How to Evaluate Long/Short Equity Funds for Specific Clients

In this article, I'll describe an eight-step process for helping clients evaluate long/short equity funds in any structure (hedge fund, mutual funds, etc.) You will see that these funds can fill specific needs that tend to be somewhat narrower and more specialized than their promoters would have you believe.

Long/Short Equity Fund Background

Long/short equity funds are the two-headed hydras of the investment world because their portfolio managers buy and sell stocks – and sometimes stock indexes, options or derivatives. The short positions offset some of the stock market's systematic risk, which makes these funds less volatile than broadly-based equity benchmarks such as the S&P 500. The average Beta of most equity long/short hedge funds is less than half that of the S&P 500 Index.

A useful index of long/short hedge fund performance is complied by Credit Suisse First Boston (CSFB). Monthly index returns since 1994 (inception) are available here:

• http://www.hedgeindex.com/secure/print.cfm?SID=570

Since inception (through 11/05), the index has returned an annualized 11.73%, compared to 10.60% for the S&P 500 Index (Total Return). We know that most hedge fund indexes tend to overstate performance by about 1-2% due to "survivorship bias" – the effect created by poor performing hedge funds that disappear and drop out of indexes. When survivorship bias is considered, you can estimate that the CSFB Long/Short Index has about matched the U.S. stock market's long-term performance.

However, the main attraction of this category isn't high return but rather low volatility. The CSFB L/S Index has averaged a monthly standard deviation of 2.98% since inception, compared to 4.28% for the S&P 500. In summary, over time long/short equity funds have produced approximately the same long-term return as the S&P 500 Index, with about 70% as much month-to-month volatility.

An Eight-Step Evaluation Process

The first four steps in the process described below will help you select clients who are candidates for long/short equity funds. The last four steps will help select long/short managers who match client needs.

Step 1 – Long/short equity funds should rarely be recommended for high-bracket taxpayers in taxable accounts. According to analysis by Lipper, the S&P 500 Index has produced a long-term "net-net efficiency ratio" of 81%. That means: After costs and taxes are subtracted for a high-bracket investor, about 81% of gross return remains. In most long/short equity hedge funds, you should not expect efficiency ratios above about 50%. In other words, expect that over time less than 50% of gross long-term return will remain for investors, after all costs and taxes. In long/short mutual funds, the efficiency ratio may not be much better unless the investment advisor deliberately attempts to manage tax impact – and few do.

Most long/short funds are inefficient because of their high management fees, high portfolio turnover (which produces short-term capital gains) and extra transaction costs related to short-selling. Hedge fund investors are further penalized by incentive allocations that typically cost 20% of portfolio appreciation. The heavy impact of costs and taxes makes these funds suitable mainly for qualified retirement plans and tax-exempt investors.

Step 2 – Long/short equity funds work best in reducing short-term portfolio volatility, not long-term. Today's institutional investment market is driven by monthly performance reports and evaluations. This is due mostly to the layers of accountability in the institutional investment process, and also to institutions' need to make distributions of cash from portfolio returns. In contrast, many individual investors aren't greatly concerned about how their IRAs or 401(k)s perform month-to-month, if long-term results are satisfactory. For long-term investors, there are simpler and more efficient ways to moderate portfolio volatility than long/short equity funds. The best candidates for long/short equity funds include: 1) institutions; 2) individuals who are worried about short-term volatility; and 3) individuals who are withdrawing money periodically from investment portfolios, such as through Systematic Withdrawal Plans.

Step 3 – Long/short equity funds should be avoided by clients with structured asset allocation programs. A detailed analysis of long/short equity hedge fund performance, authored by R. McFall Lamm, Jr., may be downloaded here:

• http://www.trendfollowing.com/whitepaper/long_short.pdf

Although Dr. Lamm is a cheerleader for hedge funds in general, even he acknowledges their weaknesses in asset allocation strategies.

Long/short funds often shift portfolio style weighting between small cap and large cap, and they also vary the "net exposure" on either the long or short side. Writes Dr. Lamm: "While this may produce improved performance, it comes at a cost of much less control over the asset allocation decision. Indeed, it raises the important question of whether allocating to long/short hedge funds is really an asset allocation decision since at times long/short managers may be short the desired cap exposure."

Step 4 – Long/short equity funds work best for investors who believe that the market is entering a specific type of environment. Primarily, that is a market that features sustained up or down trends, as opposed to a choppy market. To a lesser extent, long/short funds also tend to prosper in periods when small-cap stocks outperform large-cap.

Strong, sustained trends favor long/short equity funds because of their ability to adjust the mix of longs and short positions, or net exposure. The vast majority of these funds have more long exposure than short – thus, they are "net-long." For example, a fund that has 65% of portfolio weight in long equities and 35% in shorts is "30% net-long." However, most managers make adjustments in net exposure based on the current market environment.

These shifts are reflected in the correlation of monthly returns between the CSFB L/S Index and the S&P 500 Index, as shown in the graph below. A higher correlation indicates a higher "net long" position in long/short hedge funds overall.

Correlation of the CSFB Long/Short Equity Fund Index With the S&P 500 Index

(1997-2005, based on rolling 36-month periods)

As the graph suggest, it takes time for managers to recognize trends and make adjustments in the long/short mix. In late 2002 and early 2003, some managers continued to reduce net-long exposure even after the market had bottomed. In choppy markets, it is easy for long/short managers to get whipsawed on net-exposure calls.

