source: Bloomberg, Oppenheimer Alternative Investments Group<br />
• Evaluating the per<strong>for</strong>mance of the quartiles (based on 12 month trailing returns) of the<br />
10 constituent sectors of the S&P 500 since 2000 indicates that there have been periods<br />
during which the dispersion in returns has been meaningful. During such periods the<br />
surface area <strong>for</strong> a specialist investor to generate alpha on both the long and the short<br />
side increased. <strong>The</strong> two charts on the next page list the box plot 1 <strong>for</strong> the financial and<br />
healthcare sectors. All other sectors have similar results: wide range of return<br />
distributions across calendar years.<br />
• For example, the elevated level of the equity market volatility during and immediately<br />
after the financial crisis made 2009 the year with the largest return dispersion over the<br />
past 5 years, where the top per<strong>for</strong>mer within the S&P 500 financial sector generated a<br />
+420% return while the bottom per<strong>for</strong>mer lost 52% in value. Half of the financial stocks<br />
generated annual returns between -1.2% and +43.8% in 2009.<br />
• <strong>The</strong> wide dispersions in returns (min vs. max or Q1 vs. Q3) in 2009 and most of the other<br />
years as showed in the charts below make the case <strong>for</strong> strong security selection within<br />
sectors by highly skilled investment teams.<br />
1 <strong>The</strong> Dispersion analysis (box plot) displays the worst per<strong>for</strong>mer, first quartile (Q1: the lowest 25% of data), second<br />
quartile (median), third quartile (Q3: the highest 25% of data) and the best per<strong>for</strong>mer within the specific sector from<br />
2000 to 2012. <strong>The</strong> widths of the box indicate the distance between Q1 and Q3 and the differences between the min<br />
and max represent the degree of dispersion.<br />
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Financials 1<br />
450%<br />
400%<br />
350%<br />
300%<br />
250%<br />
200%<br />
150%<br />
100%<br />
50%<br />
0%<br />
-50%<br />
-100%<br />
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012<br />
Max<br />
Top Quartile<br />
Median<br />
Bottom Quartile<br />
Min<br />
Healthcare 1<br />
Source: Bloomberg, Oppenheimer Alternative Investments Group<br />
400%<br />
350%<br />
300%<br />
250%<br />
200%<br />
150%<br />
100%<br />
50%<br />
0%<br />
-50%<br />
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012<br />
-100%<br />
Source: Bloomberg, Oppenheimer Alternative Investments Group<br />
• <strong>The</strong> investment case <strong>for</strong> diversification across a team of specialist sector investors is<br />
based on the data which indicated that the level of dispersion within a particular sector<br />
since 2000 varied among sectors during discrete time periods (e.g. there was a higher<br />
level of dispersion in the healthcare sector relative to the financials sector between<br />
2004-2006).<br />
1 <strong>The</strong> Dispersion analysis (box plot) displays the worst per<strong>for</strong>mer, first quartile (Q1: the lowest 25% of data), second<br />
quartile (median), third quartile (Q3: the highest 25% of data) and the best per<strong>for</strong>mer within the specific sector from<br />
2000 to 2012. <strong>The</strong> widths of the box indicate the distance between Q1 and Q3 and the differences between the min<br />
and max represent the degree of dispersion.<br />
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• When evaluating sector per<strong>for</strong>mance dispersion (measured by the difference between<br />
the 3 rd quartile and the 1 st quartile), we can see that there are periods of relative<br />
outper<strong>for</strong>mance and under-per<strong>for</strong>mance by the different sectors since 2000 which in<br />
our view rein<strong>for</strong>ces the case <strong>for</strong> an equity portfolio comprised of sector specialists.<br />
90%<br />
Per<strong>for</strong>mance Dispersion Within S&P 500 <strong>Sector</strong>s<br />
80%<br />
70%<br />
60%<br />
Healthcare<br />
Info Tech<br />
Cons Staples<br />
Utilities<br />
Industrials<br />
Financials<br />
Materials<br />
Cons Discret<br />
Energy<br />
Telecom Serv<br />
50%<br />
40%<br />
30%<br />
20%<br />
10%<br />
0%<br />
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012<br />
Source: Bloomberg, Oppenheimer Alternative Investments Group<br />
Manager Selection Criteria<br />
In our experience, we view manager selection as critical to investment success. We do not<br />
