Parsing Long/Short Equity Liquid Alts Performance, Fees and Net Exposures
Investors interested in long/short equity mutual funds would be well advised to consider more than their much-more competitive fees vs. private hedge fund peers. To genuinely hedge the long components of a portfolio, look for lower net long exposures in a long/short equity allocation, and added value on the short side even in rising equity markets.
The sharp focus on investment management fees nowadays has brought private hedge funds under heavy scrutiny, along with their generally poor performance against long-only benchmark indices. So expectations that liquid alternative mutual funds, which effectively offer the same strategies as the limited partnerships (LPs) but at a much cheaper price, would outperform their aging prototypes, after fees, are entirely reasonable. After all, ’40 Act liquid alt mutual funds typically charge flat management fees of less than 2%, which is a far easier net-of-fee performance hurdle than the LP’s old compensation model of a 2% management fee and 20% profit cut.
But at least in one segment of the liquid alt space—long/short (L/S) equity investing—it turns out not to be the case: the old-fashioned LPs have outperformed their young mutual fund progeny, net of fees, Thornburg’s Connor Browne points out in a recent video. Five-year annualized total returns as of August 31 totaled around 4.5% for the Morningstar Long/Short Equity mutual fund category, while the LP hedge funds returned 5.8% a year, according to Hedge Fund Research Inc. “Given the lower fee burden,” the mutual fund group “should have outperformed,” Browne says.
Are the L/S mutual funds running with less embedded risk than the LPs? “In fact, we find that the mutual funds have higher beta, higher standard deviation and higher market exposure than the LP hedge fund universe,” Browne reports. The higher market exposure casts an even harsher light on the performance differential, as the S&P 500 Index has risen dramatically in the period, returning a stellar annualized 14.52%. Given their higher net long exposure of about 60%, which is significantly more than the estimated 35% to 40% net long exposure among the LP L/S equity funds, the L/S mutual funds should have meaningfully outperformed their private peers.
Perhaps there’s some degree of self-reporting bias among the LP group’s performance and positioning data delivered to private hedge fund tracking firms. But based on available data, it’s clear that as a group, net and gross exposure levels differ noticeably from the LPs to the L/S equity mutual funds, many of which don’t appear to actually be walking the hedge fund walk. Gross exposure levels between the two segments also differ markedly.
Although both use leverage in a bid to magnify returns, LP structure funds often average around 200% total gross exposure, with long positions—bets that stocks will appreciate—representing roughly 120%, and short positions—wagers that stocks are poised to lose value—comprising around 80%. Among the L/S mutual funds, category-wide total gross exposure averages just 120%, with 90% in long positions and 30% in short positions. “That doesn’t seem like enough (gross exposure) to us,” Browne says. Moreover, “we think to really diversify a client portfolio or to hedge what is mostly long exposure in a client portfolio, you need to find a manager with a lower net exposure,” he adds.
In the L/S equity hedge fund space, results should really be measured based on net exposures. Lower net long exposure levels can help offset the declines experienced when the broader equity market turns south. Although they’ll typically lag in rising markets, they really serve their purpose over full market cycles. A net long exposure of 60% isn’t much of a hedge in a down market. But even in up markets, skilled managers can still add value on the short side.