Dear Mr. Market:
You are made up of so many pieces and not all move in the same direction on each day. Some stocks can rise in bear markets and some get clobbered in bull markets. That being said, we have a special treat for you today: The following interview was granted to My Portfolio Guide, LLC from management of the Long Short Opportunity Fund (LSOFX).
My Portfolio Guide, LLC (MPG): First off…thank you for the opportunity to meet and learn more about your investing strategies. Our first question is perhaps best intended to simply set the table for our clients and readers of our newsletter:
Briefly explain why investors in typical advisory relationships should even consider using a hedge fund or alternative strategy as part of their portfolio allocation?
Long Short Advisors (LS): The simple answer is to provide downside protection in an increasingly volatile world where equity markets are near all-time highs and bond yields remain near all-time lows. A typical investor has their money allocated to a traditional blend of 60% long-only equities and 40% long-only short bonds, and has generated a fantastic high single digit return from this allocation over the past thirty years. Unfortunately for these investors, the current state of the bond market dictates that these returns are not repeatable over the next decade.
We believe the bond allocation of a traditional 60/40 blend could tread water at best given the current trajectory of bond yields.
Long-term equity volatility is unlikely to change, making a larger allocation to stocks similarly imprudent, especially at today’s record highs.
Thus, investors need to diversify into alternative strategies that have the ability to benefit not only from continued overall market strength, but also potential market weakness.
MPG: Of all the hedging and alternative investment strategies out there and now available to mainstream investors, what are some of the primary reasons to consider a “long/short” type approach?
LS: There has been a lot of talk since the beginning of the current bull market in March of 2009 that long/short equity strategies no longer work, and there is no reason to pay more than the cost of a long-only market ETF to access a strategy that has recently underperformed. We would warn investors and advisors alike to take a step back and realize that long/short equity funds “hedge”, and thus should and will underperform the general equity indices during a prolonged bull market. However, a full cycle involves a bull market and a bear market.
If you look back over the past 15 years which included over two full market cycles, long/short equity hedge funds represented by the HFRI Equity Hedge (Total) Index have actually outperformed long-only U.S. stocks, long-only U.S. bonds and an investor’s typical 60/40 blend. Further, they have done so with essentially the same risk profile of a 60/40 blend, signifying that the incremental return was a function of stock selection, not increased risk as many incorrectly assume. Another way of summing this up is basically achieving significantly higher alpha as well as Sharpe ratio.
The key here is that long/short equity hedge funds outperformed a passive 60/40 blend over the past 15 years during a record bull market in bonds. Over the next five to 10 years, the bond market is likely to see a bear market while there is no change on the horizon for the ability of a long/short equity manager to add value. Thus, it could be argued that long/short equity managers could outperform by even more in the coming years…
MPG: One of the more common questions we have received over the years with regard to “long/short” strategies is that going long equities while being short equities obviously seems to negate any net gain. How do you answer this common misperception?
LS: No matter what kind of market investors face (bull, bear, flat, volatile, etc.), there are stocks that outperform and stocks that underperform. Long-only managers only have the ability to take advantage of half of the market that outperforms the average every year. Long/short managers, on the other hand, have the ability to take advantage of the entire market, profiting from long bets on stocks that outperform, as well as profiting from short bets against stocks that underperform. Why would you want to ignore half of the market?
The key here is that the data shows that investor returns suffer when market volatility forces them to make emotional decisions by either selling near market lows or buying near market highs. Long/short equity funds are able to smooth that volatility, which should allow investors to stay invested over longer periods and enjoy the benefits of compounded returns.
More directly relevant to your question, note that there are two types of “hedged equity” strategies. The first is directional long/short equity, which is the category where LS Opportunity Fund falls. We will almost always have positive net exposure, but will never be 100% long like the market. Over the nine years that our Sub-Advisor has been running their hedge fund, they have maintained about 50% net exposure on average. Thus, without generating any alpha, a long/short manager with 50% net exposure should theoretically generate 50% of the market’s return, all else being equal.
