Long-short money managers have been breathing a sigh of relief with the end to the Securities and Exchange Commission's ban on short sales of financial stocks. The three-week SEC ban on the short sale of some 1,000 financial stocks that ended Oct. 9 had wreaked havoc among money managers.
Long-short mutual funds, for example, typically deliver absolute returns independent of the performance of the overall stock market. They achieve that goal by shorting overvalued stocks and taking long positions in undervalued stocks. In theory, adding a market-neutral fund, such as a long-short fund, as a portfolio diversifier may deliver attractive results; market-neutral funds, including long-short funds, have low correlations to the stock market.
Marta Norton, an analyst with Morningstar, said that many long-short mutual funds are living up to investors' expectations even though they could not short financial stocks for a few weeks.
So far this year, long-short funds have taken in $6.3 billion in net flows, as investors took shelter from the financial storm that saw the average stock fund drop 30%.
"Not surprisingly, in the current down market, many long-short funds have held up much better than the traditional long-only variety and the broad market," Norton said. Reason: The fund managers had a long list of nonfinancial stocks as short-sell candidates, and they did not have to abandon financial stocks short sales that were in place before the ban was implemented, so they profited from those positions.
But the recent three-week SEC ban took its toll on many long-short managers. This year, through Oct. 10, the average long-short mutual fund declined -15.3%. While this is not nearly as bad as the average domestic stock fund 30% decline in that time, previously, the best-performing long-short mutual funds were delivering returns of 5%, according to Morningstar.
James Paulson, a co-manager at Wells Capital Management in Minneapolis, said that a large number of long-short managers, including mutual funds, hedge funds and registered investment advisors, struggled when the SEC implemented the financial stock short-sale ban. It was difficult to find a large number of stocks in other sectors to short. As a result, market-neutral strategies were thrown out of whack.
Some managers sought alternatives to shorting financial stocks. For example, John Catalfamo, a partner with Primoris Capital Management in Palm Beach Gardens, Fla., said that he often uses pair trading to hedge positions, but when the SEC prohibited the shorting of financial stocks, he turned to exchange-traded funds.
"I often hedge my stock positions by buying short ETFs in the same sector," Catalfamo said.
Meanwhile, Cecilia Gondor, an analyst with Herzfeld Advisors in Miami, said hedge funds and other institutional investors had bought closed-end funds at a discount and shorted comparable exchange-traded funds. They then closed out their positions for a profit. This strategy worked when some hedge funds bought closed-end real estate stock funds at a discount to net asset value and simultaneously shorted REIT exchange-traded funds. This activity, however, subsided due to the crisis in the banking and credit markets.
Naturally, while we are a long way from reaching a positive turnaround in the markets, another big hurdle for long-short mutual funds managers will occur when the market finally rebounds into bull market territory. A money manager may be shorting overvalued and/or financially weak companies with deteriorating earnings. But even those stock prices can rise in a bull market. For example, in the bull market of the late 1990s, the poor performance of long-short funds was due to the performance of specific stocks, rather than the direction of the market. Overvalued companies with weak earnings, shorted by some funds, led the market.
Meanwhile, some funds were invested long in undervalued stocks that continued to lag behind. It was only when the long-short funds changed course and shorted the weak stocks that they began to rebound.
Dan Pickett, co-manager of Madison, Wisc.-based Nakoma Capital Management's Nakoma Absolute Return Fund, said his fund has, for the most part, side-stepped these pitfalls. He doesn't short stocks when there are big differences between a stock's fundamentals and its market activity. He relies on dynamic asset allocation, fundamental stock selection and risk management to run the fund.
So far this year, the fund is down just 5%, and for the trailing 12 months, it is down only 2.3%. By contrast, the Standard & Poor's 500 Index declined 38% for the year, and 41% over the prior one-year period.
"The fund has lived up to our expectations," he said. "Our goal is to earn 300 to 400 basis points more than T-bills. We want to beat cash by a premium to justify the risk."
Pickett also said that the fund ranges from a 25% net short position to a maximum 60% net long stake in stocks. Last year, the fund heavily shorted financial and consumer discretionary stocks. This year, the fund lightened up on its short positions in financial stocks, but maintained significant net short positions in the consumer discretionary sector because of the recession. Pickett also engages in pair trades. For example, last year the fund profited from buying CVS Caremark Corp. and shorting Starbucks.
"The emphasis on the short side remains focused on household durables, high price discretionary goods and housing-related companies," Pickett said. "The long offsets are held in stocks we think have company specific factors powerful enough to overcome the weak economic environment or are effective hedges."
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