We’ve written extensively this year about building portfolios that can withstand multiple market conditions and how the next ten years may look very different than the last. While building the overall asset allocation is going to have the largest impact on your client’s ability to reach their investment goals over time, individual investment selection, particularly within alternatives, is a vital component of the overall success. The reason this is so critical in alternative categories is that dispersion is often much wider than in traditional asset classes.
According to one report, selecting the ‘worst’ large cap value fund could mean you earned 10% in a particular year vs. 18%; so while frustrating to lag, it isn’t a massive difference. However, if you chose the ‘wrong’ long/short equity fund you could have been down 7% in a given year vs. up 27%. I am guessing that the client conversations surrounding a fund that was down 7% is much tougher than only getting 10%.
Given alternatives are where we spend much of our time, in this post we will highlight a few things to look for when choosing a long/short equity fund (we recently covered managed futures as well). This is by no means exhaustive, however based on our nearly two decades of working with investors, it includes things that we consider important but often get overlooked when conducting alternative fund due diligence.
Category Catch All
Let’s say you are working on building base-scenario model portfolios for your clients. You’ve decided the appropriate mix of large cap value to small cap blend, as well as U.S. stocks to emerging market stocks. You know the exposures that you want, so you go to Morningstar to run a screen to find the top quartile of managers. You want to rank each of them based on return, risk, up/down capture and drawdown, but when you get there, you see that the style boxes and categories are gone and all equity managers, i.e., small, large, value, growth, U.S., non-U.S. are grouped together, as are allocation funds and sector funds. How in the world are you supposed to properly evaluate each manager according to your criteria when a plethora of styles and universes are all grouped together?
It would be a mess (and basically impossible) to do it effectively and efficiently, yet this is the scenario that presents when you go to select a long/short equity fund. The category is a hodgepodge of styles, universes, and geographies—yet they are all measured exactly the same and against the same benchmark. Is a long/short equity fund that outperformed the group over the last three years, but is domestic, better than a global fund? Since the U.S. has eclipsed non-U.S. over that time frame, I’d say that isn’t necessarily the case. Rather, they have benefited from being domestic only, and that is not reflected when you look at the category as a whole. Running performance screens is a starting point, but that performance should be deconstructed in multiple ways. You cannot simply rely on screening the category over a couple years and selecting the ‘best’ one (check out this article as to why that is a strategy that almost always results in failure); you’ll have to dive quite a bit deeper.
What follows is a list of criteria that we deem important to consider so that you make an informed decision.
The first step would be to decide what you want this strategy to do. Do you not want market exposure? Do you simply want hedged equity, or do you want a more macro-based approach? Before you even look at performance, decide what you want so that you can narrow down the list to strategies that align with the approach you want. Once you decide on your goal, assign an appropriate benchmark (i.e., if you want market neutral, then the benchmark shouldn’t be the S&P 500 Index). Check out our post on selecting benchmarks.
Once you have decided on your goal and have assigned the proper benchmark for like-funds, you’ll want to examine the gross and net exposures. In up markets, funds that have additional leverage should outperform those that are more conservative; but does that make them better funds? Not necessarily, it just means that they were rewarded for that extra risk. However, should the market turn, they may underperform more than you were expecting. If you only screened on performance and didn’t consider the leverage it took to get there, you may underestimate the risk you are adding to your portfolio. In addition, just because a fund has additional leverage, it doesn’t mean you are compensated for that. Examine the entire life of a fund and the exposure-adjusted returns and you may just see that all the added leverage didn’t do much. In fact, you could have owned a less-leveraged fund and performed the same or better (just minus the accentuated ups and downs along the way).
Another component of exposure to examine is if the fund(s) are tactical or static in their approach. If a fund adjusts its exposure, you need to have a process in place to assess how good the manager is at moving that up or down. Recency bias can really get in the way of this one, if you don’t have a process for evaluating it consistently. When a manager ‘gets a call right’ they love to notify the entire investing world with marketing pieces, tweets, and spots on CNBC…but they don’t usually shout it from the rooftops the four other times when they got it wrong. Because of this tendency, investors often assign more skill to a manager than truly exists. It’s fine to have a tactical approach, just make sure that as you do diligence you have a method for evaluating their ability to be in and out of the market over the life of the fund.