However, the other class of “hedged equity” is market neutral. This strategy is frequently what drives the misperception that you allude to. Market neutral managers have a mandate to run their portfolios dollar neutral, with an equivalent short bet to their aggregate long book. Thus, in theory, they take zero market exposure and will only generate a return if they generate positive alpha. If their alpha is zero, their return will be zero as their short book will fully offset any gains from their long book….thus the misperception that long/short funds negate any positive performance.
MPG: We recently learned that your lead portfolio manager, Jim Hillary, actually invests most of his own money into this exact strategy. To quote one of your sayings, it’s almost the same as “eating your own cooking”! Is that the norm in the industry and did he also do this while he was leading Marsico Capital Management years ago?
LS: There is no easy answer to this question, unfortunately. Most mutual fund managers are pigeon-holed into very narrow strategies, and therefore will very infrequently have the majority of their own liquid net worth invested in their own funds. Further, long-only mutual fund managers are judged relative to a benchmark, so they are only incentivized to beat that benchmark, rather than generate absolute (positive) returns. A long-only manager has a “great” year when their benchmark is down -25% but their fund is “only down” -24%! If you had all of your money invested in this strategy you would definitely not consider this a “great” year.
However, we view long/short equity as a “core” holding rather than an “alternative” strategy. We encourage investors to think about long/short equity just like they think about international or emerging markets equities. Directional U.S. long/short equity managers will always be correlated to the domestic equity market, but this correlation should always be lower than long-only equity mutual funds. A properly diversified equity allocation should include long-only U.S. equities, long/short U.S. equities, long-only international equities, long/short international equities, and emerging market equities (although there is not a great sample size of emerging market long/short managers today).
Over time, Jim hopes to deliver equity-like returns, with reduced volatility and low correlation to the overall equity market. With this mandate, he and his team are able to invest all of their liquid net worth in their strategy as they feel it is inherently well diversified and low risk. In fact, Jim is his firm’s largest individual investor, which truly aligns his interests with those of his clients.
MPG: It’s clear that interest rates have only one way to go over time and that’s likely upwards. Bonds obviously stand to get tested some more. With the proverbial “writing is on the wall”, what’s your opinion on most people sitting in the typical 60/40 (equity/bond) model and how can they incorporate a strategy like this into their current mix?
LS: As we touched on before, these investors sitting in 60/40 blends need to do something, because they simply cannot repeat historical returns with this allocation given current market levels. However, both advisors and investors need to keep in mind that bonds historically exhibit relatively low volatility. You cannot simply take your 40% allocation to bonds and put it into and alternative strategy such as long/short equity. While a typical long/short equity funds has significantly lower volatility and correlation relative to the S&P 500, it is still significantly more volatile and correlated to the overall equity market than a bond portfolio. Thus, when creating an allocation to alternative strategies, investors need to dial back both of their long-only equity and bond allocations to ensure that the overall risk profile of the portfolio does not materially change.
When thinking about individual alternative strategies, the following can be used as a roadmap:
– Long/short equity and global macro funds are a substitute for long-only equity.
– Market neutral, arbitrage and non traditional bond funds are a substitute for long-only fixed income.
– Managed futures and real assets strategies (real estate, commodities, infrastructure, etc.) are your “true” alternative strategies that have little market correlation.
MPG: In what market environments does a “long/short” strategy work best and conversely, what environments might you expect it to struggle relative to other alternative investment strategies?
LS: As one might expect, long/short equity strategies are typically going to underperform the general equity market during sustained bull markets, and outperform during bear markets. However, we have also done a significant amount of work to determine that whether in a bull or bear market, long/short equity funds have historically underperformed expectations when market correlations move towards 1.0.
