The Outliers

In last week’s blog, we examined the wide dispersion in the long/short equity category, including a couple of funds that have had incredible performance in 2020. We too were curious about this performance, so we thought we’d look a bit closer at these strategies, including how it has impacted their longer-term results. Additionally in this blog, we’ll discuss things to consider when doing due diligence in a category that can be difficult to evaluate.

Enter the 2020 outliers

Any time that a strategy puts up numbers that are so far outside the norm, it is expected that a number of investors will notice and ultimately allocate. While no doubt tempting, we think it prudent to take a step back and critically assess the strategy apart from its eye-catching year-to-date (YTD) return.

One of the best things to do may also be the most difficult—ignore the current moment and look at the past. Let’s do that now for the three (nameless) funds we mentioned in our last post that are up over 30% YTD through 9/30/20. Given strong equity performance since the financial crises and inception date limitations, the only challenging years for markets are 2011 and 2018 (none of the funds existed in 2008).

    1. In 2011, the S&P 500 Index was +2.11%, the MSCI World Index was -5.54% and the Morningstar Long/Short Equity Category was -2.81%. Only one of these funds was around as a mutual fund in 2011 and it was down more than the market.1
    1. In 2018, the S&P 500 Index was -4.38%, the MSCI World Index was -8.71% and the Morningstar Long/Short Equity Category was -6.29%. These three funds were down between 2.05% and 3.23%. While this is fine performance, It’s not to the magnitude of what occurred in 2020.

Another way to assess the strength of individual funds is to look at the ‘value’ added or return-over-beta provided historically. As we have also written about, investors in this category should take special care not to invest simply in return numbers, but look at the actual alpha (return-over-beta minus risk-free rate).


  • One note here. Often times, strategies will highlight alpha numbers over truncated periods, but it is important to look at alpha historically. Positive alpha (and negative alpha) can come in chunks and looking at those numbers over a brief window, as opposed to the long term, can lead to over/under exaggeration of their value add.

Below is the average monthly out/underperformance of these three funds since their inception in relation to their beta to the S&P 500 Index through 12/19.

Fund A:                 0.21%/month

Fund B:                 -0.09%/month

Fund C:                 -0.08%/month

Only investors in one of the funds got any value add from their manager, and the one that did add value has a relatively short track record, so unfortunately not a lot of data to go on.

2020 made a huge impact, but did investors benefit?

Investors that saw 2020 YTD numbers likely took a look at these funds and were impressed, so they went ahead and made an allocation; we can infer that this occurred by looking at AUM data. At the end of 2019, these three funds had about $245M in assets; as of 9/30/20, they now collectively have $955M(!). Without knowing exactly when these investors came in, it’s safe to assume that much came after the outsized performance these funds put up during the first few months of the year. That purchase was potentially justified by looking at the ‘new and improved’ trailing returns. But what many fail to consider is the impact this short-time frame has on the trailing returns. As you can see below, it is significant.

As of 12/31/19 As of 09/30/20
1 Year 3 Year 5 Year 1 Year 3 Year 5 Year
Fund A 9.08% 4.94% N/A 53.73% 17.24% 11.80%
Fund B 12.80% 8.80% 5.52% 34.51% 14.67% 11.85%
Fund C 19.88% 12.76% 7.22% 47.71% 19.33% 15.81%

2020 performance (much of which came from February/March) accounts for about 84% of the 3-year trailing for each of these funds on average, and accounts for 51% of the 5-year returns. It’s easy to look at these trailing numbers to justify making an allocation now, but they didn’t suddenly become better than they were nine months ago, they just had a massive outsized move that is responsible for much of the improvement in the trailing numbers.

Similarly, look at the same monthly out/underperformance from above, but updated through 9/30/20.

Fund A:                 0.88%/month

Fund B:                 0.11%/month

Fund C:                 0.25%/month

Again, it now suddenly looks like there is a great deal of value added. Alpha is indeed lumpy, but a huge lump is needed to go from little to no value on average, to nearly 50 bps per month on average. This is shown visually in the chart below. 2020 performance and updated trailing performance is owed in large part to this big jump—a time during which there were likely few investors that already had exposure.

None of this is meant to be harsh on any specific fund or approach, it is simply meant to serve as a call for investors to understand what they are buying, the performance behavior around it and what to expect in the future.

How do you pick the ‘right’ long/short manager?