On the other hand, be sure to fairly assess a strategy that has a static approach. If a fund wants to maintain a 50% net exposure, it is expected to lag not only the market, but also peers who have higher net exposures when markets are racing. Running a screen over the last three years won’t give you the best manager over time, it is going to give you the fund that had the highest beta/exposure since markets have been strong. Determining the nature of the exposure will help you evaluate whether the manager is lagging or outperforming because they are good at making tactical decisions, or because whatever their exposure is at the time is helping or limiting their return.
Going back to the beginning of this post, if every equity fund in the world was in the exact same category and you screened on five-year performance, you’d get a whole pile of U.S.-based funds on the top and non-U.S. funds on the bottom.
Does that mean that managers running domestic funds are better than managers running international funds?
No, it means U.S. stocks have been outpacing non-U.S. for several years, so portfolios with any kind of non-U.S. exposure have lagged. Thankfully Morningstar places them in different categories…but they haven’t yet done that in the long/short equity category. There are just over a dozen funds in the category that have consistent, or only, non-U.S. exposure. These funds have lagged over the last few years, but it doesn’t mean that they are worse than the rest of the S&P 500-focused strategies in the category. Make sure that you understand the universe in which the funds are operating, and evaluate them relative to that group, not the entire category which includes funds that may have led or lagged because of a mandate, not the value add of the manager.
Fundamental vs. Systematic
Some funds in the category are dependent on the skill of the manager, i.e., how he or she selects stocks, including over/underweights and how much exposure to have. Properly evaluating these managers can be very difficult given all of these moving parts, and like the discussion on exposure above, you must set up a system that evaluates these moves by a manager over time.
The other approach is more systematic; these strategies are seeking to exploit observed market anomalies (value beats growth over time, or small cap beats large cap, etc.) and implement a disciplined process to take advantage of these. This makes sense over time but can also mean that when those anomalies are nonexistent (growth has beaten value for the last decade) the strategy doesn’t perform as well. So, if a manager that is long value and short growth is lagging the peer group, does that mean they are a bad manager? Or does that just mean that the environment isn’t conducive to that approach? We’d pick the latter, but we find that investors sometimes attribute it to skill instead. This potentially means they will allocate to more aggressive growth-type strategies, since they’ve been outperforming lately, and their experience when the environment shifts may not be what they are expecting. With respect to this component of fund evaluation, neither fundamental or systematic is better or worse, it is up to the advisor to identify the approach, understand the biases present and make sure their evaluation is tied to that and not just, “fund XYZ has had the best performance over the last three years.”
We’ve written plenty about alpha (here, here, here, and even a video here) so I won’t belabor the point, but this is, in our opinion, one of the best ways to select a solid fund in this category. To be blunt, most of the funds are not worth the fees. Often, investors would be better off just owning a passive index up to a certain weight with the rest in cash instead of owning a long/short equity mutual fund. Investors can get lulled into the idea that performance equals alpha, but further diligence into the beta, factor returns, etc., can lead to a very different story.
In addition, alpha is often lumpy—it will come in waves over time so looking at it over minimal time frames can lead to over/under estimation. The best method would be looking at the entire time frame of the strategy vs. the appropriate benchmark to evaluate if you have been given alpha over the life of the fund. If that fund hasn’t delivered alpha, don’t let a good story or recent performance sway you. However, if the fund has provided alpha and you think its approach makes sense, and will be appropriate going forward, then make the selection and remind yourself that the alpha will come in lumps and only by sticking with it over time will you and your investors benefit.
Unfortunately, some of the tools we’ve come to rely on for our long-only manager screening are not available in alternative categories, so investors wanting to allocate in the space will have to do a bit more work to find top performers. Hopefully some of these points we’ve brought up will help get you started, but if you have additional questions or would like to chat through it, please feel free to reach out. While more labor intensive at the outset, the benefit to your portfolio of choosing the fund up 27% vs. the one down 7% can make a big difference in your client’s portfolio and investing experience.
Read our last blog post, Choosing a Managed Futures Fund >