In recent years, mainstream investors have increasingly embraced long-short equity mutual funds. Fund launches only began to accelerate in the aftermath of the financial crisis, so investors’ collective experience with these funds has been largely acquired during an equities bull market.
Because investors tend to think in relative terms during bull markets and absolute terms during bear markets, many advisors have indicated frustration with funds in the category. Is that frustration warranted? Have long-short equity funds performed within expectations?
We analyzed the performance of Morningstar's U.S. Open End Long-Short Equity Category Average, the HFRI Equity Hedge (Total) Index and the HFRX Equity Hedge Index from January 1998 to June 2015, which represents the longest common time frame for the three indexes. Admittedly, all of these proxies of long-short equity performance have their problems, including survivorship bias, self-selection bias and inclusion of funds that aren't truly representative of the category. However, they can still serve as appropriate reference points for investors evaluating the overall characteristics of the category.
Our analysis aimed to answer two questions. First, have long-short funds, regardless of vehicle type, lived up to the hype? And second, have mutual funds behaved materially differently from hedge funds?
We expected mutual funds to have trailed their hedge fund peers, but we assumed that gap would be narrowing. This is because many of the managers in the mutual fund space are (or were) untested at shorting stocks. Managing a short book, as opposed to simply hedging beta risk with ETFs, is a substantially different skill set from what most long-only managers bring to the table.
However, we found that long-short funds have generated returns that, on a Sharpe ratio basis, exceed long-only equities (an average of 0.46 versus 0.33 for the S&P). Additionally, they’ve demonstrated an ability to substantially reduce volatility as well as drawdowns. Given the significant opportunity cost involved in getting back to even after a large loss, this is impactful.
There is one area where expectations aren't being met — correlations — but for the wrong reasons. Any fund that has consistent net-long equity exposure is likely to move in the same general direction as equity markets over most time periods. While we are big believers in a long-short equity strategy, it isn't a great diversifier in the traditional sense. Long-short funds will understandably exhibit high correlations to equities.
Thus our second question: Are mutual fund investors well served relative to their limited partnership peers? This is admittedly more difficult to answer.
We are advocates of rigorous due diligence when selecting managers. There are great hedge fund managers and terrible ones. Simply managing a hedge fund does not confer superior skill. Likewise, there are skilled mutual fund managers and not-so-skilled ones. The manager, not the vehicle, is what matters most.
The chart above shows that in the late 1990s, investors did far better in hedge funds. But as stated earlier, there were few mutual funds in the category at that time, and some were not properly categorized. Since then, the results are mixed. The annualized return differential between the HFRX index and Morningstar category average since January 2000 is a mere 25 basis points in favor of mutual funds. At a minimum, this suggests there hasn't been much of an advantage based on vehicle.
We think it's fair to conclude that long-short equity funds have lived up to their promise. However, manager due diligence is key. If long-only active managers have difficulty consistently adding value, it's fair to say that the additional complexity of managing a short book makes it even more difficult. The bottom line? Invest with managers who prove they generate alpha on both the long and short books. If they can't, you’re likely better off putting your money elsewhere.