In 1949, Alfred Winslow Jones created A.W. Jones & Co., a partnership which invested $100,000 in stocks using leverage and a mix of long and short positions. Instead of employing a standard management fee, Jones would only make money if his clients made money, charging 20 percent of all profits. This was first vehicle of its kind, which years later became known simply as a “hedge fund.” In its first year, Jones’ partnership would earn 17.3%. Over the next decade, he would outperform every mutual fund by 87%, a remarkable feat.
Many hedge funds would follow in Jones’ path over the years but few could have envisioned what the industry has become today.
In the first quarter of 2014, total hedge fund assets set a new record, surging to $2.7 trillion. Yes, you read that correctly: trillion. The demand was strongest within the long/short equity strategy, with investors allocating over $16.3 billion in new capital during the quarter. Overall assets in the long/short equity space reached $761 billion, the largest area of hedge fund capital.
Long/short equity has consistently been one of the most popular hedge fund strategies. Most individuals, even with limited knowledge of the markets, can understand a long and short idea on a particular stock. It makes sense to us intuitively to buy “good companies” and short “bad companies.” Plus, we all love a good story and every stock in a long/short portfolio has a story behind it.
The main selling points and objectives for the long/short strategy are twofold: 1) to outperform the stock market over the course of a market cycle through “alpha” generation or stock picking, and 2) to preserve capital during periods of market stress.
For many years, long/short managers largely achieved both of these objectives.
First, let’s take a look at a chart of the rolling 3-year annualized alpha for long/short equity funds (as represented by the HFRI Equity Hedge Index). You can see from the chart below that these funds generated significant alpha during the 1990’s of between 7 and 25%. These were the best of times for long/short equity funds and the equity markets. Alpha generation degraded substantially from 2000 through 2007, but still remained positive. Things changed in 2008 and from an alpha standpoint these funds have never recovered, producing consistent negative alpha over the past few years.
Note: There are many factors that have likely contributed to this alpha degradation, from increased competition within the hedge fund space to higher correlation and lower valuation differential among individual equity securities. I will explore these factors in more detail in a subsequent research piece.
Next, on the task of preserving capital, long/short equity funds largely achieved this objective during the 1990, 1998 and 2000-2002 Bear Markets, limiting maximum drawdown to roughly 10%. There was a noticeable change during the 2007-2009 Bear Market, when long/short equity funds saw a maximum drawdown of over 30%. We also saw increased stress during the recent 2011 decline.
What is the driving force behind this reduced ability to preserve capital during periods of market stress?
Long/short funds have been gradually transformed over time into a lower beta version of the equity market. Over the past three years, the rolling correlation with the S&P 500 has been consistently over .90. This is a markedly different profile than what existed in the early 1990’s.
This wasn’t always the case, but today we’ve come to expect long/short funds to be down every time the market is down. In looking at months in which the S&P 500 has declined since March 2009, we can see that long/short funds have not been able to produce a positive return even once. Every time the S&P 500 has been down, long/short funds have been down as well, albeit a bit less.
A look at the rolling beta to the S&P 500 explains why long/short funds are down less, but still down. At close to .60 over the past 3 years, it is at the high end of its historical range and a much different profile than what existed for much of the 1990’s and early 2000’s. When you have this much beta to the market, it is nearly impossible to look different than the market.
But why have correlations and beta to the S&P 500 risen over the years and why are they particularly high today? There are likely a combination of factors at play, but it is my belief that herding and career risk are by far the most important factor. After a relentless bull market, long/short managers, particularly the larger managers who control most of the capital, have little incentive to look different from the equity indices.
The assumption is as follows. Clients will not abandon them if they are down while the S&P 500 is down as they have been conditioned to assume this is normal after the 2007-2009 Bear Market and 2011 sharp decline.
On the other hand, missing out on upside has increasingly become an unforgivable sin for managers. This is particularly true in the current environment, where we have seen a record advance for the S&P 500 and near record lows in volatility. Lacking the ability to differentiate by picking individual stocks, managers are increasing their net exposure to levels where they can ensure that they do not miss out on further gains. After all, if the equity market only goes straight up and there is little differentiation among individual stocks, then the only way to perform is to increase your exposure or beta to the market.
David Tepper’s words last November were a perfect gauge of the current mood in the industry:
“I would be worried if I was a long/short guy and not long enough. That’s what I would be worried about. I’m not worried because I am long enough. But if I was a long/short guy and I could only go 60% long and I couldn’t go 100% long with the potential for the biggest risk of this market…through the whole year  being another year of +20-30%…and if you can only go 60% long, it’s really hard to perform. So what I am worried about? I worry about some of my friends that are long/short managers; I don’t want them to lose their jobs.” – David Tepper, November 21, 2013
Tepper was essentially saying that because (in his mind) the market could only go up a significant amount this year, the only way for long/short equity funds to keep pace is to increase their exposure or beta. What appears to have been lost on Tepper was the fact that these funds had already been increasingly behaving like a long-only product, but he seems to be suggesting that this shift was not enough. They needed to take it a step further in his view and become “100% long” if they want a chance to “perform” and no “lose their jobs.” The effect of this blatant condescension and peer pressure from one of the most powerful and respected voices in the industry should not be underestimated, and long/short funds have continued to increase net exposure this year.
