From the June 2006 issue of Wealth Manager Web • Subscribe!

June 1, 2006

A Home of Their Own

In February, Morningstar officially recognized long/short mutual funds by rolling out a fund category for the niche. It's the Morningstar equivalent of saying, "Welcome to the party, here's your seat."

Previously, long/short funds were catalogued under the moderate and conservative allocations categories. No longer forced to live surreptitiously within other equity categories, long/short funds now have a Morningstar corner that they can call their own. The practical result is that investors can easily slice and dice the group, just as one can crunch the numbers on, say, small-cap equity, short-term bond funds, or any of the dozens of other Morningstar fund categories.

Formal recognition is one thing; deciding if long/short is worthy of a strategic allocation is something else. The fact that Morningstar identifies the group as something separate and distinct doesn't change the reality that this is still an eclectic bunch with mixed results. "There's a lot of very diverse strategies in this category, even though there aren't a lot of funds in the category," says Dan McNeela, a CFA and associate director of fund analysis for Morningstar.

If history is any guide, the diversity is set to increase. Indeed, the long/short mutual fund population, although relatively small, has been growing. One reason is that it's riding on the coattails of the hedge fund boom. So-called alternative investing strategies have been hot in recent years. Some of the popularity has spilled over into long/short mutual funds, which specialize in various hedging strategies, albeit in relatively diluted form compared with their privately managed counterparts.

Labels aside, deciding what determines if a fund engages in a long/short strategy is more art than science. Morningstar's definition requires that short positions comprise at least 20 percent of portfolio assets over time. Some question if that's the right number. Others say that trying to pick any number is hopelessly subjective since the 20 percent minimum excludes some funds that are elsewhere deemed worthy of the long/short label.

In any case, Morningstar's definition pulls in 28 funds as of this past February, according to its Principia fund analysis software. That's up from four funds a decade ago, with four new launches coming just last year. Total net assets in the category were $9.9 billion in February, although the five biggest portfolios held nearly 80 percent of the money (see Table 1). The oldest is the 29-year-old Gateway, which hedges by selling covered call options on its stock portfolio.

There are more choices in the long/short category, but it's debatable if investors should dive in. Looking at the category's trailing performance, for instance, shows mixed results. For the three years through this past February, the long/short category average produced an annualized total return of 7.4 percent, which trails the S&P 500's 17.1 percent by a wide margin. The five-year record is better, with long/short funds posting a 4.6 percent annualized total return versus 2.4 percent for the S&P 500.

More encouraging results can sometimes be found in individual funds. Consider Diamond Hill Focus Long/Short, which through this past February has handily beat the S&P 500 over the past three years by an annualized 720 basis points over the index.. That makes the fund the performance leader in the category over that 36-month stretch.

Unfortunately, there's plenty of mediocrity, or worse, in the category, a caveat that convinces some advisors to steer clear. "I don't think anyone's consistently distinguished themselves [among long/short mutual funds] to the extent that long fund managers have distinguished themselves," says Tony Ogorek, a CFP who runs Ogorek Wealth Management, Williamsville, N.Y. He admits that the idea of mixing long and short is "seductive" because it offers twice as much opportunity as long only. But real-world results too often trail expectations, he concludes.

Another wealth advisor cautiously uses the group for client accounts by way of the Laudus Rosenberg Value Long/Short Equity Fund.. "It's done okay for us; it hasn't done great," says Norm Boone, CFP and president of Mosaic Financial Advisors in San Francisco. "We're looking to it as an absolute-return fund rather than a big winner," he explains.

If stellar returns aren't necessarily the attraction, perhaps a more-relevant analysis comes from looking at hedging aspect of the funds. The mixing of long and short equity positions, after all, is the raison d'?tre here, so long/short portfolios' ability to shine should reveal itself in the record of altering the risk/reward profile found in long-only equity funds.

In fact, on a number of hedging-related metrics, long/short funds overall look better than a performance-only profile suggests. For example, the five-year trailing price volatility for the long/short fund category (measured by standard deviation) is a relatively modest 8.66, or about 60 percent below the S&P 500's volatility. Meanwhile, the long/short category posts an R-squared of just 31 against the S&P, suggesting that the funds have a tendency to move independently of the stock market. In addition, the beta reading for long/short is a low 0.29, offering yet another sign that a large chunk of the market effect has been squeezed out of these portfolios.

But before you conclude that all's well, keep in mind that the long/short category posts a three-year trailing Sharpe ratio of just 0.66--less than half of the 1.5 for Morningstar's equity large blend category.

Overall, proceeding cautiously seems eminently logical in the long/short category. Although the same might be said for every fund group, the caveat is particularly fitting for this corner of the mutual fund world. In fact, some go as far as to warn that the extreme diversity among long/short mutual funds eliminates the value of analyzing the category on broad level.

That shouldn't come as a surprise, since the same holds true for comparing various hedge fund groups, says Ron Surz, president of PPCA Inc., a San Clemente, Calif. software boutique that designs portfolio-evaluation tools. One example: Peer-group analysis doesn't work well with hedge funds, he explains, courtesy of the wide variety of strategies that define the marketplace. By contrast, large-cap equity funds, for instance, are sufficiently similar so as to warrant analysis of the portfolios on a group level.

