Long-Short Funds: Long on Complexity, Short on Returns

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If Rube Goldberg had been a portfolio manager, instead of a cartoonist renowned for designing comically complicated machines for accomplishing simple tasks, he might have specialized in long-short equity funds.

These funds use a mix of positions, owning some stocks in the hope that their prices will rise and holding others “short” — borrowing shares and selling them in the hope that their prices will fall. The funds also may use derivative instruments like stock index futures.

Long-short funds might be particularly appealing now that trading is so volatile and prices are moving up and down instead of up and up. But with all that buying and selling, the average long-short fund barely broke even over the 12 months through June, according to Morningstar, and returns over five years are only marginally better than those of bank deposits or short-term bond funds.

Financial planners attribute the persistent weakness to a mix of financial and market factors. Some hold out hope that returns will improve when conditions change, flipping the influence of those factors from negative to positive. Others maintain that the inherent complexity and expense of long-short funds ensures that they will remain poor investments. What everyone seems to agree on is that they have failed for many years to enhance or protect portfolios.

“The biggest thing to realize is there’s been a perfect storm for long-short funds,” said Christopher Cordaro, chief investment officer of RegentAtlantic, a financial planning firm based in Morristown, N.J. “Performance for the past 10 years has been abysmal, compared to the S&P 500 index. But to be fair to them, everything has gone against them.”

That includes a long run of underperformance by value stocks, which typically trade at lower multiples of earnings than the broad market because their earnings tend to undergo large swings in line with the economic cycle. Long-short managers have traditionally preferred value stocks over growth stocks, which are often more expensive because their earnings are more stable.

What makes the value tilt especially harmful, Mr. Cordaro pointed out, is that it’s reflected in both parts of the portfolio: The funds have been buying weaker value stocks and shorting stronger growth stocks.

“With long-short, you’re doubling down on that value mentality,” he said.

Another drag on returns is the historically low level of interest rates. That matters because much of a long-short fund’s assets — the proceeds from shares sold short — sits in low-yielding money-market funds. Yet another factor, Mr. Cordaro said, is that borrowing stock to sell short costs around 2 percent a year, more than in the past.

When assets sold short are subtracted from assets in long positions, the average fund in the group has a 58 percent net market exposure, according to Morningstar, so you might expect returns of about 58 percent of what long-only domestic stock funds produce. Alas, the average long-short fund gained just 1.1 percent in the 12 months through June, compared with a 5.2 percent gain for long-only funds.

Long-short funds were in the black over five years, but their 2.8 percent annualized return was well below the 8.2 percent gain recorded by long-only funds.

When it comes to expenses, long-short funds post numbers that are far higher than their conventional peers’, and this is nothing to cheer about. Their average total expense ratio, Morningstar says, is 2.22 percent a year, well above the 1.03 percent that the average long-only fund costs. That’s too much for Leah Bennett, president of Westwood Wealth Management in Houston.

“They’ve been asked to justify their fees, and they haven’t,” Ms. Bennett said. “They’re too expensive, too complex, and there are too many cheaper alternatives for hedging a portfolio.”

Among them are high-quality bonds, whose price movements are minimally correlated with those of stocks, she said. Another alternative she mentioned is funds that sell options. This is a way to collect income that other investors — the ones who buy the options — pay for the right to capture further appreciation a stock might achieve.

When long-short funds have done well in recent years, it’s often from having greater net exposure to the market than their peers, not because they’ve identified good stocks to buy or sell short, Mr. Cordaro said.

Alexander Healy, co-manager of the Natixis ASG Tactical U.S. Market fund, considers that more a feature than a bug.

Mr. Healy’s fund gets Morningstar’s highest rating, five stars, and ranks in the top 20 percent of long-short funds in three-year risk-adjusted returns. It achieved its success mainly by going heavily into stocks — a net exposure as high as 130 percent of assets — when its quantitative model determined that risk was declining and prices were rising.

When the model foresaw worsening conditions, net exposure dropped to 50 percent or less. The fund returned 11.7 percent a year in the three years through June, well above the 9.2 percent return of Vanguard Balanced Index, a fund that maintains a mix of about 60 percent stocks and 40 percent bonds.

“Long-short equity managers in general” try to outperform by “picking winners and shorting losers,” Mr. Healy said. “We think the biggest impact on long-short portfolios is how you adjust exposure to the market over all.”

The Natixis fund does that by keeping about 60 percent of assets in stocks and exchange-traded funds and varying the amount of stock index futures contracts it owns or holds short. An advantage of that approach is it’s easy and cheap; expenses are about half the rate of the average long-short fund.

Mr. Healy’s portfolio recently was 110 percent long, but that could decline soon because of “signs that we may be entering a period of heightened volatility,” he warned.

The Alger Dynamic Opportunities fund has used the opposite approach, more or less, to earn its five-star rating and rank among the best long-short funds, with risk-adjusted returns also in the top 20 percent over three years. During that period, it had an 11.7 percent annual return, matching that of the Natixis fund.

The fund tries to keep net market exposure within a tight range, 40 percent to 60 percent, and it analyzes individual stocks to “try to identify where we think the best growth opportunities are” according to economic and commercial trends, said Dan Chung, the lead manager. Human analysts do the work, with quant methods employed only for risk management.

The fund is most heavily exposed to technology, health care and industrials, Mr. Chung said. The trends that make those niches appealing include the movement of data management to cloud servers, the increased use of technology in drug trials and insurance management, and the growth and increasing sophistication of waste management and recycling.

Recent large long positions that conform to at least one of these trends include Waste Connections and the cloud-based technology service providers Paylocity Holding and SPS Commerce. Among the fund’s big shorts lately have been Flexion Therapeutics, which makes injectable pain therapies, and the social media company Snap.

While these trends have very long life cycles, in his view, share prices are not immune to ordinary economic developments. That’s why the fund’s net exposure is near the bottom of its normal range.

“This is the most conservative the fund has been in about a year and a half,” Mr. Chung said. “There are a lot of uncertainties in the world.”

Despite the healthy performance of some portfolios, long-short funds remain out of favor. In the 12 months through May, a net $12 billion was withdrawn, according to Morningstar, nearly one-third of the $39.1 billion invested in them when the period began.

Westwood does not use long-short funds in its portfolios. “We’re not seeing client demand for them,” Ms. Bennett said.

Mr. Cordaro and his colleagues “have been invested in long-short in the past, but we’ve been out of them a long number of years now,” he said.

But while the storm buffeting the funds may be perfect, it’s not permanent, as far as he’s concerned. When conditions are more favorable, he will consider putting clients into funds of “well established managers who have good quant modeling and can also put some good fundamental research behind it.”

Portfolios that he said fit the bill include Nuveen Equity Long/Short and AQR Long-Short Equity.

The time for trying long-short funds may not be here yet, but Mr. Cordaro sees it approaching.

“Cash yields have gone up, so the funds have less of a headwind, and value has been out of favor for 10 years and will come back into favor at some point,” he said.

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