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| Sales Insight - November, 2005 |
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How to Evaluate Long/Short
Equity Funds for Specific Clients
Top financial advisors evaluate investment opportunities systematically and
particularly, as opposed to haphazardly and generally. When you can help your
clients navigate a methodical process tailored to their personal needs, the
value of your services will increase – whether or not investments perform as
expected.
A case in point is one of the hottest investment
solutions of 2005 and probably 2006 – long/short equity funds. This is by far
the largest category of equity hedge funds, with an estimated $300 billion of
global assets, and it also represents a small but fast-growing niche of mutual
funds and separate accounts. As former “long-only” managers, analysts, and
traders seek greener pastures, new long/short equity funds are being formed at a
torrid pace. In 2005, this was one of a few hedge fund categories that had
respectable performance, summarized below.
2005 Performance for Standard
& Poor’s Indices
However, there are two big problems with
long/short equity funds. First, only a few financial advisors understand how to
methodically evaluate them for specific client situations. Secondly, the
marketing stories these funds tell often tend to “talk around” the most
important questions advisors should be asking. (See the list at the end of this
article.)
In this article, I’ll describe an eight-step
process for helping clients evaluate long/short equity funds in any structure
(hedge fund, mutual funds, etc.) You will see that these funds can fill specific
needs that tend to be somewhat narrower and more specialized than their
promoters would have you believe.
Long/Short Equity Fund Background
Long/short equity funds are the two-headed hydras
of the investment world because their portfolio managers buy and sell stocks –
and sometimes stock indexes, options or derivatives. The short positions offset
some of the stock market’s systematic risk, which makes these funds less
volatile than broadly-based equity benchmarks such as the S&P 500. The average
Beta of most equity long/short hedge funds is less than half that of the S&P 500
Index.
A useful index of long/short hedge fund
performance is complied by Credit Suisse First Boston (CSFB). Monthly index
returns since 1994 (inception) are available here:
http://www.hedgeindex.com/secure/print.cfm?SID=570
Since inception (through 11/05), the index has
returned an annualized 11.73%, compared to 10.60% for the S&P 500 Index (Total
Return). We know that most hedge fund indexes tend to overstate performance by
about 1-2% due to “survivorship bias” – the effect created by poor performing
hedge funds that disappear and drop out of indexes. When survivorship bias is
considered, you can estimate that the CSFB Long/Short Index has about matched
the U.S. stock market’s long-term performance.
However, the main attraction of this category
isn’t high return but rather low volatility. The CSFB L/S Index has averaged a
monthly standard deviation of 2.98% since inception, compared to 4.28% for the
S&P 500. In summary, over time long/short equity funds have produced
approximately the same long-term return as the S&P 500 Index, with about 70% as
much month-to-month volatility.
An Eight-Step Evaluation Process
The first four steps in the process described
below will help you select clients who are candidates for long/short equity
funds. The last four steps will help select long/short managers who match client
needs.
Step 1 – Long/short equity funds should rarely
be recommended for high-bracket taxpayers in taxable accounts. According to
analysis by Lipper, the S&P 500 Index has produced a long-term “net-net
efficiency ratio” of 81%. That means: After costs and taxes are subtracted for a
high-bracket investor, about 81% of gross return remains. In most long/short
equity hedge funds, you should not expect efficiency ratios above about
50%. In other words, expect that over time less than 50% of gross long-term
return will remain for investors, after all costs and taxes. In long/short
mutual funds, the efficiency ratio may not be much better unless the
investment advisor deliberately attempts to manage tax impact – and few do.
Most long/short funds are inefficient because of
their high management fees, high portfolio turnover (which produces short-term
capital gains) and extra transaction costs related to short-selling. Hedge fund
investors are further penalized by incentive allocations that typically cost 20%
of portfolio appreciation. The heavy impact of costs and taxes makes these funds
suitable mainly for qualified retirement plans and tax-exempt investors.
