This screen is a good starting point for navigating an eclectic group of "alternative" options.
Searching for an appropriate long-short fund for your clients' portfolios requires extra homework. After all, the category represents a fairly eclectic group: Some strategies can be appropriate core holdings for risk-averse investors, while others are more sensitive to stock price movements and might provide less of a cushion in a downturn.
Morningstar Office and Principia are helpful tools for combing through the long-short category. Given the wide range of strategies at play, we searched for long-short funds with five-year records that came out ahead of the category average during that time frame. And because style and management consistency should be a top priority, we made sure that the current management team was responsible for the five-year record.
Special Criteria = Distinct portfolios only
And Morningstar Category = Long-Short
And % Rank Cat 5 Yr <= 50
And Manager Tenure (Longest) >= 5
Lastly, it's key to limit the results to funds with below-average fees. Funds in this category tend to sport some pretty hefty expense ratios, especially those with smaller asset bases or more trading-intensive strategies. So, we required that the funds be open to new investments with expense ratios under 1.5% annually.
And Purchase Constraints not = Closed - New Investment
And Audited Expense Ratio < 1.5
After performing this initial sweep, we suggest following up with Morningstar Fund Analyst Reports to get a sense of how these funds have fared during various market cycles in order to find the portfolio complement or anchor that best suits your clients' needs.
As of Oct. 15, this screen pulled eight funds from roughly 75 options in the category. We'll highlight some examples of long-short portfolio anchors and supporting players that get a green light from Morningstar analysts.
Hussman Strategic Growth
This fund is one of the most reasonably priced options on the list. In fact, it was one of the cheapest options in its category even before the fund's board decided to slash its expense ratio to 1.04% annually from 1.1%. In addition to this shareholder-friendly move, we've been impressed by other steps taken by this fund's management. For example, manager John Hussman provides weekly commentaries and low minimum investments, and he has a sizable personal investment alongside fundholders. In addition, the fund is overseen by an independent board, which is compensated in fund shares.
Hussman analyzes market conditions by keeping tabs on price trends, trading volume, and valuation measures, and he then makes decisions on the most attractively priced stocks.
In addition, he uses put and call options on the S&P 500 Index to hedge the portfolio when his market outlook is gloomy, or he can simulate 150% market exposure through call options when things look rosier.
Hussman was able to limit the fund's losses in 2008 to 9%, putting it in better standing than two thirds of other long-short strategies. More importantly, the strategy has delivered over the long term. Its 2.9% average yearly return in the past five years beats the S&P 500's results by more than 2 percentage points.
This fund may have had low market exposure in the past, but Hussman plans for greater market exposure in the future. This fund is a good risk-managed alternative to a core equity holding.
Our only Analyst Pick in this category is Gateway. Patrick Rogers invests this portfolio's assets in a broad basket of stocks that reflects the S&P 500 Index.
He simultaneously sells call options and buys put options on the index depending on the price of volatility. When the market dips, the call options make money, which mitigates some of the stock losses. Buying index put options also provides protection from large market declines. When volatility spikes, however, these puts get expensive, and Rogers won't write puts on 100% of the portfolio.
This strategy limits upside-the bogy was up 16% for the year to date ended Oct. 1, while this fund gained 2.5%-but it's certainly an attractive core holding for risk-averse types. In 2008, the fund's 14% loss represented just 40% of the broad market's loss, which is precisely what the fund is designed to do.
Rogers' experience and active risk management are another notch in the fund's favor, making it an attractive alternative to passive buy-write option strategies available through some ETFs.
Calamos Market Neutral Income
This fund's two distinct strategies combine to provide solid risk-adjusted returns. Manager John Calamos (who has more than 20 years of experience investing in convertible securities) relies on covered call writing, which involves selling calls on the S&P 500 Index as well as muting downside risk through index puts. And to a lesser extent, Calamos uses convertible-arbitrage, which seeks to exploit mispricing in convertible bonds while offsetting some equity risk by selling the related stock.
Last year, the convertible market blew up in part because of forced selling by hedge funds, contributing to this fund's 13% loss. That said, continued market volatility in 2009 has boded well for the covered call strategy, and the fund has posted a healthy 10% gain for the first three quarters of this year.
Investors looking to diversify the risk of their equity holdings should consider the fund as a portfolio complement. The firm's expertise in convertibles investing argues strongly in its favor, and we think that it can continue to provide solid long-term results.
Diamond Hill Long-Short
This option makes a good portfolio complement for bolder investors. Its raciness comes from its short positions, which are fundamental directional bets on individual stocks rather than hedges to offset market exposure. Managers Chuck Bath and Ric Dillon will also short index ETFs on occasion, which serves as a bet against a basket of stocks (such as all holdings within the Russell 2000) when individual shorts are hard to borrow. They keep the fund's net equity exposure (long-stock minus short-stock dollars) between 40% and 70% of net assets, and for the long portion of the portfolio, they rely on bottom-up stock analysis, emphasizing firms with shareholder-friendly management teams and sustainable competitive advantages.
The fund's 2008 performance underscores the fund's riskiness. It shed roughly 24% compared with the typical peer's 16% loss, partly because management had trouble finding viable short replacements after covering some short positions, including Ford F, before they hit bottom.
That said, we've been pleased to see that management has stayed true to its strategy, and we think that they are well-positioned to replicate it successfully long term. As of October, the fund's 5.6% average gain in the past five years outpaced the S&P 500 Index by 4 percentage points.
Bath's long-term fundamentally based strategy has prospered over the long haul-both here and at Diamond Hill's long-only funds. We think this fund will continue to do well for the long haul.
Karin Anderson is a mutual fund analyst with Morningstar.