Most investors think of stock ownership decisions as somewhat binary: buy/avoid; sell/keep. There’s another choice: Sell what you don’t own in hopes of it declining. This is called shorting. Segment almost never shorts because the math of ownership is simply too compelling. Yet, with the trauma inflicted by the market decline of 2008-2009, many investors are lured into believing that a tad of shorting could reduce the harm of being “long”.
With prospective investors having a built-in appetite for something less risky, many hedge funds and mutual fund companies are happy to oblige with funds designed to add a “tad of shorting”. These “Long/Short” Funds sound great in concept. But once again, Wall Street tells a story that the math simply doesn’t support.
Long/Short Managers look to provide market neutral or hedged returns by buying a portfolio of stronger stocks and simultaneously shorting a portfolio of weaker stocks. In the purest sense they could be long 100% and short 100%, essentially eliminating market risk and only capturing the difference in returns derived from stock selection. The primary objective is to deliver stable returns with better downside protection. Hedge Funds are the most popular vehicle structure delivering this, given the flexibility they offer to portfolio managers, but are often illiquid. Long/Short Mutual Funds (also called Liquid Alternatives) are another choice providing more flexibility to investors to move in and out as needed.
We studied a universe of 66 such funds that have been around for at least the last three years. In total there are slightly over 100 funds to choose from that focus on US and international equity markets, with various specializations. We were gracious in our data use in two ways: we chose the lowest-fee version of each fund and we avoided using the 5-year numbers which were even worse.
Admittedly, Segment is a bit of a gadfly. We don’t take Wall Street spiel at face value. Accordingly, we do like to compare every investment opportunity with the lowest cost S&P 500 index fund (Wall Street’s kryptonite). While each strategy is different and might follow various benchmarks, the simplest option available to all investors is to blindly invest in the S&P 500. Wall Street often prefers to compare its offerings to their “peer group”, which might all be doing something equally stupid. In the case of Long/Short Funds, returns will typically lag the S&P 500, to both the upside and downside. Thus, for apples to apples comparison we need to look at risk adjusted return. Calculating the Sharpe Ratio is one way of doing so. The Sharpe Ratio looks at returns above the risk-free rate per unit of risk (measured by standard deviation of returns). Unfortunately, this penalizes a fund’s score for lumpy returns, even when all the lumpiness was to the upside. Sortino Ratio is a similar and useful metric since it measures only downside risk. Going back to our universe of 66 Long/Short Funds, we analyzed each fund’s Sharpe and Sortino ratios over the last three years using Morningstar. This has been a strong period for equities with the S&P 500 returning over 11.9% annualized. The period was particularly attractive for active managers as returns have been fairly dispersed across companies, sectors and assets. With several bouts of downside in the period, managers had numerous opportunities to prove their mettle. Long/Short Managers generally have the widest flexibility to add or subtract risk. It would seem reasonable to expect that on a risk adjusted basis at least half of our universe should have outperformed the S&P 500 over the last 3 years.
It turns out the number is far worse. Of the 66 funds we screened only three had Sharpe and Sortino ratios above the pure stock choice, the Vanguard 500 Index Admiral Fund. Of the three, two were close enough to the Index Fund to be proxies and only one was meaningfully better than the Index Fund. That fund is the AQR Long-Short Equity Fund. If we consider tax inefficiencies of a Long/Short Fund we are left without a single winner.
A synthetic Long/Short Equity Fund can be created by buying an equity index fund paired with a money market fund. If we had $100 to invest and we split that between the Vanguard 500 Index Admiral Fund that charges virtually nothing (0.04% fee) and the other portion in the Vanguard Federal Money Market Fund, we would end up with about half the risk and a Sharpe ratio that is slightly better than the Vanguard 500 Index fund alone and better than 97% of the Long/Short Funds we analyzed, after fees but before taxes are considered.
One reason for the underperformance of the Long/Short Universe is that annual fees average over 1.5%. That may not seem like much, but it’s 37 times higher than the Vanguard S&P 500 fund. But even if you disregard fees and look only at gross returns you still end up with only nine outperformers. Accordingly, if you invested in a Long/Short Fund that waived all fees, you would still generally end up worse off than the synthetic Long/Short Equity Strategy.
Risk as measured by volatility of returns is low for Long/Short Funds as their short positions act as a hedge. However, risk of underperformance is actually very high since they are making two separate choices – which stocks to buy and which to short. Shorting is also usually done in more rapid fashion, leading to higher turnover and costs, increased chance of underperformance, and often creating perilous tax consequences.
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