2 and 20 For Lower Beta? The Utilities/Staples Test
Now, if investors want to pay a 2% management fee and 20% of their profits (“2 and 20”) for a lower beta equity product, what exactly is the problem? Nothing, I suppose, if investors truly understand what they are buying. However, I can assure you that most do not and when they hear the word “short” in the description of the strategy, they are assuming they are buying an absolute return vehicle that has the potential to be up when the market is down, not simply down less.
The other issue I have is that 2 and 20 is an extremely high price to pay for lower beta, especially when there are many ETF products in existence where a similar exposure can be easily replicated with significantly lower fees. Let’s take, for example, the two lowest beta sectors in the S&P 500, Utilities and Consumer Staples, and compare a 50/50 portfolio of these two sectors to the long/short equity strategy. I call this the “Utilities/Staples Test.” Since 2003, a 50/50 portfolio of Utilities and Consumer Staples would have significantly outperformed long/short equity funds with a Total Return of 230% versus 104% for the HFRI Equity Hedge.
Note: Many Hedge Fund Investors believe that the HFRI Equity Hedge Index overstates returns due to survivorship bias. As such, I have also included the investable HFRX Equity Hedge for comparison purposes. Actual performance is likely somewhere in between the two, but closer to the HFRI Equity Hedge.
While the outperformance is significant, surely one must have been incurring greater risk with a long-only exposure to Utilities and Staples. As it turns out, though, this was not the case. Since 2000, risk has been equivalent on average when looking at beta and in recent years the Utilities/Staples portfolio has actually exhibited lower beta than Long/Short funds.
Drawdown tells a similar story, with similar declines during the 2007-09 Bear Market and a lower drawdown for the Utilities/Staples portfolio during the 2011 sharp decline.
Looking ahead, though, which strategy is more likely to protect capital during the next downturn? Based on current correlations, it would be hard to say that long/short funds will look much different than the S&P 500 during the next downturn. With a rolling correlation above .90 for long/short equity versus less than .50 for Utilities/Staples, long/short funds are unlikely to provide any additional preservation of capital and may in fact provide less.
Lastly, in terms of the coveted “alpha,” long/short funds have been producing negative alpha in recent years while a simple Utilities/Staples portfolio has actually generated positive alpha.
- The alpha-generating long/short equity strategy of the 1990’s and early 2000’s appears to be a thing of the past.
- This is likely a function of increased competition in the space and an increase in correlation and lack of differentiation among individual equity securities.
- Over time, the long/short strategy has essentially morphed into a lower beta, long-only product that has actually delivered negative alpha in recent years and shown an inability to protect capital during market declines.
- While widely considered an “alternative” strategy because of the short side, investors should be questioning this label as long/short funds are behaving more and more like traditional equity investments. With a rolling correlation of over .90, it is hard to argue that they are providing any “alternative” other than a lower beta version of the S&P 500.
- The increase in correlation to the S&P 500 over the years is likely due to herding and career risk as long/short managers appear unwilling to incur the risk of not participating in an up market. The lack of volatility and historic advance over the past two years has only accentuated this issue, with the now widespread belief that the only way to perform is with higher exposure to the market.
- While many investors appear to be happy paying 2 and 20 for lower beta exposure, this would appear to be irrational behavior considering the relative ease at which one could replicate such an exposure at a reduced cost.
- One such replication, consisting of a 50/50 portfolio of Utilities and Staples, has widely outperformed the long/short strategy in recent years with equivalent risk and a lower correlation to the market. While not nearly as exciting as a long/short fund with a story for each individual stock in their portfolio, this would appear to be a better option for many investors if what they seek is simply lower beta.
- This analysis represents average performance and some might argue that there are still many long/short funds that have generated positive alpha over the years. I would agree that this is certainly true but would question the ability of most investors to pick such funds. Also, given the poor performance of long/short equity fund of funds in recent years, it does not appear that even professional investors have been successful in separating the wheat from the chaff.
- After a 200+% gain for the S&P 500 from the March 2009 low, many long/short equity managers have naturally benefited with sizable gains. Before assigning credit to these managers for any “stock-picking” prowess, I would encourage investors to compare their results with a simple ETF portfolio of Utilities and Staples (the “Utilities/Staples Test”). The results may surprise you.
I look forward to expanding upon this analysis in the future and covering other hedge fund strategies in addition to long/short equity. The trend of increasing correlation and uniformity in hedge funds is of great interest to us and our clients at Pension Partners. We believe there is high value in thinking differently from the crowd as an investment manager.
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CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.