Being short apparently has its benefits

Retail Investing, 130/30 10 May 2010

Last week we told you about a survey of institutional investors that found resistance to the idea of hedge funds managing long-only funds and vice versa. Today, we’ll revisit the topic of “convergence” from a retail investor’s standpoint.

Whether they are managed by alternative or traditional managers, mutual funds with hedge-like strategies have been growing in popularity for some time.  A new study by Jingzhi Huang of Penn State University and Ying Wang of SUNY-Albany (“Should Investors Invest in Hedge Fund-Like Mutual Funds? Evidence from the 2007 Financial Crisis“) concludes that these hedged mutual funds outperformed the market during the financial crisis, but that there is more to the story than meets the eye…

The paper examines hedge fund-like mutual funds during the June 2003 to December 2008 period, with an emphasis on the 2007/08 financial crisis.  Specifically, it looks at a sample of market neutral, long/short, and 130/30 US equity mutual funds listed by Morningstar.

(Note the growth in the AUM of 130/30 funds in 2005, even though the number of those funds remained puny.  You can see why they attracted so much attention in 2006.)

According to the paper, market neutral and long/short equity funds have higher risk-adjusted returns than a passive index fund.  The chart below from the paper shows the raw annual returns of each category (VFINX is the Vanguard S&P 500 Index Fund).

However, the paper concludes that hedge fund-like mutual funds in general add no value for investors, based on four-factor alphas – even in the 2008 down market.  The chart below created with data from Table 4 of the paper, shows the negative monthly alphas produced by these strategies from ’03 to ’08, from ’03 to the beginning of the financial crisis and during the financial crisis itself…

But wait.  Huang’s and Wang’s research finds that the addition of shorting actually added value…

Alas, while short positions taken by these funds do generate alpha, the duo argues that the gain from short positions is not sufficiently large to offset the loss from long positions.

This can be taken two ways.  One might say: “Thank goodness these funds were allowed to short – shorting is a good thing that saved the day!”  Or one might say: “These managers made such awful long picks that even the tail wind of successful shorts couldn’t help them!”

Huang and Wang take the dim view of these products. “In general the portfolio-level performance analysis indicates that hedge fund-like mutual funds do not have investment ability nor provide investment value to investors,” the paper says. What’s more, they say that hedge fund-like mutual funds “have a higher correlation with market movement in the crisis.”

Of course, there are some benefits to hedge fund-like mutual funds, namely that they don’t perform as poorly as their long-only cousins in bad times. Indeed, while the performance of hedge fund-like equity funds was found to be diminished by their (under-performing) long equity positions, the short positions taken by these funds significantly contribute to their overall performance, especially during the 2007/08 financial crisis.

In the end, Huang and Wang acknowledge the value in hedge-like mutual funds, despite the fact that they come up empty on a four-factor regression…

“…market neutral and long/short equity funds clearly outperform passive index fund on a risk-adjusted basis during the 2007 financial crisis, thus providing investors with shelter from a stormy market. Investors seem to recognize the skills of top hedge fund-like mutual fund managers and reward them with more fund flows.”

Who said it sucks to be short?

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