Based on our analysis, fundamental stock pickers such as long/short equity managers are not able to add value when the entire market moves in unison in either direction. We have found that managers overall destroy value during the few historical periods when the correlation amongst S&P 500 constituents relative the S&P 500 Index moves above 0.70 as it did during certain periods in 2010, 2011, and 2012. (We have charts on all this if anyone is interested)
Note, however, that the only other time since the Great Depression that correlations surpassed this level was a brief period starting in October of 1987. In all other monthly time periods where correlations are below 0.70, long/only short equity hedge fund managers generate significant alpha.
MPG: Briefly educate or summarize to our readers what leverage is and how it differs between traditional hedge funds and the LS Opportunity Fund (LSOFX)?
LS: Leverage is the act of using borrowed money to invest more than your investor capital. If a fund has $100 million in assets from its investors, but borrows an additional $100 million from a bank for a total investment of $200 million, that fund is though of has being 2x levered, or using 100% leverage (i.e. they are 100% more invested than their clients have actually invested in the fund).
The Investment Act of 1940 restricts mutual fund leverage to just 33.3%, or $1 per every $3 of investor assets. Thus, a long/short equity mutual fund has the ability to be 133.3% gross long and 33.3% gross short, for 100% net exposure. You may recall that this rule lead the popularity of the “130/30” funds in the late ‘90’s and early 200’s. Traditional hedge funds have no such leverage restriction, which led to dramatic underperformance by certain funds in 2008/2009 which were levered up eight to 10 times. (Lehman Brothers and Bear Stearns had mortgage portfolios levered up to about 60 times!). While leverage theoretically boosts positive returns, many investors tend to forget that it also magnifies negative returns.
At Long Short Advisors, we feel that leverage tends to increase volatility over a cycle without a requisite increase in returns, and thus we have eliminated it in the LS Opportunity Fund. We proactively restrict gross long exposure in the Fund to 100% rather than the 1940 Act restriction of 133.3%.
MPG: Thank you for that explanation and to follow-up on another distinction, please touch on “incentive fees” are and how you manage to avoid them with the LSOFX fund?
LS: A typical hedge fund fee is often quoted as “2 & 20”. This implies a typical management fee of 2% of assets, plus an incentive fee (or performance) fee of 20%. Therefore, is the underlying hedge fund portfolio has $100 million in assets and is up 10% on a gross basis for the year, an investor in the hedge fund will see a net return of just 6%.
In writing that looks like this:
Management fee = $100m * 2.0% = $2 million
Incentive fee = $100m * 10% gross return *20% incentive fee = $2 million
Total Fee = $4 million
Net Investor Return = $100m original investment + $10m gross return – $4m fees = $106 million = 6% net return
However, a long/short equity mutual fund is not permitted to charge an incentive fee per the Investment Act of 1940. Using the same example we just covered, an investor in the mutual fund would not be charged the incentive fee and therefore make an incremental 2% return. That obviously works out to be an 8% net return relative to their hedge fund counterpart realizing just a 6% return.
In summation, the main take-away for investors is that incentive fees take a significant bite out of investor returns, which is one of the main reasons that investors are migrating to ’40 Act funds, in addition to daily liquidity, full portfolio transparency, lower minimums and other benefits.
MPG: We previously discussed markets haven’t been kind to long/short equity performance and that’s certainly been the case over the past few years. Have long/short equity mutual funds been gaining much traction given their relative underperformance in 2011 and 2012?
LS: Great question…Despite 2011 being the worst relative performance year for long/short equity funds in history, followed by a mediocre 2012, asset flows into this category have accelerated significantly over the past eight quarters. Total assets have more than doubled from $20 billion in December of 2011 to over $42 billion today. Several sources expect assets to double once again over the next three years.
MPG: We’ve noticed that on the “long” side of some of your more recent holdings you appear to have heavier weighting towards the Consumer Discretionary and Healthcare sectors. Is that still the case and does it indicate you may feel this market is a bit frothy?
