Practical Applications of A Performance Update—Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long—Short Funds

Practical Applications

• Retail investors seeking hedge fund—like performance may be interested in equity long–short mutual funds. However, such funds have not been available for long and require study to gauge their relative performance.

• Equity long–short funds slightly underperformed hedge fund indexes, substantially underperformed the S&P 500 Index, and generated negative alpha for the entire period from June 2013 to December 2019. On the other hand, long–short funds exhibited reduced volatility in the same range as hedge funds.

Key Definitions

Hedge fund

A hedge fund is a type of open-ended pooled investment vehicle. Hedge funds use various strategies to earn active return. They are a highly diverse group, usually classified according to their investment styles (e.g., equity long–short, event-driven, global macro, etc.). Hedge funds invest across the whole spectrum of asset types—including equities, bonds, commodities, currencies, and derivatives—though they generally favor liquid assets. Hedge funds usually are established as limited partnerships with the fund manager as general partner and investors as limited partners. Hedge fund managers charge significant fees; a common arrangement is 2% per year of invested assets plus 20% of profits. Hedge funds are less regulated than mutual funds and are able to use leverage and other strategies that mutual funds often cannot. Ordinary retail investors generally are not eligible to invest in hedge funds; the funds are open only to high-net-worth individuals and institutional investors.

Mutual fund

A mutual fund is a type of open-ended investment company that issues redeemable shares. The number of outstanding shares can fluctuate as new shares are issued and as shareholders redeem previously purchased shares. Mutual fund share prices are determined daily by reference to the value of the underlying assets rather than by trading. A mutual fund differs from an exchange-traded fund (ETF) in that the shares of an ETF trade on an exchange and can be bought and sold throughout the day, just like common stocks. A mutual fund differs from a closed-end fund (CEF) in that a CEF has a fixed number of non-redeemable shares that trade like a stock on a stock exchange. A mutual fund differs from a unit investment trust (UIT) in that a UIT has a fixed underlying portfolio. Mutual funds are heavily regulated under the Investment Company Act of 1940.

Equity long–short mutual fund

An equity long–short mutual fund is a mutual fund that follows the same investment strategy as some hedge funds. It buys (aka, goes long on) certain equities in the hope of selling them after their price rises, while borrowing other equities and selling them (aka, short selling) in the hope of buying them back after they drop in value. This is known as taking a long–short position on equities, and it is designed to reduce risk by hedging against losses if the stock market drops—and to make the fund emulate the performance of hedge funds.

Negative alpha

Alpha (Greek letter α) refers to the portion of excess returns on an investment (i.e., returns above the risk-free rate) not attributable to excess returns on the market as a whole. Thus, alpha refers to the portion of returns associated with the investment’s idiosyncratic risk, as distinguished from systemic risk (i.e., the risk of the market as a whole). Active investment management seeks to achieve excess returns by selecting investments with positive alphas. In this connection, achieving positive alpha may reflect a manager’s superior performance. Conversely, negative alpha is the degree to which an investment portfolio (or strategy) realizes excess returns less than the market as a whole. Negative alpha can signal inferior performance.

Discussion

David F. McCarthy and Brian M. Wong provide an update to the research McCarthy did in 2014 on equity long–short mutual funds, extending the research period to provide more data and more robust findings.

BACKGROUND

In 2014, McCarthy published a study of equity long–short mutual funds that were similar to hedge funds. He studied the prospectuses and annual reports of 242 “alternative” mutual funds and identified 47 that were most comparable to hedge funds. He analyzed their composition and performance from January 2008 to June 2013. He found that such funds gave investors access to equity portfolios similar to those of hedge funds and also performed similarly to hedge funds. However, he noted that the time span of the data was short—a result of the fact that equity long–short mutual funds had only recently become available—meaning the study would need follow-up to determine the validity of the results.

“ The analyses described in McCarthy (2014) indicated that equity long–short mutual funds offered equity exposures similar to private-placement equity long–short hedge funds and performed quite similarly to them in both absolute and risk-adjusted terms. However, it noted that the time period of the analysis (i.e., January 2008–June 2013) was short.”

