The investment buzz has come almost full circle

A very interesting and revealing series of articles appeared in the financial media a couple of months ago.
These described how institutional investors have become disappointed with many hedge funds. It seems that their relative performance suffered in the rising equity market, because many hedge funds, as a basic part of their strategy, sell stock short.
So this group of supposedly sophisticated investors now seeks long-only approaches to capture more alpha, they say. In fact, this recent turn toward long-only investing seems to have become the new rage among many who were once enthusiasts for hedged strategies.
This news would be funny were it not also so sad, for it brings the investment buzz almost full circle to where it was some 10 years ago.
Investment fashion, it seems, always chases the investment approach that most recently has shown the best relative performance. So it always seems to follow the cycles — but with a lag, of course.
And because the cycle continues to move, this basically short-term and backward-
looking approach also almost always comes to tears. Yet the sad pattern persists, as this latest turn in preferences seems to confirm.
The long and short of it
The cycle that now seems to be coming full circle began in the late 1990s. Then, rapid gains in equity prices created a great enthusiasm for long-only strategies.
As the stock gains persisted, investors — both institutional and individual — redoubled their long-only enthusiasm. They exaggerated the approach with leverage.
They focused it by curtailing efforts at diversification in favor of a concentration on the market leaders, which at the time were growth strategies in general and technology strategies in particular, especially in the dot-com sector.
These most fashion-conscious investors were the most hurt, then, when the equity market, particularly the tech sector, turned down in the spring of 2000. All equity investors suffered losses in that market retreat to 2002, of course, but the worst pain occurred among those who took their enthusiasm for the previous winning trend to extremes through that use of leverage and concentrated holdings.
Licking their financial wounds in that downturn, these fashion-conscious investors began to cast about for a new winning strategy. They noted that despite the market carnage, hedged portfolios did relatively well largely because their use of short sales prospered during the market downdraft.
So they turned to this alternative strategy. As their enthusiasm grew, they began to see these hedged approaches as a kind of portfolio salvation.
Of course, by 2002, the market already was turning upward. These investors, however, continued to look backward, as they always do, and so they remained entranced by the seeming triumph of hedged strategies.
Those who noticed the early equity gains stuck with the hedges, still shaken by the losses of previous years. With the increasing popularity of the hedged approach, many of the same fashion-conscious investors that in the late 1990s had piled into the fashionable preference for technology piled into this new fashionable approach.
It seemed very different to them. It was, in the sense that it was hedged and not long only.
But fundamentally, they were doing what they did before: chasing whatever had done well in the period just passed.
Now it is apparent even to these investors that the equity market in 2002 had made a fundamental upward turn. In 2003, the broad-based Standard & Poor’s 500 stock index rose by more than 25%.
Almost any short position that year would have detracted from an investor’s overall performance. In 2004, the pace of advance slowed to about 10%, and in 2005, it slowed to about 5%.
But even these relatively modest advances made short selling problematic. Last year, the S&P 500 re-accelerated, rising by about 15%.
After this experience, these same investors seem to have decided finally that hedged portfolios, with their now seemingly vulnerable short positions, offer none of the hoped-for salvation that they once promised when the market was suffering. So investment fashion has turned again, now against hedged approaches and toward long-only approaches.
There still is time. The new fashion still is young.
The equity market has ample fundamental support to rise still farther and reward long-only strategies at the expense of the hedged approach. But if history is any guide, these expected advances will raise the enthusiasm of the fashion conscious, so that in the fullness of time, just as before, they will exaggerate the approach, leverage their long-only strategies and focus their portfolios narrowly on whatever groups happen to lead this time.
When such activities become the rage, then investment fashion indeed will have come completely full circle. And this group of investors — institutions and individuals — this altogether too large group that chases what once did so well, will have set itself up for yet another disappointment and more losses.
Obviously, no strategy wins all the time. In a market with inevitable ups and downs, the long-only approach will outperform the hedged approach in some environments and the hedged approach will come into its own in other environments.
Periods of intense enthusiasm for certain sectors will reward focused portfolios over more broadly diversified portfolios, which in their turn will defend much better when those enthusiasms die, as they always do. Those who stick to a strategy will have periods of gain and loss.
If that strategy is well conceived, however, their portfolios will gain over the long haul.
The naive sophisticates
The real losers will remain the fashion-conscious investors, who switch strategies in order to pick up the most recent winners and who usually buy in just in time to see this latest winning approach suffer its inevitable setback.
There is a sophisticated air about these sorts of strategy switchers. They seem much more current and much more alert than others.
They diligently track all the recent leaders and laggards and think that they know why some strategies have done well and others haven’t. Probably because of this appearance, they also attract the most media attention.
But for all its seeming sophistication, their behavior in reality shows a fundamental naiveté about how markets move. It also is more likely to lose than the seemingly more plodding group that picks a suitable strategy and sticks with it.
Milton Ezrati is a partner and the senior economic strategist for Lord Abbett & Co. LLC in Jersey City, N.J.