compromise on investment skill which we view as a scarce commodity. We regard having a<br />
‘best athlete’ as significantly more important than having the right call on a particular sector. In<br />
our view, an investor can make the correct call on the opportunity set within a particular sector<br />
or industry group but not fully capture the opportunity by having sub-optimal manager<br />
selection. Furthermore, based on our experience, in an adverse market environment a weaker<br />
investment team is more likely going to encounter significantly greater headwinds than the<br />
highly skilled investment team.<br />
When we evaluate sector managers, we look <strong>for</strong> the following characteristics:<br />
<strong>Sector</strong><br />
• Investment sector must exhibit dispersion in per<strong>for</strong>mance between industry groups and<br />
companies<br />
• Sufficient investment universe within the sector: large surface area<br />
• Liquidity on a single name basis and appropriate average daily volume<br />
• Ability to borrow securities <strong>for</strong> short-sales at reasonable cost<br />
Portfolio<br />
• Low net-exposures: looking to capture dispersion within sector vs. the direction of the<br />
sector.<br />
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• Ability to create alpha on both the long and the short-side- little or zero use of index<br />
based hedges or relative shorts or pair trades which do not constitute alpha ‘bets’ and<br />
introduce basis risk or require higher leverage to generate attractive levels of alpha<br />
Team<br />
• Significant years of experience in the sector, including a lengthy tenure at brand name<br />
hedge fund firms<br />
• <strong>Long</strong>-short portfolio management experience<br />
• Team based approach: allows <strong>for</strong> increased analytical band-with to cover sub-sectors<br />
and greater depth individual names<br />
• When we have select sector teams, the search has been driven first and <strong>for</strong>emost by the<br />
pedigree of the investment team and secondarily by their sector specialty<br />
Process<br />
• Disciplined investment process <strong>for</strong> sourcing and analyzing investment ideas which is<br />
scalable and repeatable<br />
• Differentiated analytics which results in a variant perception relative to other market<br />
participants<br />
Portfolio and Risk Management<br />
• Strong skills-set in optimizing analysis and security selection into a coherent portfolio<br />
with idiosyncratic risk and sufficient level of risk<br />
• Disciplined use of price or risk-reward targets and combined with <strong>for</strong>titude and<br />
conviction to selectively increase risk in ideas in periods of risk-aversion or market<br />
dislocation<br />
• Ability to manage market risk, factor bets, liquidity, leverage and basis risk<br />
Conclusions<br />
We believe investors can increase the probability of success by investing with dedicated sector<br />
specialists with deep domain knowledge versus the all encompassing generalist.<br />
By combining sector focused investment teams that utilize a long-short approach, investors can<br />
potentially build effective diversification to the major sectors which exhibit per<strong>for</strong>mance and<br />
dispersion differentials over time. Furthermore, the use of a long-short approach effectively<br />
increases the surface area <strong>for</strong> alpha generation relative to long-only investments.<br />
Investing with sector specialists in our view does not represent a directional view on a particular<br />
sector. We view a sector specialist as an effective investment in capturing the dispersion<br />
between winners and losers in a particular sector. Our experience has demonstrated that<br />
having strong understanding and experience in a sector where the portfolio manager has<br />
narrow focus and deeper knowledge effectively enables them to analyze change and discern the<br />
winners and losers relative to the generalist investor.<br />
Investing in securities is speculative and entails risk. <strong>The</strong>re can be no guarantee that any<br />
investment strategy will be successful. <strong>The</strong> opinions expressed herein are subject to change.<br />
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<strong>The</strong> Alternative Investments Group is a division of Oppenheimer Asset Management Inc., an<br />
affiliate of Oppenheimer & Co. Inc.<br />
AIG040313CM1<br />
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