Long-Short Equity Funds: Heroes or Hype?

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.