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More Than Meets the Eye With Long-Short Equity Betas

Beta ranges reveal a dizzying array of approaches.

When I was a kid, any time my mother took my brother and me to Baskin-Robbins for ice cream, I was under strict orders: "Chocolate, vanilla, or strawberry!" That's because if not limited to those three choices, I would find myself overwhelmed by the plentitude of the 31 flavors and unable to make any decision at all. (What my family considered my chronic indecisiveness I now recognize as a function of the far more sophisticated-sounding "paradox of choice.")

Investors considering a long-short equity strategy face a similar quandary. By Morningstar's latest count, there are nearly 150 long-short equity funds. While the label long-short equity indicates a fairly straightforward strategy--a portfolio that combines long positions in stocks with a (usually) smaller sleeve of short positions designed to take advantage of stocks expected to fall in price--in fact there are a dizzying array of flavors on the long-short equity menu board.

One of the best ways to penetrate this fog is through the lens of beta. Beta is a measure of a fund's sensitivity to a benchmark market--typically, in the case of long-short equity funds, the S&P 500 is a proxy for the U.S. stock market. The average beta for the long-short equity Morningstar Category over the trailing three years through May 31, 2015, is 0.51, or about half the risk of the market. This makes sense, since long-short managers are aiming to reduce some of the risk of the stock market while retaining a portion of the upside as well. However, focusing on the average beta exposes us to the "flaw of averages" and ignores the significant variability around that data point.

Free-Range and Penned-In Betas As one of the criteria for putting a fund in the long-short equity category, Morningstar looks for betas that average between 0.3 and 0.8 over a three-year period. As Exhibit 1 shows, funds in the category are all over the beta map, though they are indeed more heavily weighted around the midpoint. Clearly, this means that investors must take a close look at the approach of a given long-short equity manager to understand the risks and exposures involved. A fund that invites 80% of the market's risk is a far different creature than one that takes on only 30%.

Readers may also wonder how it is that some funds exhibit betas outside of the 0.3-0.8 range. In some cases, this may be because of misclassification (I encountered a few such cases while going through this exercise). More often, however, it's the byproduct of managers who take an active approach to adjusting the exposure of their funds. An active manager may dial up the fund's exposure (and thus the beta) during periods they believe are favorable to stocks, then reduce it when they believe the risks are higher. In addition, certain types of hedged equity strategies may purchase forms of portfolio insurance (such as buying out-of-the-money puts) that don't come into play until there's a sharp market correction.

All of this further complicates the nature of choices within long-short equity. Not only must investors determine whether a fund leans toward greater or less market exposure, they must also assess whether that is a stable or dynamic quality over time. To illustrate the point, I looked at the degree to which rolling one-year betas had changed for funds in the category over the past three years. The data cover 68 long-short equity funds with at least one-year histories as of May 31, 2013.

The first thing to note is that, in general, betas change over time. The median range, or variation, of betas in the group over time was 0.405. But the range of the variation is quite wide. Active stock selection can lead to naturally shifting beta, but many long-short equity funds also act deliberately to increase or decrease their net long exposure in an attempt to tactically time the market. For example, the smallest range of betas belonged to

Funds at the more stable end of the scale tended to involve strategies which, like Gateway or Bronze-rated

Beta as a Guide With such variations in beta, and the stability of beta, across long-short equity funds, how should investors go about picking the right flavor? First, it's worth remembering that beta is not the be-all and end-all of long-short fund selection: You'll want to look at many other factors, such as the experience of the management and the particulars of the strategy in place for both the long and short portions of the portfolio.

But it makes sense for an investor to begin with some assumptions and expectations. Are you more interested in a fund that takes on more market exposure or one that limits it, instead trying to earn a larger share of its returns from manager skill? Based on the answer to those questions, you can look for funds with higher or lower beta ranges.

As a next step, ask whether you are comfortable with a manager who allows beta to float by wide ranges based on perceived opportunities in the market or macro views on the economy; or do you prefer the certainty of knowing a manager will keep beta within a limited range? A more active strategy offers the potential for capturing more upside during bull markets while also protecting on the downside but exposes investors to market-timing risk, and few managers have exhibited consistent skill at market-timing over the long term.

In the end, it's a matter of personal preference and portfolio fit. For every customer who wants to try a new-fangled Lunar Cheesecake ice cream, there's always one who's content with good old basic vanilla.

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