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Still a Lot to Like About Long-Short Equity Funds

Despite lackluster 2012 returns, investors shouldn’t write off long-short equity funds.

Nadia Papagiannis, CFA, 01/14/2013

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. 



Nadia Papagiannis is an analyst with Morningstar.

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