January 2016
Long/short equity from four proven portfolio teams and a leader in investment oversight Leo M. Zerilli, CIMA Head of Investments John Hancock Investments
Michael T. Carmen, CFA, CPA Equity Portfolio Manager Wellington Management Robert L. Deresiewicz, M.D. Global Industry Analyst Wellington Management
Andrew R. Heiskell Global Industry Analyst Wellington Management
John F. Averill, CFA Global Industry Analyst Wellington Management
Key takeaways Stretched stock valuations and increased market volatility present challenges for today’s investors, as traditional asset allocation has not always provided sufficient protection against portfolio losses during extreme equity price declines. Long/short, or hedged, equity approaches can offer investors the opportunity to lessen the price volatility of a diversified stock portfolio while still participating in rising markets. Historically a hedge fund strategy, long/short equity has become an increasingly popular choice for mutual fund investors seeking the potential downside protection that more rigorous risk management affords. In 2013, John Hancock Investments launched John Hancock Seaport Fund, a long/ short equity offering combining four distinct hedge fund strategies from Wellington Management.
Executive summary A well-constructed asset allocation strategy has historically helped reduce portfolio volatility and lessen the risk of extreme capital losses. However, many investors found their shared faith in traditional diversification tested during the global financial crisis when many different types of assets declined in lockstep. Concerns have persisted through an extended recovery, and in recent years many mutual fund investors have turned to long/short, or hedged, equity strategies, which aim to limit portfolio volatility and downside risk. In addition to outlining key concepts behind long/short equity in general, this paper will explore particulars about how it’s practiced by four different specialized hedge fund teams at Wellington Management. Each of these teams manages a distinct portion of John Hancock Seaport Fund, which employs long equity positions to seek capital appreciation along with short equity positions designed to help limit losses by actively managing market exposure.
Long/short equity funds: blending the art and science of investing Leo M. Zerilli, CIMA Head of Investments John Hancock Investments
“The best long/short managers have the ability to dial net exposure up or down while also populating the fund with promising investment ideas on both the long and short sides.”
Long/short equity strategies offer investors something most long-only mandates cannot: potential downside protection. In fact, a long/short fund has the opportunity to generate alpha (incremental return over a benchmark index) in three ways. First, like any equity fund, it can add value through the selection of long stock positions. Second, it can tactically hedge its net market exposure, or beta, when conditions warrant by using derivatives or by shorting baskets of stocks or exchange-traded funds (ETFs). Third, a long/short fund can potentially add alpha by choosing which ETFs or other equity assets to sell short if the manager expects those particular instruments to decline in value more than the market. The key to success in all cases is nimbleness. The best long/short managers have the ability to dial net exposure up or down while also populating the fund with promising investment ideas on both the long and short sides.
Long/short investing is at least as much of an art as a science, which is one reason why the quantitative-only methodologies behind the so-called 130/30 strategies of the early 2000s failed to make inroads with investors. Also, with 130% gross long exposure and 30% gross short exposure, 130/30 strategies, by definition, maintained static net exposure of 100% regardless of market conditions, a structure that robbed skilled managers of a crucial risk management tool.1 Another reason for the limited success of those early strategies is that many managers were trying to run them without prior experience in short selling, a process that requires different skills than those developed through long-only investing. Today, we’re seeing a different dynamic, with long/short mutual funds run by managers who came from the hedge fund world. Investors need to understand the trade-offs associated with long/short strategies versus traditional long-only funds. Among them is the risk of underperforming during certain environments, including strong bull markets. Moreover, long/short equity funds shoulder the costs of dividend payments and interest charges related to the short sales—expenses that don’t burden long-only funds. However, the benefits of long/short investing can become more evident in choppy or downward-trending markets.
John Hancock Seaport Fund: net exposure typically ranges from 35% to 85% Total investment exposure through 12/31/15 (%) 120 100 80
104% Gross long exposure
60
48%
40
– 56% Gross short exposure 48% Net exposure
20 0
n G ross long exposure n G ross short exposure N et exposure
–20 –40 –60 –80 1/14 2/14 3/14 4/14 5/14 6/14 7/14 8/14 9/14 10/14 11/14 12/14 1/15 2/15 3/15 4/15 5/15 6/15 7/15 8/15 9/15 10/15 11/15 12/15
Source: Wellington Management, as of 12/31/15.
