Hedging Hurt Long-Short Equity Funds in 2016

Josh Charlson: 2016 was a tough year for many funds in Morningstar's long-short equity category. It's not surprising that funds that engage in hedging, or shorting, as long-short equity funds do, would lag long-only funds in a year when many equity markets boomed. But the average long-short equity fund gained only 2.3%--far less than one might expect, considering that the S&P 500 returned around 12% and the typical long-short equity fund averages around 50% exposure to the stock market.

However, the averages mask a wide range of returns in the category. Long-short equity returns ranged from 25% at the top end to negative 17.6% at the bottom--a huge spread. Part of the disparity results from the fact that betas, or market exposures, can range widely in the category, and on top of that many managers have the flexibility to move that exposure around actively during the year.

Let's look at how a few of the funds covered by Morningstar fared. Diamond Hill Long-Short is an example of a fund that benefited from its typical stance of higher net exposure. Diamond Hill, which gained almost 11%, also benefited from its strong, value-oriented long approach. An example of successfully managing exposure came from Boston Partners Long/Short Equity, which gained an astonishing 23%. Manager Bob Jones gained significantly on his shorts early in the year, then closed out many of those positions and allowed gross short exposure to decline from 47% to 23%, bolstering the fund on the long side later in the year. Boston Partner's two other long-short funds, which tend to be more diversified and more static in their exposures, also did well, though to a lesser extreme. Finally, Gotham Absolute Return benefited from the ascendance of value, rebounding from an awful 2015 to produce an 8.4% return last year. On the downside, onetime market darling Marketfield Fund continued to struggle, as its defensive stance and failure of several of its themes to click led to a 3.5% loss for the year.