Historically, institutional investors have allocated to long-short equity hoping for attractive returns that are not too dependent on market exposure. In the past, institutions have accessed long-short equity via hedge funds, but more recently some are looking to mutual funds for their long-short allocation.
One of the reasons for the disparity between retail and institutional funds has been the appreciable difference between both the risk and return characteristics. When considering total returns for long-short equity, hedge funds have historically had the upper hand when compared directly to their mutual fund counterparts. As shown in the table below, the HFN Long-Short Equity Index has outperformed the average long-short equity mutual fund over every trailing period with the exception of the past three years. Over the last 15 years, the difference is substantial at 7.43% per year net of fees.
However, how much risk, or beta exposure, are the two groups taking? For the latest 10-year period, the average mutual fund beta of 0.53 has been considerably higher than the average institutional hedge fund beta of 0.38.
The key question though is how much alpha, or return, from security selection, or skill, have managers in both groups provided? The results reveal that hedge fund long-short equity managers have produced more alpha than the average long-short equity mutual fund manager for all time periods, ranging from 0.27% over the last three years to 6.14% over the last 15 years.
However, in spite of the historical underperformance of long-short equity mutual funds, it appears that the tide is turning in their favor due primarily to a recent migration of institutional hedge fund managers into the mutual fund space. Today, there are nearly 100 funds in Morningstar's Open-End Long-Short Equity Mutual Fund category, which represents appreciable recent growth, but the number of mutual funds is still less than 10% of the number of institutional long-short hedge funds. Whether through a fund of funds or direct, many managers that in the past were only available via private partnerships are now accessible in mutual fund format.
According to a recent survey by Morningstar, long-short equity mutual funds are becoming the vehicle of choice for institutions. The survey stated that "while 61% of institutions said they accessed long-short strategies via hedge funds in 2010, only 26% indicated that they used hedge funds for that strategy [in 2012]. In contrast, more than 45% of institutions said they access long-short strategies via mutual funds versus 38% in 2010." Josh Charney, alternative investment analyst with Morningstar, said that "the long-short mutual fund space has grown up a lot over the last few years," noting that the factor for both retail and institutional investors boils down to finding the best talent.
It is clear that despite the superior outperformance of hedge funds, institutions are now allocating heavily to long-short equity via mutual funds rather than hedge funds. What remains to be seen is which funds within the mutual funds peer group can deliver on true institutional strategies with low beta exposure allowing the return to be generated predominantly from alpha.