A Bad Quarter Rolls, and the Performance Strikes

We’ve written in the past about the long/short equity category and how the recent performance of several of these strategies has a lot to do with the fact they have high beta relative to the category, and lots of leverage (here and here). Today, we wanted to write about something else that has been slowly affecting the way performance of the category has looked relatively, and becomes even more impactful when Q3 2018 comes to an end. We think investors who aren’t looking at this may overestimate the effectiveness of certain funds in the category, and perhaps question the merit of their current holdings.

Over the last nine years, save for a couple of bumps, equities have been on a strong ride, and in the case of 2017, the ride had much lower volatility than average. In fact, the last time we saw a quarterly drawdown of anything significant was in Q3 of 2015…almost three years ago when the S&P fell 6.4%. Things were even worse for non-U.S. stocks as the MSCI EAFE Index fell 10.23%, including a 7.36% drop in August and a 5.08% loss in September. As we know, humans are very susceptible to recency bias (except perhaps when it comes to picking their favorite Star Wars movie), so it is likely that many investors don’t remember how Q3 2015 felt. And, given that markets have continued their strong ascent since then, this period is not likely something many dwell upon.

However, if you are invested in long/short equity funds today or are embarking on a search in the category, this time frame is instructive as to the efficacy/goals of the strategy and is something that may slip through screens for those that don’t dig into the details.

A Bad Quarter Rolls

At the end of Q3 of this year, Q3 2015 performance will be rolling off for both the category and individual funds’ three-year numbers. The result? This roll off will hide the underwhelming performance of many strategies during the last period when investors expected their long/short equity funds to protect client capital. Of course, some investors may want the aggressive positioning of more opportunistic options in the category. But, more often than not, advisors are looking to hedge their exposure and limit volatility and downside.

For this analysis, we looked at the 60 funds in the Morningstar long/short equity category*. During Q3 2015, the average drawdown was 3.4%, so the group overall captured just over 50% of the downside. That average, however, masks some of the destruction of capital that took place in these funds over the quarter. The bottom half of funds were down an average of 6.47% (worse than the S&P 500 Index). Additionally, over this timeframe, there was over an 1,000 bps spread between the top and bottom quartiles (something we also like to talk about in this category).

Fund Q3 2015
S&P 500 Index -6.44%
MSCI EAFE Index -10.75%
Long/Short Funds -3.39%
Bottom Half of Funds (Avg.) -6.47%
Bottom Quartile (Avg.) -8.57%
Top Half of Funds (Avg.) -0.32%
Top Quartile (Avg.) 1.78%

Source: Morningstar

The good news for funds that did not do well over this period is that this terrible memory is about to disappear from their rolling 3-year track record (although not such good news for funds that actually did their job). Advisors may have already seen an uptick in the amount of material they are receiving in conjunction with wholesaler calls/emails; we aren’t in the prediction game here, but I’m going to go out on a limb and say it is about to get much worse in the next six weeks.

The Performance Strikes

Once this quarter rolls off, the rankings in the category start to look very different. Of the 15 funds in the top quartile at the beginning of this year, seven of them will move out of the top group, and one moves out of the top half all together.

Looking a little deeper, funds that were ‘added’ to the top quartile captured even more of the drawdown of the market in 2015 (i.e., 80% vs. 30%), while funds that were ‘removed’ actually put up positive performance that quarter.

3-Year Annualized as of 12/2017 3-Year Annualized as of 7/2018 minus 8/2015 and 9/2015* Q3 2015 Beta Alpha
Top Quartile as of 12/2017 8.48% 9.42% -1.92% 0.61 0.50%
Top Quartile minus 8/2015 and 9/2015 7.11% 10.69% -5.36% 0.71 -1.00%
Funds Added to Top Quartile 6.22% 9.97% -6.01% 0.70 -1.62%
Funds Removed from Top Quartile 7.25% 7.26% 1.34% 0.49 1.60%
S&P 500 Index 12.92% 16.85% -6.44%
Source: Morningstar
*34 calculation periods 10/2015-7/2018. Used one fund per share class and removed the tactical funds that are not long/short and only adjusted their long exposure.

Another thing you’ll notice is that the betas creeped up for funds that are now in the top quartile. The difference in betas between funds that were added and those removed was 0.21. So the question here is, are these funds really that much better performing? The answer is, not really, they just have more market exposure. Similarly, are funds that left the top group worse performers? Or is it just that their sensitivity to the market is lower – and thus would be expected to lag in an environment where the market has very positive returns with no significant drawdowns?

You can see the value of what you are paying by looking at alpha. As you can see, funds that were added to the top quartile have negative alphas while those that were removed have positive. Moving into some of these funds with great 3-year numbers after Q3 2015 rolls off doesn’t mean you are getting a better long/short fund – all it means is that you are paying to increase your market beta. In addition, the negative alpha tells you that you will actually be paying to underperform a similar market exposure, as measured by beta, using a passive instrument and hedging with cash. (You would have been better off putting $0.70 of your $1.00 in SPY and holding $0.30 in cash than paying management fees for these funds). So, no matter how eye popping the performance on the chart that just crossed your desk looks, these numbers indicate you might not be getting the value you expect for the price.

We’ve seen this before, many investors screen on rolling performance, compare the top to their current holdings and then decide whether to make changes. At the same time, their phone starts ringing and their inbox fills up with fantastic-sounding stats. Discerning advisors will keep this information in mind and scrutinize the carefully culled data points that will cross their desks.

To help you out with that, here are a couple of questions to ask when the next fund rep reaches out.

Questions to Ask:

    • How did your fund do in Q3 2015?
    • How did it do in 2011?
      Global stocks were down over 5% that year and the long/short equity category caught much of that.
    • What is your beta?
      Make sure that the benchmark against which they measure is appropriate. We’ve seen a lot of this…some have T-bills as their benchmark but have over 100% exposure to stocks and are net 80% long. It’s pretty easy to show a lot of alpha when you are measuring your ultra-levered portfolio to cash. Their beta, and as a byproduct alpha (and other measurements), will be way off if they aren’t calculated vs. the appropriate benchmark.
    • Once you have the beta, measure that versus getting passive exposure at that beta level and see if they’ve really provided value.
      Measure the performance of a passive portfolio and cash at their beta level to the performance of the fund over the same time frame (after fees) to see if the investment has outperformed.

As always, stay vigilant, and scrutinize what comes across your desk. If you have any questions, or want help comparing strategies, don’t hesitate to reach out to your partner at 361 Capital.

Read more in the The (Really) Long and the Short of It >