What can you say of a mutual fund category where the best-performing fund in 2020 is up 45% while the worst is down 60%? With such disparities, can Morningstar’s “Long-Short Equity” even be considered a “category” at all?
While long-short funds can short, or bet against, securities to hedge their portfolios, how they hedge can vary immensely. “Even though it’s probably the most homogenous category among the liquid-alternative asset classes, Long-Short Equity still has a lot of heterogeneity between what some of the funds are attempting to do,” says Erol Alitovski, a Morningstar analyst who covers the category. Some managers take advantage of “style biases”—growth versus value stocks, for instance—he observes. And some funds don’t have the long and short exposure determined by a manager; many are quantitative, rules based, and systematic. Regardless of who’s at the helm, the amount of hedging—or net long exposure after deducting shorts—can also vary dramatically.
Consider that best-performing fund, the $157 million ABR Dynamic Blend Equity & Volatility (ticker: ABRTX), which has returned 43% so far this year. It employs a rules-based algorithmic system to buy volatility or VIX index futures on the S&P 500 index as a hedge. Since markets become the most volatile when stocks decline, those futures generally have an inverse relationship—or, in Wall Street terms, a negative correlation or beta—with the market. “There are two exposures in the fund, long volatility and long equity,” says ABR’s manager Taylor Lukof. “There’s no shorting, but volatility has a negative beta. So that’s why [the fund is] in the long-short category.” The fund’s long stock exposure is in the S&P 500.
ABR’s algorithm buys and sells VIX futures based on the index’s price momentum so that as volatility increases, the fund becomes more hedged, and when it decreases, less hedged. This simple strategy has worked perfectly this year; the fund is the second-best performing mutual fund overall. “If you look at this fund’s performance, it did not have a downtick from Feb. 24 until March [18]. And there were days when the market was down 10%,” Lukof says. “Volatility trended straight up over that period.” The fund gained 35% in March as the S&P 500 fell 12% but also gained 5% in April as the S&P rallied 12%, having reduced its hedges as volatility declined.
Lukof is critical of competing long-short funds for not providing investors with enough downside protection, calling them “expensive ways to get beta reduction.” In other words, they are too correlated to the market’s moves, offering only modest protection. The average long-short equity fund was down 7.4% in March and gained 5% in April.
Yet there have been a handful of funds that have held up well using more-traditional long-short strategies. RiverPark Long/Short Opportunity (RLSFX) is up 23% this year through smart, long bets on growth stocks such as Amazon.com (AMZN), up 31% this year, and diabetes-monitor manufacturer DexCom (DXCM), up 64%, but also shorts on beleaguered energy stocks at the start of 2020, then real estate, casino, travel, and entertainment stocks as the coronavirus crisis deepened. Crucially, manager Mitch Rubin has the wide flexibility to tactically adjust his short and net long exposure in response to market and individual stock moves.
“We don’t normally trade this actively, but this year our [net long] exposure went from mid-60s [percent] to low 20s, back to the low 70s,” Rubin says. “So, we were in the low 60s to start the year into early March, and then through March is where we dramatically took our exposure down, mostly by growing our short book.” He soon unwound or “covered” many of those shorts as individual stocks fell as much as 30% in one day in March, he says. The end result was the fund gaining 7% during the March slide and 8% during the April recovery.
Now, Rubin’s short positions consist of “more-traditional secular losers” such as office real estate investment trust Boston Properties (BXP) and shopping-center owners Federal Realty Investment Trust (FRT) and Regency Centers (REG). Rubin’s growth manager thesis is that not only do e-tailers like Amazon eat shopping centers’ lunch, but that the crisis accelerates the trend to do everything at home, including working remotely. “The landlord in general is in a difficult position in a worsening economy,” he says. “And in this case, it’s exacerbated by the potential that people don’t have the same need for space coming out of this.”
High-priced growth stocks like Amazon have crushed value stocks for so long that it’s hard not to wonder what will happen to Rubin’s fund if the trend reverses. “A large handful of long-short equity managers have a value bias,” notes Alitovski. That’s hurt funds that Morningstar rates favorably, such as Bronze-rated AQR Long-Short Equity (QLENX), which uses the value factor in its quant screens and is down 16% in 2020. Alitovski calls the value-growth performance difference this year “historic.” Indeed, the brutal 60% year-to-date decline of that worst-performing fund, the $20million RMB Mendon Financial Long/Short fund (RMBIX), which invests in cheap small banks, is testimony to that.
Given that historically such trends have eventually reversed, it’s worth also considering funds that don’t have as much style bias, such as JPMorgan Opportunistic Equity Long/Short (JOELX), up 3% this year. “We need to ask the [performance] question differently—not in terms of growth versus value,” says manager Rick Singh of the JPMorgan fund. “I’ve divided my investible universe into three categories, which I think are more appropriate for where we are today—survivor, thriver, and then dier.” Singh buys the first two and avoids or shorts the diers. In the survivor category, he includes top health-insurance firms such as Cigna (CI) and UnitedHealth Group (UNH), which are “nice growers at reasonable valuations,” unlike today’s tech darlings.
While value long-short funds are problematic today, they could be tomorrow’s leaders in this motley category.
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