Now that the tide has gone out, to paraphrase Warren Buffett, we see who’s been swimming naked. And it appears that almost the entire asset management industry has been on the nudist beach. As we are currently witnessing, all long-only funds rely largely on market beta for returns, are highly correlated to the market and each other, and therefore offer little in the way of diversification benefits. 
Over the past few years, a rampant bull market in liquidity has dulled investor appetite for diversification and led to a chronic underappreciation of short alpha capability. Absolute Return Funds offer hedging of market exposure but have attracted often valid criticism: either they have a too volatile “return free risk” profile or they charge high fees for “going nowhere”.
We believe that the true attraction of alternatives is not through well-timed negative beta, or low volatility for its own sake, but by the consistent and diversified generation of “double alpha” on both long and short books. It might surprise people to learn that our strong performance in negative markets has been achieved despite always being net long the market in aggregate.
The ability to generate short alpha had become a lost art in a bull market where short books have generally been a handbrake to returns. Now in just a few weeks the European market has fallen back to 2011 levels, short alpha is being rewarded in spades. Deceits, Ponzi schemes and poor business models which were previously sustained by investor complacency and a general lack of scepticism, have been unmasked and are now unravelling at an astonishingly rapid pace.
Investors in general have not prepared for this. They have simply extrapolated the recent bull market past and positioned themselves only for positive outcomes. They are in woefully underweight short alpha capability which is a skill that cannot be cheaply replicated by passive product.
Our strategy has previously had periods of inconsistent returns, particularly when we failed to appreciate the dangers of shorting in liquidity bull markets. When you are right in the long term but so painfully wrong in the short term, the lesson I took was that the fund was not sufficiently diversified to deal with short-term failure, even if my stock analysis proved correct in the long-term. This is a lesson that even the market bulls would do well to heed today.
Many investors won’t have previously experienced a bear market like we saw in 2008. The current environment is a supreme test of the skill of portfolio construction: aiming to deliver consistent positive returns - whilst managing volatility and correlation in a highly volatile, negative market where individual stock correlations often converge - is not easy.
It is also important to remember that this bear market will eventually pass. We are expecting a “V-shaped” recovery. But it is by no means clear that we are yet at the bottom of the “V”. That’s why we hedge.
Barry Norris is manager of the Argonaut Absolute Return fund. The views expressed above are his own and should not be taken as investment advice.