The benefits of an active long-short ETF
Markets are volatile and traditional portfolios are under pressure. Long-short ETFs aim to profit from both rising and falling stocks, but they come with trade-offs investors need to understand.
Markets are sending mixed signals, investors are feeling it, and recent events in the Middle East are a stark reminder of just how quickly sentiment can shift.
Escalating geopolitical tensions, persistent inflation, shifting central bank policy globally and uneven global growth have all combined to create an environment defined by volatility.
Sharp rotations and sudden drawdowns have become the new norm.
In this landscape, relying solely on long-only equity strategies can leave portfolios exposed. This is where an active long-short strategy can earn its place.
A more adaptable way to invest
Most investors know how long-only strategies work: buy stocks you believe will rise, and profit as they (hopefully) do. But this investment approach has a structural limitation; it only works in one direction.
A long-short strategy removes that constraint. It combines long positions in companies expected to rise with short positions in those expected to fall, allowing a portfolio to generate returns on both the long and short positions the portfolio takes.
In volatile environments, that flexibility becomes critical.
When markets decline, long-only portfolios are increasingly exposed.
But an active long-short strategy has the ability to generate returns from falling share prices, helping to cushion downside. And when markets recover, it can still participate in the upside.
While some active long-short strategies can be difficult for everyday investors to access, those offered through an ETF structure are not.
An ETF is liquid, significantly more accessible and offers a transparent and convenient way to access what has traditionally been an institutional-style strategy.
Breaking free from index constraints
One of the defining advantages of an active long-short ETF is its ability to move beyond benchmark limitations.
In markets like Australia, indices are heavily weighted toward a small number of sectors and companies.
Long-only ETF strategies often inherit this concentration, whether intentionally or not.
But active long-short ETFs are not bound by these constraints.
By incorporating short positions, managers can take advantage of both positive and negative views, building portfolios based on conviction rather than index weight.
This expands the investable universe and allows for a more balanced exposure, reducing reliance on a handful of dominant stocks and sectors.
Managing risk in real time
Volatility is about how portfolios respond to it.
An active long-short ETF provides a more dynamic approach to risk management.
Portfolio managers will adjust their long and short exposures as conditions change, increasing defensive positioning during downturns and leaning into opportunities when markets stabilise.
This ability to actively manage exposure can help reduce drawdowns, smooth returns, and limit unintended risks.
It also allows for more precise control over sector and factor exposures, making portfolios more resilient in the face of sudden market shifts.
Unlocking new sources of return
Beyond risk management, an active long-short ETF is designed to generate alpha.
By identifying both outperformers and underperformers, it provides investment returns that are not dependent on overall market direction.
This can be particularly valuable in periods where index returns are muted, but stock-level dispersion is high.
A long-short strategy offers investors the ability to increase a portfolio's market exposure by reinvesting the cash generated from its short-selling transactions of overvalued stocks, to long positions in stocks which offer higher conviction, as shown in the graph below.
This allows managers to use good stock picking to create a portfolio with greater than 100 per cent total exposure, and in turn magnifying returns over the long term.
Understanding the trade-offs
As with any strategy, there are risks to consider.
Short selling introduces unique challenges, including the potential for losses if share prices rise sharply.
The use of leverage can amplify gains but can also amplify losses. There are also practical considerations around borrowing costs, and transaction expenses.
Fees may be higher than traditional passive or long-only strategies, reflecting the active management and complexity involved.
Crucially, performance is highly dependent on manager's skill.
The ability to identify both long and short opportunities, and to manage risk effectively is central to outcomes.
A role in modern portfolios
The investment landscape has changed and portfolio construction needs to evolve with it.
Active long-short strategies are not a replacement for traditional equities, but a complement, one that can increase diversification and improve overall portfolio resilience.
In an environment shaped by geopolitical shocks, including the ongoing Iran conflict and the resulting market and economic fallout, diversification provided by a long-short strategy is increasingly valuable.
Of course, not all active ETFs are the same. TCAP - the ASX listed ETF version of Ten Cap's Alpha Plus Fund is currently one of the best performing alpha extension funds within the Australian long-short universe.
Alpha Plus aims for "equity-like" returns but with less market volatility given the fund's ability to hold both long and short positions.
It offers clients core exposure to the ASX200 Index but with the additional option of holding up to 10% outside the benchmark in small and mid-cap stocks. It is style agnostic and utilises a proprietary sector based hedging strategy, making it a smart choice for investors.
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