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Why allocate now?
John Hancock Seaport Fund
Long/short equity mutual funds have attracted a growing interest since the financial crisis. Many investors have allocated a portion of their equity exposure to long/short funds to insulate their portfolios against market declines. According to Morningstar, total assets in the category now stand at nearly $50 billion.2
Number of equity issuers
294
Top 10 long issuers (% of total market value)
17
Overall fund gross long exposure1 (%)
104
Overall fund gross short exposure1 (%)
–56
Overall fund net exposure1 (%)
48
Net exposure by category (%)
Even after August’s double-digit market correction, elevated equity valuations still suggest more muted returns ahead. For the past 60 years, when U.S. stocks traded at levels similar to today’s trailing price-to-earnings (P/E) ratio3 of 18, the market went on to return only about 4% per annum over the subsequent decade—and in no case was it a uniformly smooth journey.
In search of asymmetry At John Hancock Investments, one of the benefits of our manager-of-managers model is that we can search the world to find managers with the talent and specific expertise required to effectively manage a given investment mandate. Our search for a uniquely qualified long/short manager ultimately led us to Wellington Management, a private partnership that launched its first hedge fund in 1994. We selected four of Wellington’s most seasoned and successful investment teams. At the end of 2013, we introduced John Hancock Seaport Fund, a long/short equity mutual fund with an approach that is in many ways similar to that used by a hedge fund of funds. With net long market exposure typically ranging between 35% and 85%, we designed the overall fund with the intent of capturing about 80% of the MSCI World Index’s4 upside while endeavoring to limit losses to roughly 60% of the index’s downside. The fund seeks to achieve this asymmetric return profile with approximately two-thirds of the price volatility of the index over time. The fund is a multistrategy approach; our team at John Hancock Investments allocates the fund’s assets across four distinct long/short equity portfolios, each managed by a different hedge fund team at Wellington. As of December 31, 2015, the fund’s target allocations were 35% diversified equity portfolio, 25% healthcare portfolio, 20% financials portfolio, and 20% information technology portfolio. In the pages that follow, we’ll review each team’s investment philosophy and process in turn.
Geography United States
34
Europe
11
Emerging markets
2
Japan
1
Canada
0
Asia/Australia
0
Sector/industry Healthcare
23
Financials
20
Information technology
19
Industrials
8
Consumer discretionary
5
Materials
2
Telecommunication services
1
Other
–1
Market indexes
–29
Market capitalization Over $10 billion
22
$5 billion to $10 billion
9
$1 billion to $5 billion
17
$500 million to $1 billion
1
Under $500 million
0
Source: Wellington Management, as of 12/31/15.
Net exposure ranges at the portfolio level1 (%) 160% Target net exposure range for the fund (35% to 85%) 120% 80 40
35 to 85
30 to 70
0 to 100
–20 to 120
Financials portfolio
Technology portfolio
0 –40
Diversified equity portfolio
Healthcare portfolio
Portion of fund assets (%) Diversified equity portfolio
35
Financials portfolio
20
Healthcare portfolio
25
Technology portfolio
20
Source: John Hancock Investments, as of 12/31/15.
