Performance During The Pandemic (Part 1)
In part one of this two-part series, Alpha Theory analyzes how their clients performed during the COVID-19 pandemic. Read on to discover what can be learned from the managers who outperformed and how to avoid the mistakes of those who underperformed.
As major indices approach, and even surpass, their pre-COVID levels, we wanted to take a step back and look at how our clients weathered the storm. What can we learn from the managers who outperformed, and how we can avoid the mistakes of those who underperformed? Using February 19th, 2020, the all-time high of the S&P 500, as a starting point, we broke our clients into quintiles based on the alpha returns versus the SPY ETF over the period ending July 24th, 2020 (see below for total returns by quintile). We also narrowed our analysis to look exclusively at long/short clients to ensure an apples to apples comparison.
All quintiles stayed net long over the duration of the period (chart below). Looking at just the top (green) and bottom (red) quintiles, we get a sense of how important net exposure was over this period. Not only was the top quintile carrying the highest net exposure, but they were also the first to get their net back to pre-COVID levels (April 7th). In contrast, the bottom quintile has yet to exceed pre-COVID levels of net exposure.
Looking at the long exposure of the return quintiles (chart below), we see almost no difference between the long exposure of the best and worst-performing managers.
This means that the big difference in net exposure between the best and worst performers was due to higher short exposure for the worst performers. The worst performing funds in the fifth quintile had much higher exposure on the short side, which ate into their returns as markets returned to life. You can also see that their short exposure has only increased since the market bottom, further eroding returns as markets continue to climb.
But this is only part of the story, as high long and short exposure with a small net positive exposure should have led to a small gain over the period. In order to understand what’s really going on, we need to look at gross exposure-adjusted returns on the long and short side.
Long Return on Invested Capital (ROIC – what was the return of the average position-weighted stock return over the period – excluding leverage = +15% for the highest quintile, -10% for the lowest quintile) was the major contributor to the difference in quintiles.
Short ROIC for the period for all clients was tightly clustered compared to long ROIC, with the best performing cohort losing about 2% on their shorts and the worst performing losing 9%. In fact, the top and bottom performing quintiles from a total return perspective had almost identical short ROIC.
The poor long return for the 5th quintile combined with increasing short exposure was a major cause of their underperformance. Investors in the top cohort, despite large losses as markets plunged, were willing to add exposure at the bottom and frankly, just picked better longs.