Long/short equity funds are one of the largest categories of single-strategy alternative mutual funds Morningstar tracks. Beware: the fund lineup is as diverse as it is deep. Individual long/short fund characteristics vary considerably. Without careful analysis, advisors risk picking a fund that performs quite differently than expected, or invites unintended risks into their client’s portfolio.
The following highlights some of the key differences among long/short equity funds, and what those different characteristics may mean for fund performance and risk. It also offers pointers on fund due diligence. The purpose is not to promote one type of long/short fund over another, but to shed light on the differences so that advisors can analyze the strategies more closely and know what to expect from them in different environments.
Gross Differences in Gross Exposure
Gross exposure is a long/short equity fund’s total exposure to the market, including both long and short positions and the use of leverage. The range in gross exposures among long/short funds in the Morningstar category is staggering: A fund’s exposure varies anywhere from 14% on the low end to as high as 342%.
A high gross exposure could mean the fund is taking a lot of leverage in an attempt to monetize investing around a particular factor. As a hypothetical example, the manager may believe that over time, the smallest stocks within an index will outperform. To monetize this factor, the manager then goes long the smallest stocks in the index and shorts the largest stocks. By employing leverage, for example going 200% long the smallest stocks and 100% short the larger stocks, the fund can increase its gross exposure and in turn, take a larger bet on this factor. The greater the fund’s gross exposure, the higher the outsized returns will be when smaller stocks outperform.
Gross exposure comes with risk, however. If smaller stocks are out of favor, large gross exposure exploiting this single factor will lead to large underperformance. Advisors considering a fund with large gross exposure need to be aware of the environments in which the fund will underperform, and make sure they can stomach such environments.
Due diligence tip: Different gross exposures can make it challenging to determine different long/short managers’ relative skill. To determine each manager’s skill, advisors must normalize the returns of funds with different gross exposures.
To illustrate the point, consider two long-short funds that both seek to monetize two factors: size and momentum. If one fund focuses on exploiting these two factors and has gross exposure of 200%, and another seeks those same factors but has gross exposure of just 100%, the manager with gross exposure of 200% should be expected to have double the returns when those factors are in favor. If the manager with 200% gross exposure returns, say, 10% and the manager with 100% gross exposure returns 8%, then, all things being equal, the latter manager has demonstrated more skill.
Varied Net Exposures, Varied Fund Objectives
Net exposure among funds in Morningstar’s long/short equity category also varies greatly, ranging from 14% to 137%. Higher net exposure means the fund will capture more of the equity market’s return. The suitable net exposure of a long/short equity fund depends on where it fits within a client’s broader portfolio.
If an advisor plans for the long/short equity fund to comprise a portion of the client’s equity sleeve, a higher net exposure is warranted. Other advisors use long/short equity funds as a portion of their fixed income allocation. In these cases, the advisor should be seeking to dampen equity market volatility, and should seek funds with a low net exposure. Similarly, advisors using long/short equity strategies as a diversified return stream and placing it within an alternatives allocation should also seek low net exposure.
Due diligence tip: To get a better idea of how volatile a long/short equity fund might be, advisor’s need to look at both net and gross exposure. Often, focus is given only to net exposure. A fund might be 100% long and 100% short, and tout that the zero net exposure offsets risk and dampens volatility. That is likely true in many market environments. For example, in a broad market downturn, an equity long/short fund with zero net exposure will likely outperform long-only equity strategies. However, if the manager is seeking to monetize one or two particular factors, if it has high gross exposure it can significantly underperform when those factors are out of favor, even if its net exposure is low.
Advisors should also consider whether the net exposure is static, or changes over time. If the net exposure changes, the advisor must evaluate that manager’s ability to time market movements.
Striking Differences in Fund Beta
A final characteristic where long/short equity funds vary is beta, which ranges from 0.07 to 0.90 within Morningstar’s long/short equity lineup. With such different beta levels, advisors can naturally expect different return profiles. Generally, a higher beta fund is a good fit if the advisor is placing the fund within a client’s equity allocation. Lower beta funds act better as a diversifier or fixed income replacement and can add ballast to portfolios when equities sell off. For advisors, the key is to make sure the long/short equity fund’s actual returns are equal to or better than the targeted beta suggests.
Due diligence tip: Advisors must hold managers to the standard of the beta levels they target. If a fund targets beta of 0.8 and can’t catch 80% of the equity market’s return, for example, the fund can’t justify the high fees and doesn’t belong in a client’s portfolio.
Target Markets Also Vary
Another contrast among funds within the Morningstar long/short equity category is the home markets in which they invest. Morningstar breaks out different categories for international, U.S. and global long-only equity funds, with further distinctions based on style and market cap. But long/short equity funds are all grouped together, meaning an advisor can’t easily find strategies domestically or globally focused, or even find long/short equity funds that specialize in the health care sector. The differences in target markets further illustrate just how diverse the long/short equity category is, and how expectations for each fund can vary.
Toss Out the Rankings, Think About Goals
Perhaps the only common thread among long/short equity funds is the Morningstar category they share. The stark contrast in gross and net exposures, beta and target markets mean advisors must look beyond rankings or performance numbers and ask what they want the long/short equity fund to achieve within a broader portfolio. Long/short equity strategies can provide value for clients, but only when the individual fund characteristics are understood and matched with appropriate expectations.