The long and short of long-short funds

When you board an airplane, the one thing you don’t want is a wide range of outcomes. If you’re headed to Fort Lauderdale, you’d probably prefer not to land in Vladivostok. A trip that’s supposed to end in New York City shouldn’t end in Altoona.
Similarly, if you’re choosing investments for your clients, you probably have reasonable expectations for those investments. In fact, much of the advantage of diversification is not increasing returns, but decreasing unpleasant surprises.
Which brings us to long-short funds. These funds can both bet on a security rising in value, or going long. They can also bet that a security will fall in value — going short. It’s a hedge-fund technique. In its more mild-mannered form, it’s basically a diversified stock mutual fund that has a relatively small short position — a hedge against market declines. While the short position will reduce returns on the way up, it should also reduce losses on the way down.
A somewhat more aggressive variant is that a long-short fund can make active bets on both the long side and the short side. If everything works out, you make money when stocks rise and when they fall. If everything doesn’t work out, you can lose money in both bull and bear markets.
Last year’s returns from long-short equity funds offer a wide range of outcomes. On the happy side, there’s LoCorr Long/Short Equity (LEQIX), up 25.33% for 2016, according to preliminary data from Morningstar, the Chicago investment trackers. The least happy side: Highland Long/Short Healthcare (HHCZX), down 14.68%.
What gives? In defense — sort of — of Highland, health-care stocks were one of the worst places to be last year. The average health-care fund tumbled 10.6% in 2016 amid worries about the fate of the Affordable Health Care Act. Small-cap health-care stocks, particularly biotech, were hit particularly hard, as management noted in its annual report dated June 30.
On the other end of the spectrum, there’s LoCorr Long/Short Equity, whose record is fairly remarkable, given its 52.3% cash position (as of the end of September) and 45.25% net long position. And many of those stocks were small-company stocks, nearly a third of which were in the consumer cyclical sector.
A wide array of outcomes is just one drawback to long-short funds. Expenses are another. The average long-short stock fund has a 1.97% expense ratio, according to Morningstar, and 26 share classes have expense ratios north of 3% a year. That’s a heavy load to bear, and tough to justify for retirement accounts under the new Department of Labor rules.
Another drawback is the difficulty in measuring performance. “The only thing you can be really sure of is that performance will be different from its benchmark,” says Todd Rosenbluth, director of ETF & mutual fund research at CFRA. “They are far from benchmark huggers. Perhaps the most applicable benchmark would be cash.”
And that would, in fact, make sense. Many advisers use long-short funds as a stabilizer for clients’ portfolios. The traditional methods of dampening volatility — cash and bonds — look singularly unattractive in the current market environment. The average money market mutual fund yields 0.24%, according to iMoneyNet. The bellwether 10-year Treasury note yields 2.5%, and is more likely to go up than down. Because bond prices fall when yields rise, adding bonds could just add to the misery of a bear market sparked by a spike in rates.
The average long-short fund has returned 5.73% a year the past five years, handily beating money market funds but severely lagging the Standard and Poor’s 500 stock index, which has gained an average 14.66%. Offsetting the lower returns is lower volatility: The average long-short fund has a standard deviation of 8.61 vs. 10.37 for the S&P 500.
If downside protection is the highest priority to you, then you should look at how a long-short fund fared in down year, Mr. Rosenbluth suggests. If the fund lagged in a rising market, you’d want it to have above-average performance in a down year. And, he added, there’s a critical difference between long-short funds and cash: At some point, even the best ones will lose money.

Related Topics: Morningstar Inc.