This simple trick can help you halve some alternative fund fees.
Long-short equity funds can add useful diversification to an equity portfolio, but the strategy tends to come with a hefty price tag. The average long-short equity fund charges a whopping 1.85% expense ratio. Fees are, and have always been, the enemy of long-term returns, so it’s hard to blame anyone who considers a nearly 2% price tag a nonstarter. But with a little creativity, an investor can get a similar return profile from equity market-neutral funds at a much more appetizing price.
Equity market-neutral mutual funds are often touted as a fixed-income alternative, because of their low-return/low-volatility profile. Certainly, the category’s returns (1.25% annualized over the three-year period ended Aug. 31) and volatility (3.54% annualized standard deviation over the same period) look far more like bonds than stocks. But funds in the market-neutral Morningstar Category are fundamentally equity-based strategies, and with a relatively simple maneuver, it’s possible to transform an equity market-neutral fund into a long-short strategy with about half the fees. But first, a quick refresher on equity market-neutral strategies.
Equity Market-Neutral Explained
Equity market-neutral strategies are similar to long-short equity strategies. Both make bets on stocks management thinks will go up (the longs) and on stocks expected to fall (the shorts). The key difference, however, is that equity market-neutral strategies make an equal amount of bets on both sides of the equation, while long-short equity funds tend to have around 50% more long exposure than they do short exposure. By making equal long and short bets, equity market-neutral funds are effectively hedging out most, if not all, of the market risk in the portfolio. Removing the stock market’s risk, or beta, from a portfolio means that the fund’s returns are going to be driven almost solely by a manager’s ability to pick stocks. (The funds usually have a small amount of market exposure with equity market betas around 0.10, which means the fund tends to gain or lose about 10% of the market return plus or minus whatever excess returns the manager can generate through stock-picking.) That’s opposed to long-short equity funds, where betas generally range from 0.4 to 0.6, although there can be a great deal of variation, as we covered here. To be included in Morningstar’s market-neutral category, a fund must consistently exhibit an equity market beta of less than 0.3.
The Beta Test
For most funds, beta is the primary driver of return. After controlling for beta and fees, very few managers generate excess returns, or alpha. Managers who can consistently generate alpha are few and far between. For example, the average long-short equity fund had a negative alpha of 2% (relative to the S&P 500) annualized over the three-year period ended Aug. 31. That suggests the average long-short equity manager detracts value through stock-picking. The market-neutral category average has been slightly better, with annualized alpha of 1.17% over the three-year period. But, since long-short equity carries so much more market exposure and stocks have been in a positive trajectory over the past three years, the long-short equity category average return is 5.83% annualized over the past three years, more than 400 basis points higher than the average market-neutral fund.
If paying for market exposure minus poor stock-picking sounds like a bum deal, you’re not mistaken. The good news is that a skilled manager is skilled regardless of how much beta, or systematic risk, the strategy takes on. With the increased availability of exchange-traded funds today, investors can easily and cheaply buy beta to layer on top of a lower-exposure, alpha-generating strategy and, in the process, lower the overall fees. Let’s take a look at three different examples of how this would work.
Example 1: Vanguard Market Neutral VMNIX
In our first example, we’ll start with a U.S.-focused market-neutral fund, Vanguard Market Neutral VMNIX, which has a Morningstar Analyst Rating of Bronze. Aside from the fund’s high minimum investment ($250,000 for retail shares), it has the all the attributes of a good fund, specifically, a robust process, a tenured and well-resourced management team, and low fees. To bring the fund’s equity market beta in line with the long-short category norm we’ll combine it with a low-cost ETF, in this case, Vanguard S&P 500 ETF VOO. For this example, we’re assuming we have $100,000 to allocate to an equity alternative strategy. We’ll look at the results of splitting the investment equally between Vanguard Market Neutral and Vanguard S&P 500 ETF (rebalanced annually) versus putting the entire investment in the average long-short equity fund, half in the S&P 500 ETF and half in cash (our benchmark), or in Vanguard Market Neutral by itself. Any low-cost market-cap-weighted ETF would work. We’d suggest choosing whichever one is available at an investor’s brokerage commission-free to reduce the costs of rebalancing. The results for the three years ended Aug. 31, 2015, are shown in Exhibit 1.
Over the past three years, combining Vanguard Market Neutral with an S&P 500 ETF would have led to better absolute and risk-adjusted returns than the average long-short equity fund or a do-it-yourself low-beta equity index strategy. Of course, if equity markets had tanked over the trailing three years, then adding beta would have detracted from the market-neutral fund’s returns. But as long as the market-neutral fund was delivering positive alpha, the returns would be an improvement over the comparison investments. Combining the market-neutral fund with a low-cost ETF didn’t have a particularly large impact on expenses in this case, since Vanguard Market Neutral is already the cheapest liquid alternative mutual fund (at 0.15% annually). In our next example, we’ll see a more dramatic impact on price.