LS: As has been the case with our Sub-Advisor’s investment process for nine years, it is a fundamental, bottom-up portfolio that simply reflects the team’s best individual stock ideas on both the long side and the short side. The Fund’s largest position since inception, and the largest position in our Sub-Advisor’s underlying hedge fund since early 2009 has been Liberty Media and its various subsidiaries (Liberty Media, Liberty Global, Liberty Interactive, Liberty Starz, etc.). Since media is lumped into the “consumer discretionary” sector per the GICS classification system, it appears as though the Fund is extremely overweight all of consumer discretionary, when in fact it only reflects a tactical overweight in media. Note that our Sub-Advisor first bought Liberty Media in their hedge fund back in late 2008 at $3.26 relative to its current price of about $160, and they continue to think there is further upside.
Likewise, the Fund has historically and will continue to reflect a large healthcare bet, both on the long and the short side. This is due to two separate reasons: Frist, the healthcare sector lends itself perfectly to long/short equity investing as it is effectively a zero-sum game that has winners and losers every year, no matter what is happening in the overall market/economy. New drugs cannibalize old drugs, generics cannibalize branded drugs coming off patent, treatment and service revenues and profit margins are dictated by changes in government regulations and Medicare/Medicaid reimbursement, industry consolidation leads to insurmountable scale advantages for larger players, etc.
Secondly, our Sub-Advisor happens to have an extremely strong and seasoned healthcare analyst who has been with the firm since inception in 2004. He has been a positive contributor to performance both on the long and short side of the portfolio in the healthcare sector across all market environments. With a strong team in a sector that is ripe for stock picking, healthcare will remain a deep focus of the Fund for years to come.
MPG: As an investment advisor, we at My Portfolio Guide have a core belief that anyone can buy something with the hopes of it going up and that most humans are inherently optimistic and wired as such. What we find is that few have the ability or skill to know when to sell. Tell us a bit more about your sell discipline.
LS: The ability to know when to sell is akin to the ability to actually sell a stock short- it is inherently hard for the reason you describe, and this inherent difficulty leaves very few managers who actually do it well, and do so on a consistent basis. While our investment team is certainly not infallible, our primary decision makers have together for over nine years and adhere to a strict sell discipline based on the following:
-Position appreciates to a level that creates too much volatility or Fund concentration.
-Stock has reached the investment team’s assessment of intrinsic value.
-An unanticipated event or corporate action changes the original investment thesis.
-Short position hits the 15% stop-loss limit.
-Displacement in the portfolio by a better idea.
MPG: Great…thanks for that…and one last question! If you had to single out the one thing that you believe distinguishes the LS Opportunity Fund from any of your competitors, what would that be?
LS: Most of our peers try to emulate a hedge fund investment strategy within a mutual fund structure. The LS Opportunity Fund’s (LSOFX) Sub-Advisor is a nine year old, $550 million hedge fund. Investors in LSOFX are getting the best of both worlds- a season hedge fund investment team whose pay is primarily dictated by absolute performance rather than relative performance, but within a familiar mutual fund structure with the benefits of daily liquidity, full portfolio transparency, and no performance fees, among others.
MPG: Thank you very much. We truly appreciate the time and information you shared with us. We actually have an office near you and since much of your investment management team happens to be based in Denver, CO hopefully we’ll get the chance to connect again soon. Thank you!
LS: Absolutely…our pleasure. Talk with you and feel free to directly reach out to us anytime.
Investment Disclaimer: This article and interview is provided for general information only and nothing contained in the material constitutes a recommendation for the purchase or sale of any security, mutual fund, or strategy. Although the statements of fact in this report are obtained from sources that My Portfolio Guide, LLC considers reliable, we do not guarantee their accuracy and any such information may be incomplete or condensed. Views are subject to change on the basis of additional or new research, new facts or developments. The investment risks described herein are not purported to be exhaustive, any person considering an investment should seek independent advice on the suitability or otherwise of the particular investment.
Past performance is not a guide to the future. Before making any investment decision, you should read the relevant offering documents and in particular the investment policies and the risk factors. You should ensure you fully understand the risks associated with the investment and should also consider your own investment objective and risk tolerance level. Remember, you are responsible for your investment decision. If in doubt, please get independent financial professional advice.