Despite lackluster 2012 returns, investors shouldn’t write off long-short equity funds.
Long-short equity funds received more inflows than any other alternative mutual fund category in 2012—$5.4 billion through November, out of a total $16.4 billion. This trend is likely a result of the volatility in the market—the annualized standard deviation of daily returns was 15.26% for the S&P 500 in 2012. Although this figure is significantly less than it was in the prior four years, the specter of large losses still haunts many investors.
Long-short equity funds certainly did a good job of protecting against the downside in 2012—the average fund captured less than 60% of the returns in months when the S&P 500 was down. But the average long-short equity fund’s lackluster 2012 return—5.2% relative to the S&P 500’s 16% jump—means that the average long-short fund didn’t do nearly as well when the market was up.
But investors shouldn’t write off long-short equity funds. There’s still a lot to like about this category.
Where’s the Alpha?
When looking at the long-short equity category, investors should keep in mind that alternative strategies are notoriously heterogeneous. While most long-only mutual fund managers keep their fund’s holdings within a few percentage points of some commonly accepted market benchmark, most alternative managers have a wide mandate, making it difficult to discern a good long-short equity fund from a bad one. There is no commonly accepted holdings universe or benchmark for long-short equity funds, so managers typically can pick any stocks they want. They also can vary the funds’ exposure to the market, using a broad swath of risk management tools (options, cash, and short positions, for example). The result is a wide dispersion of returns. Absolute returns in the long-short equity category ranged from negative 17.0% to 25.2% in 2012, while the large-blend category’s range was about half as wide (4.2% to 28.1%). Interestingly, however, the same percentage of managers in each category--28 %--added alpha relative to the S&P 500 in 2012. This means that long-short equity managers were no better or worse at stock-picking (or sector allocation) than their long-only counterparts. Alpha, however you slice it, is hard to come by.
There were some clear alpha generators in the long-short equity category in 2012, however. The strategies that worked best played in the riskier spectrum of equities—small caps and emerging markets. Topping the charts was Keeley Alternative Value KALVX, a small-cap fund that outsources its hedging to Broadmark Asset Management. This fund earned a whopping 12.5% alpha to the Russell 2000 Index last year. Robeco Long/Short Equity BPLSX, another small-cap strategy (which also shorts small caps), earned a 9.8% alpha to the index. Other top performers included River Park Long/Short Opportunity RLSIX and Blackrock Emerging Market Long/Short Equity BLSIX.
What Doesn’t Go Down, Doesn’t Have To Go Up (As Much)
When allocating to a long-short equity strategy, investors have to think long term. A good long-short equity fund that loses a lot less than the market during a downturn has to capture much less of an upswing in order to stay afloat. For example, when a portfolio loses 50%, it has to earn 100% to break even. If that loss, or drawdown, was reduced to only 25%, only a 33% recovery is needed. The average long-short equity fund lost 23% between November 2007 and February 2009, less than half that of the average large-blend fund. Although the losses still haven’t been recouped on average, several funds in the category have succeeded. Caldwell & Orkin Market Opportunity COAGX lost only 12.6% during the crisis, and over the last six years, has earned 3.8% annualized for investors, better than the S&P 500’s 2.3% return. Wasatch Long/Short FMLSX lost more during the crisis (26.6%) but has participated more in the market’s upside, earning 4.6% annualized during the last six years.
Getting Bang for the Buck
Finally, fees are coming down for some of these notoriously expensive alternative strategies. For example, Schooner A shares SCNAX are down 3 percentage points to 1.97%, Pyxis Long/Short Equity’s A shares HEOAX are down 10 basis points to 1.88%, and Mainstay Marketfield’s institutional shares MFLDX are down 19 basis points to 1.56% (this fund’s investment minimums recently have been increased to $5,000,000 as Mainstay took over as the advisor to the fund). Although these reductions are due to increases in assets, rather than a deliberate effort by management, every basis point helps. The cheapest fund, Gateway GATEX, is still cheaper than some long-only stock funds, at only 94 basis points for the A shares. Investors should expect these strategies to become even more shareholder friendly as more assets come into the category and as competition among fund companies heats up.