We consistently hear from investors that what they want from the category is a strategy that gives some upside participation, but also importantly protects on the downside. For us, the ‘right’ strategy may not always be the best performer over every trailing time period, but it would be the strategy that gives you value, as well as an appropriate risk/reward payoff. If that’s what you are looking for, there are three things we’d suggest looking at.

Upside/downside capture

What you should focus on here is that there is a spread (a positive one) between the numbers and how those capture numbers relate to the beta. If your up and down capture have either a spread that is negative, or matches the beta, you’d probably be better off using cash to hedge.

Sortino ratio

Similarly, many people look at Sharpe Ratio when evaluating funds. While useful, because the calculation uses standard deviation, it can sometimes punish funds that deviate on the upside (upside deviation is a good thing, but it still counts as deviation). The Sortino Ratio essentially measures the return per unit of downside risk. If you want a strategy that pays you for each unit of risk you are taking, I’d argue Sortino Ratio tells you a lot more than Sharpe.

Alpha – specifically short-side alpha

As mentioned earlier, alpha is of utmost importance and you should not pay additional fees for beta-like performance. One thing to consider as well is alpha coming specifically from the short side. From what we’ve seen, this is rare, but does exist, and when conducting due diligence, ask managers to get you those numbers. For each of these measurements, make sure that you examine the full historical numbers, not just the three-year or five-year (or whatever time frame is on the fact sheet).

How do you invest before the manager has its significant outperformance?

Unfortunately, predicting this is impossible, so timing your purchase will be a frustrating (and likely a losing) endeavor, but you can capture these sometimes huge moves. The trick is to do your due diligence up front and then remain patient, even during lagging periods. During those leaner times, other fund companies will call you to tout their outperforming strategy, clients will get antsy and you may even get frustrated. This may lead you to abandon your strategy and move into one that has better near-term numbers (those of which you already missed out on) only to then enter into another period of lag. This constant chase by investors—which you can easily track by looking at AUM numbers—has undoubtedly led to lots of disappointment.

Often times the best way to ensure you are there when it outperforms is to maintain conviction during the inevitable time when it underperforms. If you have done your due diligence from the start and have confidence in the ability of the manger (confidence that relies on more than just “they got 2020 right and now their five year looks awesome”) to continue adding value, you should stay patiently invested through the downs, so you are there for the ups.

How do you know if current or past performance will continue?

The dispersion in the category is largely due to the different biases of each fund. Some are growth focused, while others are value. Neither is necessarily better than the other, but when growth stocks are leading the way, growth funds should outperform. If market conditions change and value leads, this will reverse. For strategies with stated biases or more quantitative approaches, understanding their tilts will help put performance in context and give some direction around when to expect the strategy to be stronger. It’s important to remember that strategies with explicit biases will not just improve because time has gone on (i.e., growth vs. value does not consider the calendar). They will more likely improve when the environment they are seeking to benefit from is in favor. In these cases, you need to wait for that change in conditions, or look for strategies in the space that have more flexibility in their tilts.

Asking this question for opportunistic managers (ones that should be able to adjust from growth to value for example) is more challenging. Often recent performance has an outsized impact on our perception of their future success—but that future success is not predictable. I would ask these managers what it is about their approach and style that leads them to believe that they will outperform other opportunistic managers—managers who also happen to think they’ll outperform.

Look back at past results. How many other times were they positioned correctly? How many times did their positioning hurt? Think about your willingness to sit through those times when everything is not going right. Can you handle that? Can your clients? While nothing is wrong with these types of approaches, it can be more difficult to assess the potential for future under/outperformance.

A year like 2020 often has outsized influence on our judgement of the efficacy of different strategies. This year is but one data point to consider. Whatever the next drawdown is, it’s unlikely it will be caused by a global pandemic that resulted in businesses closing for weeks and hundreds of thousands of deaths. The next correction will have different conditions surrounding it, and the best strategies this time may not be the best then, and the worst now may not be the worst then. Our innate behavioral tendencies, like recency bias, may have us chasing the hot dot now, but it’s important to recognize this bias and not let it get in the way of doing the work required to truly evaluate funds in this category, including the outliers on the upside and the downside, as well as all those in the middle. For investors willing to truly look under the hood, finding strategies that have added value over time and have a reasonable expectation to continue doing so, are there if you are willing to look for and then ultimately stick with them.

Please don’t hesitate to reach out to your partner at 361 if you have questions on the space or would like any insight, we are happy to share our opinion and experience.

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