Three Traits of a Successful Long-Short Equity Manager

The alternatives category provides an exciting new approach to the old asset-allocation conundrum. Many investors seek the long-term return potential of the stock market, but bail out when volatility creeps up a few notches, only to miss out on any sort of recovery. The difficulty for advisors is how best to dampen volatility in their clients' portfolios, so that it's palatable during turbulent times, while still insuring that their clients will have adequate funds for retirement. A long-short equity fund may be just the solution. Since these funds can short securities, managers can hedge the portfolio and boost returns in a down market. But buyers beware; not every long-short fund is good. In fact, the average long-short mutual fund manager has lost money over the last one and three years (ended Sept. 30), while the S&P 500 is up. Several long-short managers have handily beaten the market, however, on both a total-return and risk-adjusted return basis. Here are a few traits that separate the good from the bad.

Proven Short-Seller
Conveniently, the first characteristic of the most skilled long-short managers can be found right in the category's name: short(ing). Despite the number of funds that short (there are more than 70 long-short equity funds), there are few that are good at it. Although screening on a manager's short performance is difficult (funds are not required to segregate long and short performance), one way to determine a manager's shorting acumen is see how much alpha (or outperformance above the fund's exposure to the market, or beta) a fund provided during a market's rough patch, which is when a shorting strategy should pay off. Of the 27 funds around in 2008, only 10 exhibited alpha.

Besides looking at past performance, one should also investigate a manager's shorting background. Pay close attention to specific experience related to short-selling. A manager with long-only experience exclusively may not be an ideal candidate for a long-short fund. Managers tend to be better at short-selling if they couple their security valuation and selection with some sort of timing discipline. Most hedge fund managers use technical indicators, such as momentum. The reason is as follows: A losing short position becomes a larger part of the portfolio because the stock is going up (and can keep going), while a losing long position becomes a smaller part of the portfolio, and can only go to zero. A badly timed short position can be much more costly than a poorly timed long call.

Wasatch Long/Short FMLSX is an example of a fund that follows the right approach. The managers look for clear reasons for why valuations may soon fall and look for technical breakdowns before they pull the trigger. If the thesis turns out to be wrong, and the short goes against them, they will cover or trim the position, as they did with technology stocks in the third quarter 2010.

Diamond Hill Long Short DIAMX, on the other hand, is an example of a fund with a history of shorting problems. Its 2008 to 2010 struggle forced management to fundamentally change the way it approached shorting this year. Prior to the change, it shorted securities based solely on high prices. Consequently, it shorted stocks that continued to rocket up in 2010. Management has adjusted its strategy to accommodate more lofty valuations in stocks with upbeat fundamentals, but timing has not yet made its way into the fund's shorting process.

Macro–Aware
When selecting a long-only manager, choosing a skilled market-timer is often not high on the priority list. More often, managers are judged on how they perform against their peers, so managers with laserlike focus on their sector or style of expertise are often preferred. But long-short managers can boldly go, well, anywhere and have the freedom to raise or lower market exposure, which affects the funds' total return. Therefore, part of a long-short manager's value-added is not just to pick the right stocks, but also to time the market.

These days stocks both within and across sectors are more highly correlated than ever (as measured by the CBOE S&P 500 Implied Correlation Index, for example), so a long-short manager needs a greater grasp of the fundamental macroeconomic environment. Most long-short managers such as Highland Long/Short HEOAX state that they are fundamental stock-pickers, but even Highland Long/Short alters its market exposure using exchange-traded funds based upon its macroeconomic outlook.

A few long-short managers actually start the security selection process with macroeconomic research. Marketfield MFLDX is a good example. Marketfield constructs its portfolio around a handful of macroeconomic themes and then figures out how to best trade those themes, whether it be a selection of representative securities or a sector exchange-traded fund (Brazilian banks in the last quarter of 2009, for example).