In a blazing bull market (for the S&P 500, at least), alternative strategies sit in the shadows, awaiting the day when they will again be called on to help clean up the mess that a fallen bull market left behind. In particular, long-short strategies are chronically misunderstood. They are essentially the Rodney Dangerfield of investing: “they get no respect at all.”
Back on March 25 of this year, Barron’s published an article on Long-Short mutual funds. When Barron’s writes something, we take notice, especially when it deals with alternative funds. As the co-manager of a Long-Short fund myself, I took special interest in this piece, particularly since its headline (“Long-Short Stock Funds Lose Their Shine”) implied that these liquid versions of the classic hedge fund strategy have somehow lost their appeal. As with many investment debates, my response is a strong “it depends.” Allow me to explain by identifying and responding to some key points made in the article by a group of accomplished and esteemed industry pros: the writer, Lawrence C. Strauss, Nuveen strategist and long-short fund manager Bob Doll, and Josh Charlson, Director of Manager Research for Alternative Strategies at Morningstar.
1. There is “a lot of confusion” (quoting Nuveen market strategist and long-short manager Bob Doll) about how long-short mutual funds work
I think much of that confusion comes from the long-only mentality that is still ingrained in the minds of many investment advisors. Decades of owning stocks for growth and bonds for alleged safety have made advisors skeptical of long-short and other alternative strategies. But when you think about it, clients don’t come to an advisor to buy stock and bond funds for them. They come to them to draw as straight a line as possible between a few things regarding their money and how to pursue their goals in accordance with their tolerance for risk.
At the core, the vast majority of investors who have accumulated significant wealth are risk-averse. And, if they have amassed a good portion of what they need to live on in retirement, the advisor’s primary job is “risk management,” not return enhancement. So why, then does so much of the long-short discussion in this article and elsewhere come down to a comparison to the S&P 500 and other headline stock market indexes? And with low global interest rates having reduced bond investing to a choice between low positive returns or negative returns in the coming years, long-short strategies can fill that gap quite nicely from a risk-management perspective.
2. It is hard for long-short managers to determine how closely they should correlate their fund to the broad stock market
That is because of what I said above, that long-short managers are too often compared directly to equity indexes. Those equity indexes are fully invested, don’t short at all, and in most cases are capitalization-weighted, which is a pretty illogical way to invest when you think about it. After all, it forces you to buy stock after they have gone up a lot, which works for a while before it breaks hard the other way. But that is another subject for another article.
Yes, there is a portion of long-short investing (namely the long side of the portfolio) that can be compared to the S&P 500, et al. That’s why at my firm, we monitor our long-only performance in addition to the total return of our long-short strategies. Beyond that, why are we assuming that long-short managers even want to correlate closely to the stock market? You see, the value proposition for many long-short managers is that they will produce a share of the equity market’s upside and shave losses in bad markets. But that assumes that the equity market is even related to the objective of the fund!
My firm’s Hedged Dividend strategy does not use bonds, and even has the word “dividend” in it, to emphasize that we invest in dividends paid by equities. But the strategy is not about investing in stocks. It is about using stocks as a tool to achieve a particular investment objective, which is a reasonable level of cash flow, protection from major declines in value (caused by the stock market or other factors) and, wait for it….the potential to profit at times from the upside offered by equities. So, unless capital appreciation is the primary objective of a fund, I don’t see why so much of the evaluation of long-short funds references what the equity market is doing.
3. It is hard to make the case for a hedged-equity strategy since the broad stock market has gone up so much the last few years
This may be the most misunderstood factor in evaluating long-short strategies right now. While it is true that the S&P, Dow and Nasdaq have produced strong returns the past three years, most of the rest of the stock market worldwide has not. As my proof for that statement, I refer you to the returns of another set of S&P Indexes, their Target Risk Series. These are mixes of US and non-US stocks and bonds, including large and small companies, growth and value-oriented stocks, etc. Basically, the classic style box approach and internationally-diversified approach that many advisors swear by.
It might surprise you to learn that in the three years ended 3/31/17, the S&P Aggressive, Growth, Moderate and Conservative indexes all produced cumulative returns of less than 10.5% (see chart below). In other words, if you try to compare a long-short manager to the S&P 500 over the past few years, you are assuming that the investor’s alternative way to just own an S&P 500 fund and some cash. In reality, investors and their advisors diversify, and those diversified portfolios look nothing like the S&P 500 the past few years. They are not even close. This should put long-short returns in perspective.
Those facts notwithstanding, in long-short portfolios, both the long and short segments are present at all times, but it does not mean that they should both be expected to contribute positive returns at all times. The effectiveness of a long-short strategy should not be judged solely during bull markets. The long positions carry the portfolio during bulls and the short portion should drive performance during bear markets. The Barron’s article addressed only a period in which the broad equity market flourished, except for a six-week drop to start 2016 which was the worst start to a year in modern stock market history. Long-short strategies were particularly valuable and effective during this time, and I think they will be when the next inevitable market drubbing is upon us.
4. Another difficulty for long-short managers is successfully shorting individual stocks in a generally rising stock market
I admire a manager who thinks they can add value on the short side by stock-picking, but I agree with the statement in the Barron’s article. This is one reason why my firm believes in keeping it simple on the short side. We believe that the core short position used should actually be a vehicle that shorts the broad market or at least large segments of it. This more directly addresses the natural fear that investors have of bear markets, crashes and the like. That broad market short position, be it through inverse ETFs, index put options or both may be a drag on total return for periods of time. But it is the investor’s best friend when the market turns nasty.
5. Long-short mutual funds are much more liquid and have lower costs (expense ratio for mutual funds versus management fee plus profit percentage for hedge funds)
They sure are. And in a time when full disclosure has become a given in the advisor-client relationship (thankfully!), mutual funds are a great place to house a long-short strategy. But you have to look at it for what it is and not what you think it should be. If a long-short fund says it is aiming to compete with the equity market in that it tries to get X% of the market’s upside, evaluate it that way. If it is more income oriented or its primary focus is on capital preservation, evaluate it that way.
Perhaps the best analogy is if you decided that all food should be healthy. You would then judge McDonalds and Burger King the same way you judge what you buy on a trip to Whole Foods.
You could do that, but you’d be missing the point, and perhaps missing out on a very viable alternative for your portfolio. So how about a little respect and understanding for long-short strategies, particularly for income and preservation-oriented clients? Focusing on this now could save you some headaches later.
For more insight, click HERE. Comments provided are informational only, not individual investment advice or recommendations. Sungarden provides Advisory Services through Dynamic Wealth Advisors.