What's true for hedge fund analysis is probably true for long/short mutual funds, Surz muses. He notes that an expansive sampling of hedge funds with various strategies (global macro, long/short, etc.) have been shown to post correlations with one another of only 0.2 to 0.3 (1.0 is perfect positive correlation, 0.0 is no correlation). "What the low correlations tell you is that those funds don't belong together" for apples-to-apples comparisons, Surz says.

With that in mind, how does Morningstar's 28-fund long/short universe measure up on correlations among funds within the category? In search of an answer, we used Principia to run correlations on trailing three-year total returns among the largest eight long/short funds. The results vary quite a bit, with correlations ranging from a low of -0.24 up to 0.68. By comparison, running the same analysis on the eight largest large-cap growth funds shows a higher, tighter range of correlations, running from 0.83 to 0.95.

In sum, long/short funds aren't easily categorized. That's clear in both quantitative and qualitative terms.

The observation holds up under a qualitative survey, too. No one should confuse Hussman Strategic Growth (the top-performing long/short fund for the past five years through February 2006) with the Merger Fund. Both are in Morningtar's long/short category, but the similarity ends there. The Hussman portfolio is "a risk-managed growth fund," says manager John Hussman. The growth component comes by way of a stock portfolio, while the risk-managed side is delivered with a varying mix of options based on Hussman's outlook at any given moment. The degree of hedging fluctuates, depending on his analysis, ranging from 30 percent back in 2003 to the fully hedged fund position of 100 percent that prevailed in mid-March, Hussman tells Wealth Manager.

In contrast, the Merger Fund tries to profit from merger arbitrage. The fund's strategy calls for selling the shares of companies with announced plans for acquiring another firm, whose stock the Merger Fund buys. The strategy is long/short, but is driven by the historical tendency for falling prices in the stock of the acquiring company and rising prices in the target equity. The pattern is said to hold steady over time because it reflects the fact that the acquiring company gets hit with the price of the merger, while the target firm's stock benefits from what's usually a buyer's premium over the price before the merger announcement.

Yet another strategy is found in Laudus Rosenberg Value Long/Short Equity. The idea here is buying stocks that look poised to rise, and shorting those that appear overvalued.

Mixing long and short positions is nothing new, of course. A. W. Jones invented the hedge fund concept in 1949 by emphasizing shorting and leverage as strategic complements to long equity positions. The strategic challenge in 2006 is separating the talented shops from the mediocre ones. While that's fairly straightforward when it comes to dissecting long-only portfolios, the task is more complex in the long/short world.

One of the key variables for analyzing long/short results is assessing the degree of market neutrality, or the lack thereof, says Kevin Johnson, a principal with Aronson+Johnson+Ortiz, a Philadelphia money manager that oversees $24 billion. A quantitative-oriented small-cap equity shop, the firm launched a privately run long/short fund in 1997 that built on the company's stock selection focus. "When we get it right, we make twice as much money, or more than twice as much money as compared with our long-only work," Johnson explains.

A proper comparison of AJO's long/short fund with competitors requires finding like-minded portfolios, Johnson adds. That includes long/short funds that are dedicated to maintaining market neutrality, which he defines as a 50/50 split between long and short positions. Such balancing ensures that the AJO's long/short portfolio will rise, or fall, primarily on individual security selection. That's by design, he emphasizes.

AJO's approach contrasts with the ICON Long/Short Fund, a mutual fund that touts its industry-focused strategy as the determining factor for shorts relative to longs. Market neutrality is of no concern for the fund, which has dramatically outperformed the S&P 500 in the last three years through February. In essence, the fund favors companies in industries ICON deems undervalued that also show strong relative price strength. Meanwhile, ICON shorts stocks in industries that are considered overpriced and suffering weak relative price strength, says Craig Callahan, president of ICON Advisers. Security selection on individual companies, he admits, isn't crucial for results.

Unsurprisingly, ICON's shorts vary in terms of the overall portfolio. In late March, for instance, ICON Long/Short had only a three-percent short position. Over time, short positions can range from zero to 50 percent of assets. Since the fund's launch in 2002, the highest percentage of shorts has been 24 percent, in early 2004, Callahan says. In fact, because short positions can and do dip below 20 percent at times, Morningstar excludes ICON Long/Short Fund from its long/short category.

The question is whether there's any value to tracking funds in a category where strategic differences can and do produce a wide range of results. Comparing a market neutral-oriented long/short fund with ICON's long/short offering, for instance, is arguably meaningless, since one is driven by security selection and the other by industry choices.

Morningstar, however, begs to differ. "The benefit of having a category is to allow you to look at funds as a group," says McNeela. He has a point, but not necessarily the one the data firm intended. Giving long/short mutual funds a space of their own certainly makes it easier to analyze the portfolios. But the analysis may persuade some to look elsewhere for their alpha.

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