A Red Giant Engulfs the Long-Short Category

The long-short equity Morningstar Category has been one of the fastest-growing in the open-end alternatives universe, in terms of both assets and number of funds. In 2013, its organic growth rate was 81%, with nearly $21 billion in net new assets flowing into the category. Moreover, 22 new funds were launched, representing a nearly one-fifth increase in the category's count of distinct strategies, which now number 110 (four more launched in the first quarter of 2014). And growth shows little sign of abating.

What's fueling this growth, and to which funds should investors be paying attention in this quickly evolving area?

One reason for the category's asset acceleration appears to be the supernova-like asset growth of a single fund-- MainStay Marketfield (MFADX). The fund, which has a Morningstar Analyst Rating of Bronze, now consumes more than one third of the assets in the $57 billion long-short equity category. In 2013, it collected $13.4 billion to reach its current assets under management of $21 billion. The fund's success--and it has unquestionably done well on a performance basis too--not only accounts for a significant portion of the category's growth but has spurred others to enter the market in hope of riding MainStay Marketfield's orbit.

But investors don't appear to be behaving irrationally, as there's a sound investment motivation for the growth as well. Long-short funds, whose managers take traditional long positions in stocks while also betting against specific stocks or hedging the stock market as a whole, offer the prospect of participation in up markets alongside increased protection in down markets. Interest in such strategies flourished after the Great Recession, and the subsequent bull market in stocks now has many investors looking to guard against a potential correction or even longer-term reversion in the markets.

Two other factors bear mentioning as a primary impetus for the sizable inflows. Some former hedge fund managers who previously shunned the mutual fund structure and retail market have revised their opinions. There's now an influx of managers jumping ship to the mutual fund world, bringing with them legitimate expertise in short-selling. Moreover, some are taking their track records with them, as long-standing hedge fund strategies are converting to mutual funds in droves. PIMCO, for instance, purchased a tiny hedge fund firm and converted it to a mutual fund (the predecessor fund's performance is allowed in the fund's prospectus if the fund is managed in a materially similar manner). In only two short years,  PIMCO EqS Long/Short  has raised $1.6 billion, thanks to its solid hedge fund record. Two other notable hedge fund conversions are  Robeco Boston Partners Long/Short Research (BPRRX) and  CBRE Clarion Long/Short .

Given the evolving nature of this category, Morningstar is keeping a close eye on new entrants, and we'll adjust our coverage as necessary. Some of the faster-growing funds reflect the range of approaches fund companies are taking to product creation. AllianceBernstein went out and hired a veteran hedge fund manager and his team to run its $1.3 billion Select US Long/Short Portfolio (ASLAX). Gotham Absolute Return's (GARIX) ($1.5 billion) principal and comanager Joel Greenblatt is a well-known value-investing guru and author making his first foray into the regulated fund space. And the $766 million Whitebox Tactical Opportunities comes from Minneapolis-based hedge fund shop Whitebox Advisors, where comanager and firm founder Andrew Redleaf has deep roots in the hedge fund industry.

Tracking Acceleration and Orbits
Investors should keep their expectations in check when considering a long-short fund. Rarely will a long-short fund garner full participation in an up market; by their nature, these funds are hedging out exposure to the stock market, limiting both upside and downside. In 2013, the long-short category averaged a 14.6% return, slightly less than half the S&P 500's 32% return and in line with the category's average beta (a measure of sensitivity to the benchmark) of about 0.5. Similarly, in 2008, while the S&P 500 plummeted 37%, the long-short category as a whole fell only 15%.

