The bear markets of 2000-2002 and 2008 led many investors to seek alternatives to traditional, long-only equity funds. Among the popular options are long/short and market-neutral funds, which together now make up one of the largest segments of the alternatives universe. Pension plans, for instance, have poured billions of dollars into the space. An interesting question is: Has the hype lived up to the hope?
John Adams, Parvez Ahmed and Sudhir Nanda sought the answer to that question with their study, “Do Long-Short and Market Neutral Mutual Funds Sail on an Even Keel?”, which was published in the Winter 2017 issue of The Journal of Investing. Their data sample covers the period 1999 through 2013, and includes 123 long/short funds, 51 market-neutral funds and 13,725 equity funds.
Following is a summary of their findings:
- The average equity fund returned 9.0%, with a standard deviation of 24.3%, and produced a Fama-French four-factor (market beta, size, value and momentum) alpha of -0.90% (t-stat of 18). The average expense ratio was 1.2%, fully explaining the negative alpha. The 201% turnover for the average equity fund, and related trading costs, also helps explain the underperformance.
- The average long/short fund underperformed the average equity fund, returning just 5.6%, though the standard deviation was also lower, at 14.9%. However, the Fama-French four-factor alpha was worse, at -1.12%. The average expense ratio, at 1.85%, was higher than for the typical equity fund, which, along with the trading costs associated with 359% average turnover, explains the negative alpha. The correlation between average long/short funds and the Wilshire 5000 was high, at 0.82.
- The average market-neutral fund returned just 2.7%, and did so with a standard deviation of 6.8%. The average expense ratio was 1.66%. The Fama-French four-factor alpha was virtually zero (0.16%). In other words, the average fund demonstrated just enough skill to cover its expenses. Note the turnover of these funds was, at 367%, the highest of the three categories. Their correlation with the Wilshire 5000 was -0.12.
- In addition to their higher expense ratios, long/short and market-neutral funds have statistically significant higher loads, 1.23 and 1.02, respectively, compared with an average load of 0.70 for all equity funds.
Adams, Ahmed and Nanda note that the 2.7% return of market-neutral funds was just 58 basis points greater than the return on riskless 90-day Treasury bills. This is a benchmark often cited by such funds. But it’s not an appropriate one, because market-neutral funds are riskier than Treasury bills, underperforming in 20% of the years in the study’s sample (three of 15).
Given their standard deviation of 6.8, a more appropriate benchmark might be the five-year Treasury note. They underperformed that benchmark by 2.2 percentage points a year, and did so with higher volatility.
The authors concluded that, after adjusting for risk, neither market-neutral funds nor long/short funds outperformed 90-day Treasuries—though market-neutral funds provided superior risk-adjusted returns relative to long/short funds.
Adams, Ahmed and Nanda provide us with further evidence that traditional stock-picking and market-timing efforts by high-cost active managers is unlikely to generate appropriate risk-adjusted returns, whether the strategy is long-only, long/short or market neutral.
Instead of seeking alpha, we believe investors are better served seeking new, unique sources of risk and return, and then capturing those returns through funds designed to gain exposure to those new sources of beta.
At my firm, that includes such funds as AQR’s Style Premia Alternative Fund (QSPRX) and Stone Ridge’s reinsurance (SRRIX), alternative lending (LENDX) and all-asset variance risk premium (AVRPX) funds.* (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends AQR and Stone Ridge funds in constructing client portfolios.)
*Provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed that the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.