“Hedge Funds for the masses” features an update on how Long-Short (L/S) mutual funds have performed during the past couple of years. Are they really an alternative for the average investor? Here are some thoughts on this topic:
Hedge funds enjoy a certain glamour that the humble mutual fund lacks, including wealthy investors, the promise of outsized returns and billionaire money managers. Now this rarefied club is open to individual investors, and many are eagerly signing up.
The number of mutual funds attempting to replicate hedge fund strategies has risen dramatically, with 80% of today’s long-short funds launched in just the past few years. The funds have come from both mutual fund firms branching into a new area and hedge fund managers making their strategies available in mutual fund formats.
Investors have responded: in 2009 long-short mutual funds and saw more than $10 billion in net inflows, double their previous annual high, in 2006, according to investment researcher Morningstar Inc.
A move of hedge fund-style strategies into mutual funds could be a win for all concerned: investors could see steadier returns while traditional hedge fund firms open their doors to more clients. For mutual fund firms, these funds can be a way to attract new money in choppy markets and also keep investors from fleeing during times of panic.
But is this type of fund right for you? A hedge fund-style strategy should in theory deliver returns independent of the stock market — a fact that appeals to many investors still smarting from the market’s meltdown in 2008 and early 2009.
Indeed, hedge funds seem to have weathered that storm much better than mutual funds. Data from Hedge Fund Research Inc. show that the HFRI Fund Weighted Composite Index fell 19% in 2008, versus a loss of more than 40% for the average stock mutual fund.
Still, investors need to be careful if they decide to include a hedge-like mutual fund in their portfolio. Some of these offerings limited losses in 2008, to be sure, but many failed. Morningstar’s long-short fund category, where managers bet against, or “short” some stocks while staying bullish on others, saw 2008 returns ranging between a 40% loss for the worst-performers and a 12% decline for the best. The average long-short fund lost 15.4%.
The independent nature of these funds also means they’re likely to lag during rallies. The benchmark Standard & Poor’s 500-stock index rose 26.5% in 2009, but long-short funds added only 10.5% on average, according to Morningstar. On the downside, the worst performers lost 18%; the best of the group soared 82%.
“The average long-short fund was bad for investors” in 2009, said Nadia Papagiannis, alternative investments strategist at Morningstar.
Among so-called market neutral funds, which Morningstar places in the broader long-short category, there were also large differences. Vanguard Market Neutral Fund (VMNIX) lost 8% in 2008 and was down 11% in 2009, but JPMorgan Market Neutral Fund (JMNAX) lost 1.1% in 2008 and gained 9.7% last year.
Morningstar has one “analyst pick” in the long-short category, Gateway Fund (GATEX 25.53), which has seen annualized returns of 2.8% over both the past five and 10 years. Over three years, the fund is down 0.2% on an annualized basis.
Manager J. Patrick Rogers uses call options to generate income from stocks representing the S&P; 500 while buying puts as a hedge.
In recommending the fund, Morningstar noted Rogers’ lengthy tenure and the fund’s “sophisticated, yet easy-to-follow strategy.”
“The fund managed to avoid much of 2008’s market losses and keeps expenses low, making it a good fit in many investors’ portfolios,” wrote Papagiannis in a late February research note.
Gateway Fund charges annual expenses of 0.94%. Its Class A shares lost 13.9% in 2008 while the S&P; 500 fell 38.5%.
There is much more to this story, so be sure to read the entire link if this subject is of interest to you.
You may have a hard time justifying the use these types of funds, because of the lag in performance. Any investment approach, which attempts to minimize losses during market downturns, including trend tracking, will lag the subsequent upturn.
That is the problem for some investors in that they want to see bear market avoidance and expect to be in at the bottom of the next bullish rebound. It simply won’t happen. There will always be a lag. That’s why it’s important to combine bearish and bullish periods to arrive at a return that reflects both.
This is the main reason why you hear me regularly harp on the fact that the S&P; 500 still needs to gain some 14% from current levels just to reach the point we sold at on 6/23/08. When considering L/S funds, or any other bear market avoidance approach, you need to also look at the longer term picture and not just at the rebound of 2009.
In my data base, I am tracking 10 L/S funds as shown in the table above. While this represents a short term picture with the longest performance period being our current Buy cycle (since 6/3/09), it shows that some funds, especially SWHEX, have done very well by lagging SPY by only a few percentage points.
Others did not fare as well and have adjusted only slowly to the changing market conditions in 2009. L/S funds may not be the answer for everyone, but they may offer an opportunity to deploy some of your portfolio’s assets with better safety than simply buying and holding blindly.
Disclosure: I have no holdigns in any of the funds mentioned above.