Road test – hedge funds

Co-founder of the Switzer Report
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I am not normally a big fan of managed funds – maybe it is their ordinary track record, maybe it is their sometimes-outrageous fees.

However, when they do something for a retail investor that they are designed to do (unitise something that is otherwise inaccessible), then I can become a fan. I can think of three ready examples:

  • My SMSF can’t own a large commercial building – so buying units in a commercial property trust is the only way to access this asset class;
  • It is really difficult to manage exposure to smaller companies – I just can’t research all the companies, let alone create a portfolio – so appointing managers to actively manage this exposure is a sound move; and
  • As a retail investor, my SMSF can’t enhance its investment returns by doing some of things institutional investors can do – short selling, stock lending, stock spread trading and accessing the derivatives markets. Funds that do this may offer an attractive investment proposition.

A couple of subscribers have asked us to review long/short equity funds, which fall into the third category above. Here is our road test.

What is a “long/short fund”?

A “long/short fund” is like a normal equities fund in that it invests in shares or takes “long” positions, and complements these positions by short selling other shares. Shorting is selling something that you don’t own. If the price of the stock falls, a profit is made by buying the stock back at a lower price, and conversely, if the price of the stock rises, a loss will be crystalised when the stock is repurchased. To facilitate the settlement of a short sale, the manager “borrows” the stock from another institution or bank, and returns it when the short position is closed.

Effectively, the fund seeks to establish long positions in the most attractive stocks, and short positions in the least attractive stocks, to enhance potential returns in both rising and falling markets.

Most long/short funds are in a ‘net’ sense long and aim for a portfolio beta of 1.0. This is a statistical measure of how closely the portfolio is correlated to the overall market, with a beta of 1.0 meaning that the portfolio should give ‘market performance’ – for example, if the overall market goes up 10%, the portfolio goes up 10%. They then adjust the portfolio by taking long and short positions according to their active investment style to (hopefully) generate more than ‘market performance’.

The ‘net’ long position is achieved by taking long and short positions, which typically might look like this:

Gross Long Position: 140%
Gross Short Position: 40%
Net Long Position: 100%

Typically, the managers try to exploit market inefficiencies. BlackRock, for example, uses an active quantitative approach by systematically calculating forecast returns across a wide universe of stocks. Earnings expectations, relative value, earnings quality, market signals and style timing are all inputs to the model. Complementing the broad construction of the portfolio, the fund also seeks shorter-term return enhancing opportunities through participation in dividend re-investment plans and IPO/secondary market offers, and managing index changes.

Acadian employs structured stock and industry valuation methods, considering characteristics such as value, earnings growth and price-related factors. Stocks that Acadian believes are undervalued are purchased, and stocks that are overvalued are short sold.

The funds

Some of the major ‘long-short’ funds are detailed below in the following table.

Performance

The BlackRock Fund commenced in September 2011, and the Regal Fund in March 2011. Accordingly, long-term performance data is not available for these funds. Performance data to 30 June, 2013 for the five funds is:
While on paper the Perpetual Wholesale Share-Plus Long-Short Fund comes out pretty favourably, it is interesting to note that up until 2007, it lagged the index and was underperforming. All the relative outperformance has come since this time, particularly over the last two years. Also, the BlackRock Fund invests all its assets in the BlackRock Equitised Long Short Fund. Since inception in 2001, it has outperformed the S&P/ASX 200 Index by almost 9.0% pa! This outperformance is before investment management fees.

And the bottom line

If there is one take from the data above, it seems that managers (unsurprisingly) fail to consistently deliver outperformance. The best manager over the last 12 months is not always the best manager over the last five or 10 years. So deciding which manager to invest with is a bit like tossing a coin – it is just as likely to be “heads” or “tails”. This probably means minimising your ‘manager risk’ and spreading any investment over a couple of funds.

And how much to invest? BlackRock suggests that within an equities portfolio, perhaps up to 20% could be allocated to alternatives like long/short funds, with the other 80% in a mix of core and satellite holdings. My sense is this is a little high – bottom line, if your fund has growth or high growth objectives, an overall weighting of around 10% of your total equities allocation would be as far as I would go, and spread it over a couple of managers.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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