Step 2 – Long/short equity funds work best in
reducing short-term portfolio volatility, not long-term. Today’s
institutional investment market is driven by monthly performance reports
and evaluations. This is due mostly to the layers of accountability in the
institutional investment process, and also to institutions’ need to make
distributions of cash from portfolio returns. In contrast, many individual
investors aren’t greatly concerned about how their IRAs or 401(k)s perform
month-to-month, if long-term results are satisfactory. For long-term investors,
there are simpler and more efficient ways to moderate portfolio volatility than
long/short equity funds. The best candidates for long/short equity funds
include: 1) institutions; 2) individuals who are worried about short-term
volatility; and 3) individuals who are withdrawing money periodically from
investment portfolios, such as through Systematic Withdrawal Plans.
Step 3 – Long/short equity funds should be
avoided by clients with structured asset allocation programs. A detailed
analysis of long/short equity hedge fund performance, authored by R. McFall Lamm,
Jr., may be downloaded here:
http://www.trendfollowing.com/whitepaper/long_short.pdf
Although Dr. Lamm is a cheerleader for hedge
funds in general, even he acknowledges their weaknesses in asset allocation
strategies.
Long/short funds often shift portfolio style
weighting between small cap and large cap, and they also vary the “net exposure”
on either the long or short side. Writes Dr. Lamm: “While this may produce
improved performance, it comes at a cost of much less control over the asset
allocation decision. Indeed, it raises the important question of whether
allocating to long/short hedge funds is really an asset allocation decision
since at times long/short managers may be short the desired cap exposure.”
Step 4 – Long/short equity funds work best for
investors who believe that the market is entering a specific type of
environment. Primarily, that is a market that features sustained up or down
trends, as opposed to a choppy market. To a lesser extent, long/short funds also
tend to prosper in periods when small-cap stocks outperform large-cap.
Strong, sustained trends favor long/short equity
funds because of their ability to adjust the mix of longs and short positions,
or net exposure. The vast majority of these funds have more long exposure than
short – thus, they are “net-long.” For example, a fund that has 65% of portfolio
weight in long equities and 35% in shorts is “30% net-long.” However, most
managers make adjustments in net exposure based on the current market
environment.
These shifts are reflected in the correlation of
monthly returns between the CSFB L/S Index and the S&P 500 Index, as shown in
the graph below. A higher correlation indicates a higher “net long” position in
long/short hedge funds overall.
Correlation of the CSFB
Long/Short Equity Fund Index With the S&P 500 Index
(1997-2005, based on rolling 36-month periods)
As the graph suggest, it takes time for managers
to recognize trends and make adjustments in the long/short mix. In late 2002 and
early 2003, some managers continued to reduce net-long exposure even after the
market had bottomed. In choppy markets, it is easy for long/short managers to
get whipsawed on net-exposure calls.
Secondarily, there is a tendency among many
long/short managers to favor small-cap stocks over large-caps. In fact, Dr. Lamm
and other experts have observed that it is common for managers to be net-long
small-cap stocks and net-short large-caps. For this reason, the average
long-term correlation of the CSFB Index with the Russell 2000 Index (0.78) is
even higher than the same index’s correlation with the S&P 500 (0.58).
You can estimate that sustained bull or bear
markets contribute up to +1% to the average long/short fund’s relative
annualized performance vs. the S&P 500, and the small-cap bias of these funds
(on average) can contribute up to +.5% annually when small-caps are relatively
strong. Recent years have produced favorable conditions on both counts. But in
choppy markets that favor large-caps, it is more likely that long/short funds
will underperform the S&P 500 Index.
Four Steps in Selecting a Long/Short Manager
Step 5 – Demand and carefully evaluate the
manager’s short-side track record and investment process. Most long/short
funds do not publish separate performance statistics for the long and short
sides of their portfolios. But they should, and this data can be useful in
identifying talented long/short managers. Look for managers who consistently add
value through their short stock selection process. For example, if the S&P 500
Index is up 2.5% in a month and the short side of the portfolio performs better
than -2.5%, the manager is adding value.
