Swedroe: Faint Praise For 130/30 Funds

Whether in a hedge fund or mutual fund wrapper, long/short funds come up short.

Hedged (long/short) mutual funds are the money management industry’s answer to illiquid hedge fund strategies. The premise of long/short funds is that the managers can apply their security-selection skills to a broader opportunity set, which is to say they can go both long and short, instead of long only.

The broader opportunity set should make it easier to outperform long-only funds. Note that some long/short portfolios have overall positive exposures to the market.

For example, long positions might be equal to 130 percent and the short positions 30 percent—the so-called 130/30 that is somewhat common. As of July 2013, there were about 80 long/short mutual funds with about $34 billion of assets, and about 30 market-neutral funds with about $23 billion of assets.

The common term now used for long/short mutual funds is “liquid alternative mutual funds.” The questions are: Are these vehicles substitutes for privately placed hedge funds? Do they offer investors similar market exposures? And how have they performed relative to comparable hedge funds?

David McCarthy, author of the paper “Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long/Short Funds,” (from the Winter 2014 issue of the Journal of Alternative Investments) sought the answers to these questions.

While Morningstar classified 83 funds as long/short funds, to make the comparables as close as he could to hedge funds, McCarthy reduced that figure to 47 because of what he called the “narrowness of their styles,” such as event driven, or industry or sector driven. The 47 funds managed $20 billion of assets. Following is a summary of his findings:

• The average expense ratio of the long/short mutual funds was 1.89 percent, much higher than for even the average actively managed fund, but well below the typical 1.5 percent to 2 percent plus 20 percent of the returns charged by hedge funds.
• Compared with hedge funds, the gross equity exposures of long/short mutual funds were slightly lower (84 percent versus 88 percent), the gross short positions were lower (23 percent versus 39 percent), and the net exposure was higher (61 percent versus 49 percent). In other words, the two groups are not that dissimilar in their net exposures.
• The correlations with the S&P 500 Index are very high for both long/short mutual funds and hedge funds. Depending on the period and the hedge fund index, they ranged from 84 percent to 98 percent, with hedged mutual funds having slightly higher correlations—between 5 and 11 percentage points higher.
• The average beta exposures during 12-month periods were almost identical—around 0.5. While the differences were a bit wider, the lowest and highest beta exposures were also fairly similar.
• The Fama-French four-factor model (beta, size, value and momentum) explains a very high percentage of the differences in returns over the period studied. The R-squared ones are between 0.89 and 0.97. The single-factor CAPM model produces virtually identical r-squareds. This demonstrates that from an equity exposure standpoint, long/short mutual funds are very similar to hedge funds.
• In years of positive equity returns (2009, 2010, 2012 and 2013) long/short funds always returned less than their hedge fund counterparts. However, the reverse was true as well, which is to say they lost less than their hedge fund counterparts in years of negative returns, such as 2008 and 2011. During the full period, long/short equity mutual funds didn’t perform materially differently from comparable private-placement hedge funds.

The author concluded: “Although some minor differences exist, these aggregate data suggest that long/short equity funds and hedge funds offer substantially similar equity exposures. Further, comparative performance data show similar rates of return across equity long/short mutual funds and equity long/short hedge funds.

Unfortunately, given the poor performance of hedge funds (four-factor alphas were all negative), that’s damning the mutual funds with faint praise.

The evidence makes it pretty clear that it doesn’t matter whether the investments are in liquid alternatives, i.e., mutual funds, or illiquid ones, such as hedge funds. The takeaway: There doesn’t seem to be a role in your portfolio for long/short strategies.

Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.