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In this final part of our three article series, we summarize the strengths and weaknesses of Long/Short Equity Hedge Funds versus passive Long-only Equity ETFs and highlight how the Leonteq Alquant Long-Short US Equity ETP+ aims to offer the best of both worlds. Additionally, we will explore the benefits of reduced volatility and improved downside protection on long-term compounding and performance.
As we discussed in the previous articles, Long/Short Equity Hedge Funds provide robust risk-adjusted gross returns and offer superior downside protection through shorting and hedging strategies. This can be particularly beneficial in volatile markets.
However, these funds come with notable drawbacks:
These disadvantages often destroy the potential alpha and net risk-adjusted performance, as highlighted in our second article.
On the other hand, passive long-only equity ETFs address many of the issues found in Long/Short Equity Hedge Funds:
One of the only disadvantages we can think of long-only equity ETFs is their inherent passivity:
Our goal with the Leonteq Alquant Long-Short US Equity ETP+ (AQLS) is to create an investment product that combines the strengths of both approaches.
This product aims to provide active downside protection similar to Long/Short Equity Hedge Funds, while providing a clear fee advantage.
In addition to lower fees, our Leonteq Alquant Long-Short US Equity ETP+, like passive equity ETFs, offers several advantages over Long/Short Equity hedge funds, namely no minimum investment, no lock-up period, intraday liquidity and accessibility to all types of investors.
While lower fees are an obvious benefit, the importance of reduced volatility and improved downside protection might not be immediately apparent. Although we believe that robust downside protection is crucial, we often hear prospective investors question:
“Why should I care about risk management and downside protection? Ultimately, I care about returns, and the AQLS strategy has delivered similar, or even slightly lower, returns than passive exposure to the S&P 500.”
This perspective is understandable but shortsighted. Historical performance represents just one of many possible outcomes. While passive equity exposure may have slightly outperformed in absolute (but not risk-adjusted) terms recently, the future performance of the equity market remains uncertain. As such, an approach with active downside management offers more predictable outcomes by stabilizing the range of potential returns, thereby enhancing the long-term compounding effect.
To support this argument, we will explore two concepts that are indirectly linked to reinforce the importance of downside protection and risk-adjusted returns.
The volatility tax, also known as volatility drag, refers to the reduction in compound returns of an investment due to high volatility. It isn't an actual tax but a mathematical effect where fluctuating returns result in lower long-term growth compared to a steady return. Large losses particularly worsen this effect, making it crucial for investors to minimize significant downturns to improve overall performance.
As Warren Buffet famously said, "The first rule of investing is not to lose money. And the second rule is not to forget the first rule." If you lose 50% of your investment, you need a 100% gain to break even.
To illustrate the impact of volatility, let’s consider two strategies with the same arithmetic average returns over a typical business cycle of five years. One strategy (red line) grows by 8% during four years of expansion and loses 20% during a recession, while the other (greenblue line) only grows by 5.5% during expansion and loses 10% during a recession.
Even if the green blue line lags behind the red line 80% of the time, its lower volatility leads to significantly better long-term performance.
Of course, some of you might argue that this approach is effective over the long term, but you are concerned with shorter-term periods. Keep in mind, however, that business cycles are rarely clearly defined, making it difficult to determine our exact position within them. This uncertainty further supports the case for a more cautious approach.
Additionally, we are currently experiencing a period of exceptional equity market performance, with approximately 17% annualized returns over the last 15 years. In our opinion, it is hard to argue that we are in the early stages of a bull market —an argument that might be more valid immediately following major crashes or drawdowns.
Thus, we think that having an effective risk management and thus being able to reduce volatility is key to long-term investment success.
The concept of “sequencing risk” highlights the impact of the order of investment returns on long-term financial outcomes. Unlike expected value, which assumes average returns over time, sequencing risk demonstrates that negative returns early or late in an investment period can significantly deplete wealth if there are inflows or withdrawals during that period. If you want to read an interesting article about sequencing risk here is a good one from Mutiny: https://mutinyfund.com/sequencing-risk/
Simply put: "If you have any inflows or outflows to your investment portfolio, you won’t achieve the average returns of the market."
The issue with expected value (and thus average returns) is that it implicitly assumes ergodicity, whereas investing is decidedly non-ergodic.
In mathematics, ergodicity explores whether the long-term average of a process equals the average across its different states at a given time. Simply put, it asks if one individual's long-term experience is similar to the experiences of many individuals at a single point in time. If a system is ergodic, the path or sequence doesn't affect the average result. In finance, this means understanding whether average returns over time reflect actual investment outcomes experienced by individuals.
Unfortunately, much financial advice assumes ergodicity, though this is rarely the case in real life. For instance, consider the common advice to make regular investments and rely on compound interest. The assumption that average returns are exactly realized every year is likely incorrect, rendering typical illustrations of regular savings and compound interest inaccurate.
Indeed, if Investor 1 experiences a massive crash in the early years and stops investing, it is almost certain that Investor 2, who starts investing after the crash, will be better off. If the average return is 8% over the entire period, a crash in the early years means subsequent returns have to be higher to achieve this average, allowing Investor 2 to compound at a better rate.
For the illustration above to hold true, we need low variation in returns to enable effective compounding. This means yearly returns should be as close as possible to the average annualized return, i.e., having low volatility. Therefore, long-term investors should focus on managing volatility and drawdowns.
While most investors evaluate investments based on their expected value, it is more prudent to consider their expected path.
This is why we believe that including more stable strategies that perform well during periods when equities struggle can increase the likelihood of achieving satisfactory performance and improve long-term compounding.
This content is advertising material. This content as well as all information displayed on any of Alquant’s websites does not constitute investment advice or recommendation, and shall not be construed as a solicitation or an offer for sale or purchase of any products, to effect any transactions or to conclude any legal act of any kind whatsoever. Past performance is not a guide to future performance.
Alquant, a Swiss Fintech and quantitative asset manager, is transforming asset management with innovative solutions. Leveraging deep financial and technological expertise, we offer a range of services including investment products, quantitative research, and software solutions, empowering financial institutions to create the financial products of the future.
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