—A Performance Update—Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long–Short Funds

METHODOLOGY

In 2020, McCarthy and Wong performed a follow-up study to extend the analysis from July 2013 through December 2019. It examined the same set of mutual funds and used the same approach as the original study, creating an index of equity long–short mutual funds and comparing its performance to that of three popular hedge fund indexes, plus the S&P 500 Index. Three of the 47 funds from the original study had closed by July 2013—and of the 44 remaining funds, 16 had closed and another 4 had changed strategy by December 2019. The data set the authors analyzed included all these funds, both those that survived and those that closed or changed strategy.

RESULTS

As shown in Exhibit 1, the authors found that from July 2013 to December 2019, their index of equity long–short mutual funds slightly underperformed all three hedge fund indexes and badly underperformed the S&P 500 Index, both in absolute and risk-adjusted terms. It also generated negative alpha during the period—to a greater extent than any of the hedge fund indexes—but exhibited beta (i.e., volatility) in the same range as the hedge fund indexes.

Viewed individually, the best-performing long–short mutual fund had an annualized return of 10%—which is less than the 13.7% annualized return of the S&P 500 Index—and none of the long–short mutual funds generated positive alpha. The authors also found little evidence of performance persistence among long–short mutual funds, meaning that funds that were in the top half of performers in a given year had an almost even chance of moving into the bottom half by the next year. There was a slight tendency for funds in the bottom half to close or change strategy by the following year. Finally, the authors found that the total assets under management for the mutual funds in the long–short index more than doubled from 2013 to 2014 but then dropped to about half the 2013 total by 2019, while the size of the average fund rose and then fell to slightly more than where it started. However, the total number of long–short funds shrank by half, with only 24 of the original 47 funds still active and following a long–short strategy by the end of 2019. On the other hand, the authors found that the rate of fund closure for long–short funds was not out of line with that of other mutual fund categories.

“ The median equity long–short mutual fund had an alpha of –3.1% per annum. Worse, not one of the 24 surviving funds had a positive alpha over this full time period … The absolute and risk-adjusted performance of the equity long–short mutual funds would be viewed by a number of investors as disappointing.”

—A Performance Update—Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long–Short Funds

CONCLUSION

This study’s results differ somewhat from those of the 2014 study. They show that while equity long–short mutual funds continue to offer investors access to equity portfolios similar to those of hedge funds and also display lower volatility like hedge funds, they do not perform as well as hedge funds. More importantly, long–short mutual funds perform far worse than the S&P 500 Index on both an absolute and risk-adjusted basis, and they all post negative alpha.

Therefore, given the higher-quality data set for this study due to the longer period of analysis, financial advisors may wish to refer to this study when counseling clients who are interested in long–short mutual funds. Advisors may wish to make their clients aware of this study’s findings if their clients are looking at equity long–short mutual funds as a way to realize hedge fund—like performance.

David F. McCarthy

dfm{at}dfmccarthy.com

David McCarthy is the principal of D.F. McCarthy LLC, a consulting and advisory firm. In 2002, he cofounded Martello Investment Management, LP, a specialist fund-of-funds and advisory firm concentrating on absolute-return hedge fund strategies. Previously, Mr. McCarthy was an investment manager for Global Asset Management (GAM), an investment officer with the Atlantic Philanthropies, a deputy manager of the International Financial Advisory Service of Brown Brothers Harriman & Co., and a consultant with McKinsey & Co. He holds a PhD from University College Dublin, an MBA from Stanford University, and a BA from the University of New Hampshire.

Brian M. Wong

b.m.wong1224{at}gmail.com

Brian Wong is an investor and consultant. Previously, he was a director with Merrill Lynch Wealth Management, serving as managed-futures strategy head and portfolio manager for the ML Systematic Momentum Fund. He has also worked as a research analyst at Martello Investment Management, a specialist global macro fund of funds. He earned an MBA from the Booth School of Business at the University of Chicago and an MA and a BA from Tufts University.