But there's a wide range of beta exposures and approaches to exposure management within the category, not to mention a wide array of stock-selection techniques, ranging from highly fundamental and valuation-based to primarily systematic and quantitative. For instance, among the 17 long-short funds currently rated by Morningstar analysts, three-year beta ranges from as high as nearly 0.8 to as low as nearly 0.2 (and in the anomalous case of Hussman Strategic Growth, beta has been negative). Funds with consistently higher betas will tend to do better in rising markets, but they also risk offering less downside protection than desired.  Diamond Hill Long-Short (DIAMX) and  Wasatch Long/Short both have betas at or above 0.7, for instance, and performed better than the category average in 2013. For that reason, it's important for investors to also examine risk-adjusted return measures like the Sharpe ratio, Morningstar Rating, or even alpha (stock-related skill). Even though Wasatch Long/Short outperformed the category on an absolute basis in 2013, its beta implied that it should have performed better, meaning its alpha was negative last year. Diamond Hill Long-Short fared better, generating alpha on top of its already relatively higher beta.

But equally relevant is an understanding of how much a given fund's beta shifts over time. Some managers tend to maintain a fairly consistent exposure to the market, making it relatively easier to predict performance patterns. Others, particularly managers with strong macro or tactical views, exhibit more pronounced and frequent beta shifts. For example, Silver-rated  Gateway (GATEX), which follows a consistent, low-volatility collar strategy, kept its beta between 0.3 and 0.4 in every calendar year from 2010 through 2013. During the same period, PIMCO EqS Long/Short saw its annual beta run as low as negative 0.90 (in 2011) to as high as 0.61 (2013). Timing large exposure moves is difficult to execute well on a consistent basis, though managers who do so can certainly add alpha to a fund's returns.

 

Morningstar Medalists
Of the 17 long-short funds currently covered by Morningstar analysts, seven are Medalists--three Silver and four Bronze. As with any investment strategy, we favor funds that have in place a consistent, repeatable process. But with long-short funds in particular, we emphasize expertise in and ability to produce alpha on the short side of the book, in addition to traditional stock-picking.

Morningstar analysts have long given high marks to the disciplined, diversified process employed by Robeco Boston Partners at its Bronze-rated flagship Long/Short Equity (BPLEX) and Silver-rated Long/Short Research funds (the latter was a 2013 nominee for Morningstar Alternatives Fund Manager of the Year). Long/Short Research's 17.8% return in 2013 was impressive considering its beta for the year of around 0.45. Unfortunately for interested investors, both funds are now closed to new investors, though from Morningstar's perspective, such moves are another sign of the firm's admirable commitment to running the funds at manageable asset levels. The newly launched Robeco Boston Partners Global Long/Short (BGLSX) is likely to follow a very similar process but with a global mandate.

Silver-rated Wasatch Long/Short has one of the longer track records in the space, as comanager Michael Shinnick has been running the strategy with a predecessor firm since 2003 and with Wasatch since 2008. Shinnick and comanager Ralph Shive incorporate both macro and individual security-level decisions into their process, and their success is evident in the fund's topping of the category average in most calendar years, though it can be riskier than some competitors. Shinnick invests more than $1 million in the fund, another plus.

Gateway is a grizzled veteran, having diligently executed its collar strategy since 1977. Management runs a long portfolio focused on dividend-oriented large-cap stocks, while writing S&P 500 call options and buying out of the money puts. As noted above, this is a decidedly lower-beta, lower-volatility strategy, so it's slow-and-steady profile may not appeal to investors seeking more of the market's upside.

The Long and Short of It
Finally, the category's blazing star, MainStay Marketfield, has retained its Bronze rating despite its arguably unprecedented asset bloat for a long-short fund. Morningstar is certainly watching closely for adverse effects of the growth. A mitigating factor is that much of the success is driven by the top-down macro views of manager Michael Aronstein and CEO Michael Shaoul, and those can usually be executed through highly liquid exchange-traded funds and international large-cap companies. The fund stumbled, however, in the first quarter of 2014 as a number of past successes, like  Facebook (FB), retreated. Still, the fund is no one-hit wonder: It has consistently produced alpha, and Aronstein's conviction is evident in his $1 million-plus investment alongside shareholders.