In recent years, mainstream investors have increasingly embraced long-short equity mutual funds. Fund launches only began to accelerate in the aftermath of the financial crisis, so investors' collective experience with these funds has been largely acquired during an equities bull market.
Because investors tend to think in relative terms during bull markets and absolute terms during bear markets, many advisors have indicated frustration with funds in the category. Is that frustration warranted? Have long-short equity funds performed within expectations?
We analyzed the performance of Morningstar's U.S. Open End Long-Short Equity Category Average, the HFRI Equity Hedge (Total) Index and the HFRX Equity Hedge Index from January 1998 to June 2015, which represents the longest common time frame for the three indexes. Admittedly, all of these proxies of long-short equity performance have their problems, including survivorship bias, self-selection bias and inclusion of funds that aren't truly representative of the category. However, they can still serve as appropriate reference points for investors evaluating the overall characteristics of the category.
Our analysis aimed to answer two questions. First, have long-short funds, regardless of vehicle type, lived up to the hype? And second, have mutual funds behaved materially differently from hedge funds?
We expected mutual funds to have trailed their hedge fund peers, but we assumed that gap would be narrowing. This is because many of the managers in the mutual fund space are (or were) untested at shorting stocks. Managing a short book, as opposed to simply hedging beta risk with ETFs, is a substantially different skill set from what most long-only managers bring to the table.
However, we found that long-short funds have generated returns that, on a Sharpe ratio basis, exceed long-only equities (an average of 0.46 versus 0.33 for the S&P). Additionally, they've demonstrated an ability to substantially reduce volatility as well as drawdowns. Given the significant opportunity cost involved in getting back to even after a large loss, this is impactful.