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Diversified equity portfolio (35% of fund assets): unconstrained in pursuit of attractive total returns Michael T. Carmen, CFA, CPA Equity Portfolio Manager Wellington Management
“If we like the prospects of a [company]… but we’re less favorable on [its industry], we can establish a long position in the company’s stock while simultaneously shorting [an asset representative of its industry] …”
In the fund’s diversified equity portfolio, we employ fundamental analysis in an effort to identify companies with quickening growth trajectories, what we call ATOM, accelerating tangible operating momentum. We’ve been managing long/short assets since 1997, and over that time we’ve learned that growth can emerge (or reemerge) in unexpected places. That’s why our brand of investing casts a wide net: Idea generation spans a range of equity sectors, geographies, and market capitalizations. As growth investors, we recognize that growth itself is fleeting, which is why we practice a rigorous valuation discipline to manage risk. We believe that changes in consensus expectations drive stock prices and that accelerating revenue growth and improving operating margins may lead to better-than-expected earnings growth. In our experience, changes in earnings expectations are generally preceded by changes in a company’s operating level fundamentals. Shorting allows us to finesse portfolio positioning with greater precision. If we like the prospects of a particular transportation company, for example, but we’re less favorable on the transportation industry as a whole, we can establish a long position in the company’s stock while simultaneously shorting a transportation-focused ETF, thereby retaining only the desired exposure for the portfolio. Within this portfolio, we do not sell individual company stocks short; instead, market-based instruments, such as ETFs, are our shorting tools of choice. Developments in the ETF market over the past decade, with increasingly granular exposures, have allowed for more effective methods to implement short positions with similar characteristics of companies we wish to avoid—namely, those with decelerating growth, deteriorating operating margins, and full valuations. We can hold more concentrated positions in our highest-conviction long ideas, potentially without increasing the portfolio’s market risk, since we can hedge the incremental beta by shorting equity indexes.
Diversified equity portfolio: net exposure typically ranges from 30% to 70% Investment exposure through 12/31/15 (%) 160
120
80
82% Gross long exposure
46%
40
– 36% Gross short exposure 46% Net exposure
0
n G ross long exposure n G ross short exposure N et exposure
–40
–80 1/14 2/14 3/14 4/14 5/14 6/14 7/14 8/14 9/14 10/14 11/14 12/14 1/15 2/15 3/15 4/15 5/15 6/15 7/15 8/15 9/15 10/15 11/15 12/15
Source: Wellington Management, as of 12/31/15.
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Diversified equity portfolio team members
Diversified equity portfolio Number of equity issuers
50
Steven C. Angeli, CFA Multi-sector growth Joined Wellington Management in 1994
Top 10 long issuers (% of market value)
28
Gross long exposure1 (%)
82
Gross short exposure (%)
–36
Michael T. Carmen, CFA, CPA Multi-sector growth Joined Wellington Management in 1999
Net exposure1 (%)
1
46
Net exposure by category (%) Geography United States
While our process is primarily driven from the bottom up, we can also express top-down views, and we spend a lot of time contemplating the market’s downside potential in addition to its opportunities. We can increase the portfolio’s net exposure to the equity market when, in our view, the fund is likely to be compensated for assuming the additional market risk. We can also pare back net exposure quickly when sentiment turns sour and the risk/reward trade-off appears less favorable. The net exposure for this portfolio typically ranges between 30% and 70%. As a defensive complement to more traditional long-only equity styles, our long/short approach seeks to provide investors with improved downside protection, greater resilience to market volatility, a wider range of potential return sources, and a better risk/return profile overall.
34
Europe
8
Emerging markets
3
Canada
0
Asia/Australia
0
Japan
0
Sector/industry Healthcare
20
Financials
16
Consumer discretionary
15
Information technology
11
Industrials
8
Materials
6
Consumer staples
6
Market indexes
–35
Market capitalization Over $10 billion
29
$5 billion to $10 billion
1
$1 billion to $5 billion
18
$500 million to $1 billion
–1
Under $500 million
–1
Source: Wellington Management, as of 12/31/15.
Defining ATOM, accelerating tangible operating momentum The lifecycle of revenue growth and profitability
Growth accelerating Margins improving Valuation attractive Ahead of consensus
Growth moderating Fairly valued In line with consensus Growth decelerating
Early identification of operational change
Overvalued
Growth troughing
Below consensus ATOM Source: Wellington Management, 2015.
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Healthcare portfolio (25% of fund assets): investing in biomedical breakthroughs and operational excellence Robert L. Deresiewicz, M.D. Global Industry Analyst Wellington Management
“… idiosyncrasies of the healthcare market are often not fully appreciated or understood by generalist investors, which creates intrasector dispersion that can be exploited by long/short healthcare specialists with an extended investment horizon.”