Secondarily, there is a tendency among many long/short managers to favor small-cap stocks over large-caps. In fact, Dr. Lamm and other experts have observed that it is common for managers to be net-long small-cap stocks and net-short large-caps. For this reason, the average long-term correlation of the CSFB Index with the Russell 2000 Index (0.78) is even higher than the same index's correlation with the S&P 500 (0.58).

You can estimate that sustained bull or bear markets contribute up to +1% to the average long/short fund's relative annualized performance vs. the S&P 500, and the small-cap bias of these funds (on average) can contribute up to +.5% annually when small-caps are relatively strong. Recent years have produced favorable conditions on both counts. But in choppy markets that favor large-caps, it is more likely that long/short funds will underperform the S&P 500 Index.

Four Steps in Selecting a Long/Short Manager

Step 5 – Demand and carefully evaluate the manager's short-side track record and investment process. Most long/short funds do not publish separate performance statistics for the long and short sides of their portfolios. But they should, and this data can be useful in identifying talented long/short managers. Look for managers who consistently add value through their short stock selection process. For example, if the S&P 500 Index is up 2.5% in a month and the short side of the portfolio performs better than -2.5%, the manager is adding value.

For several reasons, it is more difficult for managers to add value in shorts than longs. First, many long/short managers have spent most of their careers working on the "long side" and don't have much shorting expertise. Secondly, short selling involves extra costs and trading complexities that don't apply in unmanaged benchmarks. Thirdly, risk management is more critical in shorts, because the manager's mistakes keep growing in size (as a percentage of portfolio assets) as stocks rise. Many value-conscious long/short fund managers have shorted Google stock at some point in the last year. As Google kept rising, the key question is whether they covered shorts and cut losses before the mistake grew huge.

Don't buy the line that a manager applies a "consistent investment process" in selecting both longs and shorts, because it is very difficult to do in practice. Dig for the key decision drivers and risk controls that the manager applies separately on each side. Note: Some managers have a habit of acquiring "short side exposure" through stock index derivatives or ETFs. Just remember that your clients don't need to pay heavy management fees to achieve average short-side performance. For details, see:

• An Attractive New Asset Class: "Short-the-Market"

Step 6 – Evaluate the manager's track record for adjusting "net exposure." Most long/short funds fall into one of three groups: 1) the manager tries to maintain net exposure within a narrow range at all times – such as between 20% and 25% net long; 2) the manager makes strategic shifts in net exposure in gradual increments over time; and 3) the net exposure changes sharply from month to month, perhaps because the manager is trying to strategically or tactically to time the market. In the third case, it's important to evaluate past success in timing net exposure. Erratic changes in net exposure may tend to increase the risk and volatility of long/short funds, especially in choppy markets. A manager's pure stock-picking skills have the best opportunity to flourish in funds that maintain constant net exposure.

Step 7 – Evaluate the fund's historic correlation with the U.S. stock market as a whole. Look for correlations that are below the CSFB L/S Index long-term average of 0.58. If your clients are greatly concerned about reducing short-term portfolio volatility, look for correlations of about .40 or below. This will indicate a fund that keeps net long exposure low and does a good job managing short positions. Also, ask for historic correlations of the fund vs. the Russell 2000 benchmark of small-cap stocks. A Russell 2000 correlation that is about the same (or lower than) the correlation with the S&P 500 indicates the absence of a small-cap bias.

Step 8 – Insist on a consistent, documented track record in the same style, preferably in the same fund. With so many statistics being put on the table by long/short fund promoters, financial advisors have every reason to question the validity of those statistics. Also, there are too many talented long/short managers in today's market to accept less than a strong, credible track record. The manager's performance should be audited or attested by a third-party source over a period of three years or more, net of all fees. Don't accept hypothetical or back-tested performance, and be leery of prior performance records achieved by the same manager at different organizations or funds.

This eight-step process should remind you that not all "hot investment ideas" are suitable for your clients ? and it's your job to make the suitability call objectively. Long/short funds are a useful niche solution for a small group of sophisticated investors, but they are also being sold to too many other people for the wrong reasons. This will result in many disappointed investors down the road.

Be the professional who keeps the dogs of disappointment away from your clients' doors.

Key Questions to Ask in Evaluating a Long/Short Equity Fund Manager

• What is the "net-net efficiency ratio" of your fund for a high-bracket investor in a taxable account? (net-net = after taxes and all costs)
• Does your fund have a "net exposure" target or targeted range? (e.g., neutral to 20% net long)
• Do you adjust net exposure in an effort to strategically or tactically time the stock market? (e.g., decrease net-long exposure when the market is weakening)
• Do you publish separate monthly performance results and statistics for both the long side and short side of your portfolio? If not, why not?
• What are the key drivers of stock selection on the long side? On the short side?
• Do you publish monthly statistics on the historic net exposure of the fund, net-long or net-short? If not, why not?
• What are the fund's policies in regard to the use of leverage? How much leverage is typical, and how much is used in the extreme?
• Do you commonly use ETFs, stock index futures, options or derivatives for part of your short-side exposure? If so, why?
• What is your fund's historic correlation with the S&P 500 Index? With the Russell 2000 Index?
• Has the track record of your fund been verified by a qualified third-party source? Has this track record been created by the same manager in one continuously managed fund?