For several reasons, it is more difficult for
managers to add value in shorts than longs. First, many long/short managers have
spent most of their careers working on the “long side” and don’t have much
shorting expertise. Secondly, short selling involves extra costs and trading
complexities that don’t apply in unmanaged benchmarks. Thirdly, risk management
is more critical in shorts, because the manager’s mistakes keep growing in size
(as a percentage of portfolio assets) as stocks rise. Many value-conscious
long/short fund managers have shorted Google stock at some point in the last
year. As Google kept rising, the key question is whether they covered shorts and
cut losses before the mistake grew huge.
Don’t buy the line that a manager applies a
“consistent investment process” in selecting both longs and shorts, because it
is very difficult to do in practice. Dig for the key decision drivers and risk
controls that the manager applies separately on each side. Note: Some managers
have a habit of acquiring “short side exposure” through stock index derivatives
or ETFs. Just remember that your clients don’t need to pay heavy management fees
to achieve average short-side performance. For details, see:
http://www.freeerisa.com/Insight/nov_2004.asp#1
Step 6 – Evaluate the manager’s track record
for adjusting “net exposure.” Most long/short funds fall into one of three
groups: 1) the manager tries to maintain net exposure within a narrow range at
all times – such as between 20% and 25% net long; 2) the manager makes strategic
shifts in net exposure in gradual increments over time; and 3) the net exposure
changes sharply from month to month, perhaps because the manager is trying to
strategically or tactically to time the market. In the third case, it’s
important to evaluate past success in timing net exposure. Erratic changes in
net exposure may tend to increase the risk and volatility of long/short funds,
especially in choppy markets. A manager’s pure stock-picking skills have the
best opportunity to flourish in funds that maintain constant net exposure.
Step 7 – Evaluate the fund’s historic
correlation with the U.S. stock market as a whole. Look for correlations
that are below the CSFB L/S Index long-term average of 0.58. If your clients are
greatly concerned about reducing short-term portfolio volatility, look for
correlations of about .40 or below. This will indicate a fund that keeps net
long exposure low and does a good job managing short positions. Also, ask for
historic correlations of the fund vs. the Russell 2000 benchmark of small-cap
stocks. A Russell 2000 correlation that is about the same (or lower than) the
correlation with the S&P 500 indicates the absence of a small-cap bias.
Step 8 – Insist on a consistent, documented
track record in the same style, preferably in the same fund. With so many
statistics being put on the table by long/short fund promoters, financial
advisors have every reason to question the validity of those statistics. Also,
there are too many talented long/short managers in today’s market to accept less
than a strong, credible track record. The manager’s performance should be
audited or attested by a third-party source over a period of three years or
more, net of all fees. Don’t accept hypothetical or back-tested performance, and
be leery of prior performance records achieved by the same manager at different
organizations or funds.
This eight-step process should remind you that
not all “hot investment ideas” are suitable for your clients – and it’s your job
to make the suitability call objectively. Long/short funds are a useful niche
solution for a small group of sophisticated investors, but they are also being
sold to too many other people for the wrong reasons. This will result in many
disappointed investors down the road.
Be the professional who keeps the dogs of
disappointment away from your clients’ doors.
Key Questions to Ask in Evaluating a Long/Short Equity Fund Manager
- What is the “net-net efficiency ratio” of your
fund for a high-bracket investor in a taxable account? (net-net = after taxes
and all costs)
- Does your fund have a “net exposure” target or
targeted range? (e.g., neutral to 20% net long)
- Do you adjust net exposure in an effort to
strategically or tactically time the stock market? (e.g., decrease net-long
exposure when the market is weakening)
- Do you publish separate monthly performance
results and statistics for both the long side and short side of your
portfolio? If not, why not?
- What are the key drivers of stock selection on
the long side? On the short side?
- Do you publish monthly statistics on the
historic net exposure of the fund, net-long or net-short? If not, why not?
- What are the fund’s policies in regard to the
use of leverage? How much leverage is typical, and how much is used in the
extreme?
- Do you commonly use ETFs, stock index futures,
options or derivatives for part of your short-side exposure? If so, why?
- What is your fund’s historic correlation with
the S&P 500 Index? With the Russell 2000 Index?
- Has the track record of your fund been
verified by a qualified third-party source? Has this track record been created
by the same manager in one continuously managed fund?
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