Within the fund’s healthcare portfolio, we pursue capital appreciation by taking long and short positions in the equity of companies that derive a major portion of their profits in the global healthcare sector. All four healthcare portfolio managers have been working together for over 15 years, and with over $60 billion in client assets under our care, our team is among the largest healthcare investors in the world today.5 Each portfolio manager focuses on one of four specific subsectors: biotechnology, healthcare services, pharmaceuticals, and medical technology. The portfolio is globally oriented and generally diversified across the subsectors, but exposure will at times tilt toward specific areas offering particularly compelling opportunities. Our goal is not to invest in the healthcare sector as a whole, but rather in what we view as the best opportunities within it. As value investors in a growth sector, we seek high-quality companies with attractive fundamentals that are trading below our estimates of the intrinsic value of the business. In our view, idiosyncrasies of the healthcare market are often not fully appreciated or understood by generalist investors, which creates intrasector dispersion that can be exploited by long/short healthcare specialists with an extended investment horizon. Rather than trying to pinpoint near-term catalysts linked to, say, a medical device launch or an upcoming FDA panel, we seek to exploit favorable long-term trends in healthcare, including the explosion of biomedical innovation, the graying of the population and attendant increase in per capita healthcare costs in the developed world, and the rising demand for quality healthcare in newly affluent emerging markets. Experience tells us that the volatility of stock market valuations substantially exceeds the volatility of company fundamentals, and we seek to capitalize on unjustified valuation swings, with specific security selection driven by our detailed
Healthcare portfolio: net exposure typically ranges from 35% to 85% Investment exposure through 12/31/15 (%) 160
120
80
113% Gross long exposure
52%
40
– 61% Gross short exposure 52% Net exposure
0
n G ross long exposure n G ross short exposure N et exposure
–40
–80 1/14 2/14 3/14 4/14 5/14 6/14 7/14 8/14 9/14 10/14 11/14 12/14 1/15 2/15 3/15 4/15 5/15 6/15 7/15 8/15 9/15 10/15 11/15 12/15
Source: Wellington Management, as of 12/31/15.
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Healthcare portfolio team members Robert L. Deresiewicz, M.D. Biotechnology Joined Wellington Management in 2000
Ann C. Gallo Healthcare services Joined Wellington Management in 1998
Jean M. Hynes, CFA Pharmaceuticals Joined Wellington Management in 1991
Kirk J. Mayer, CFA Medical technology Joined Wellington Management in 1998
understanding of healthcare companies and the subsectors in which they operate. We focus our effort on bottom-up, fundamental analysis of basic biomedical science, drug development pipelines, regulatory and reimbursement policies, and the business franchises of individual healthcare companies. For long positions, we seek biopharmaceutical and medical device companies with distinguished scientific efforts aimed at addressing unmet clinical needs. We also pursue healthcare services companies demonstrating operational excellence, those led by astute management teams that have created differentiated business strategies poised for a new era of more efficient, cost-conscious care. Shorting can help us better isolate a particular theme we wish to embed in the portfolio. For example, right now some of our largest long positions are in the companies most active in immuno-oncology, a treatment that seeks to engage a patient’s immune system to fight cancer. While the idea of mobilizing the immune system to treat cancer has been around since the 1880s, major scientific breakthroughs enabling the practical application of immunotherapy have only occurred within the past few years. We think the innovation cycle has reached an inflection point. Certain immuno-oncology therapies are showing promising results in the treatment of lung cancer and melanoma; potential worldwide sales in these and other cancer categories could reach tens of billions of dollars. While some biopharmaceutical companies excel in these types of breakthroughs, the innovation is much less pronounced across the biotechnology subsector as a whole. We can better emphasize the portfolio’s immuno-oncology theme by shorting market instruments representative of the subsector in general, including biotechnology ETFs. Again, our goal is not to invest in healthcare or its subsectors as a whole, but rather to invest in what we view as the best opportunities within that universe.
Healthcare portfolio Number of equity issuers Top 10 long issuers (% of market value)
114 32
Gross long exposure (%)
113
Gross short exposure1 (%)
–61
1
Net exposure1 (%)
52
Net exposure by category (%) Geography United States
40
Europe
9
Japan
5
Asia/Australia
0
Emerging markets
–1
Canada
–3
Sector/industry Biopharmaceuticals large cap (>$20B)
29
Biopharmaceuticals mid cap ($2B–$20B)
26
Biopharmaceuticals small cap (