Back to Basics on Long/Short Strategies

Financial advisors considering mutual funds that mimic traditional long/short hedge funds should take into account several factors about these increasingly popular funds, such as the fund's mandate, experts say.

A back-to-basics approach will go far toward understanding the complexities of the investment strategy, which has been on an asset-gathering tear. About $22.5 billion of new money flowed into these vehicles last year, accounting for about 8.4% of all equity fund inflows, according to Morningstar. In all of 2013, 27 funds were launched, and 16 more started up in the first quarter of 2014, to bring Morningstar's count to 121.

Morningstar alternative investments analyst Josh Charney follows several long/short funds and offers one rationale for considering this strategy. "On a forward-looking basis, we would expect the S&P to have more risk with less return," he says. "Now might be a good time to start diversifying your portfolio."

A slowdown in the market accompanied by an increase in volatility could make hedge funds begin to look more interesting. But long/short returns are especially unpredictable because strategies vary more from fund to fund than in most long-only funds. In this category, returns rely less on market dynamics and more on the decisions of the fund manager. Below are a few other key issues to consider.

DOES THE STRATEGY USE LEVERAGE?

Many long/short strategies invest more than 100% of assets. For instance, for every $100 of assets in the largest long/short hedge fund, MainStay Marketfield (MFADX, MFLDX), on June 30, 2014, the fund held $86 of long stock positions, $29.70 short, $1.50 of equity futures long and $15.50 of futures short. More than the fund's $20 billion in assets was invested, but the fund's "net" long exposure was about half the market's.

Leveraged funds will exaggerate the impact of the portfolio managers' skill and timing. Over 2008 and 2009, the MainStay Marketfield Fund, which can apply leverage, made money for its investors, compared with a loss in value for the S&P 500 over the same period. In a reversal so far in 2014, however, MainStay Marketfield was down 4.8% through August as a result of some missteps.

"They've been wrong," Charney says.  

Certain types of long/short funds, generally categorized as 130/30 funds, must use leverage to achieve their net 100% market exposure. These funds invest $130 long and $30 short for every $100 in assets.

There's even more leverage in the Gotham 170/70 fund, Gotham Enhanced Return Fund {GENIX), which is just over a year old. As of Aug. 31, the fund was up more than 13%, compared with the S&P 500's 5.5% gain. With 418 long and 428 short positions, stock picking is working for this fund.

The $3 billion Neuberger Berman Long Short (NLSAX), now in its third year, has a "fundamentally driven approach to long/short investing," according to the firm. This fund, managed by Charles Kantor, can hold up to 30% in fixed income (13% in bonds at the end of July), doesn't normally use leverage and aims to control risk.

Marc Regenbaum, senior vice president and research analyst with the Kantor Group at Neuberger, explains, "We are generally 30% to 60% net invested. We don't like leverage from a risk management standpoint." The fund was up less than 1% this year through Aug. 31 and up 9% over the previous year. 

Image: Keith Glenfield, Bank of America Merrill Lynch. Photo by Jordan Hollender

WHAT ROLE DOES CASH PLAY?

A large cash position in a long/short strategy that holds futures may indicate an aggressive portfolio strategy. The fund's investor information will disclose if cash is held as collateral against futures positions.

Other managers use cash to control market exposure. The AllianceBernstein Select US Long/Short Portfolio (ASLAX) held almost a third of its assets in cash at the end of July. The fund was up a little more than 1% through August.

"The way we think about exposure is that gross exposure is usually less than 100%," says Josh Sonneland, a portfolio specialist who works with Kurt Feuerman, lead portfolio manager for the Alliance fund. "If we don't see a lot of opportunity on the short side, we carry cash instead."

Less than 8% of assets, about half of what's typical, were in short positions as of in mid-August, which Sonneland explains is strategic. "Kurt has been positive on the market," he says.

Also, the fund managers worry about the risk in shorts for other reasons. "A lot of money in hedge funds is chasing the same shorts," Sonneland says. In addition, "merger risk is heightened when low-quality companies can be purchased with low-cost money by strategic buyers."

The manager of Pimco's EqS Long/Short Fund (PMHIX), Geoffrey Johnson, has a history of using cash strategically.

"We can go from 100% to 0% invested or even net short," he explains. "From the summer of '08 until April of '09, we were almost all in cash. We were a private partnership then, but the rules of the fund haven't changed."

"Pimco knocked it out of the park last year," Charney says. Good stock picking led to a 34% gain in 2013 even though the fund was only 65% net invested. This year through August, the fund was down 2%.

WHAT IS THE FUND'S MANDATE?

Most long/short equity funds are driven by stock selection, but macroeconomics and industry opinions influence portfolios to varying degrees. Funds differ in the priority placed on capital protection versus performance and in how many different asset classes a fund uses.

Robeco Boston Partners Long/Short Equity Fund (BPLSX), up more than 10% so far in 2014, has a relatively narrow mandate: "The fund pursues its objective by taking long positions in stocks identified by the advisor as undervalued and short positions in such stocks that the advisor has identified as overvalued." Its list of more than 300 individual company holdings, long and short, at the end of July is consistent with the stated strategy.

MainStay Marketfield's long/short fund objective seeks capital appreciation through a broad range of strategies. Its eclectic top 10 holdings list on June 30 showed long positions in Japanese and Mexican securities, along with several individual stocks, the U.S. homebuilder index and Bank of Ireland preferred stock.

Setting expectations for performance is important: Is the fund superaggressive and more volatile, or protective and lower return?

AllianceBernstein's Sonneland provides one example. "Our fund (Select US Long/Short) fits the bill for an absolute-return strategy," Sonneland says. "It has low correlation with equities, low correlation with bonds. It has the characteristics of a good market diversifier."

'FRUITFUL ASSET CLASS'

Long/short strategies will have widely varying results, making them far from interchangeable in a client's portfolio. Mainstay Marketfield's MFADX's decline of about 5% this year, Robeco Boston Partner's BPLSX's gain of more than 10% and NeubergerBerman's NLSAX's return of just under 1% illustrate the point rather powerfully.

"Investors are performance chasers," Charney warns. He suggests advisors look carefully at the long-term record, portfolios and processes of the funds, not just at recent performance.

Much of the long/short fund exposure now is concentrated in a few funds, but receptivity to the mutual fund structure for hedged exposure is growing.

"We do believe that these funds will be a lot of the future and will evolve into a fruitful asset class," Charney says. "We will see more conversions of private hedge funds to liquid alternatives." 

Margo Epprecht, Chartered Financial Analyst, is a financial writer and former stock analyst.

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