INSIGHTS
BRINGING
LONG/SHORT
EQUITY INTO FOCUS
Investors typically expect long/short equity funds to dampen overall portfolio volatility, but many of these
funds appear to be long-only funds masquerading as lower volatility vehicles. The varying investment
strategies in the Morningstar Long/Short Equity category have led to wide performance dispersion and
investor confusion. We believe investors may be taking unrealized risks by misinterpreting high returns
as a success factor.
Investors seeking to truly dampen portfolio volatility with long/short equity should look at a number of
characteristics, not just performance, to determine if a fund has compelling risk-adjusted returns.
Misinterpreting High Returns May Increase
Unrealized Risks
Investors, generally, allocate to long/short equity funds based
on performance, similar to how assets are allocated in more
traditional categories. However, looking only at performance
may obscure weak risk-adjusted returns.
Figure 1 provides an analysis of funds in the Morningstar Long/
Short Equity category by quintile. Funds in the top quintile
demonstrated strong performance as expected; however, their
strong performance may actually be driven by excess market
risk due to their high net exposure.
Net exposure, which measures a portfolio’s average exposure
to the market (long positions minus short positions) is a
rela­tively high 75.8% for the first quintile. As such, these funds
may not be appropriately hedged, which is demonstrated by
having higher betas, higher standard deviations, and higher
downside capture ratios. These funds have strong returns in an
up market but they may not provide protection in down markets.
This dynamic held true in 2014 as the top-returning quintile of
funds that year took more risk to achieve the appear­ance of
better perform­ance. Eight of the top 10 funds in 2014 had net
exposures of over 70% (with several over 90%)!
Beta, which measures a portfolio’s volatility in comparison to
the overall market, is the highest for the top quintile. With a beta
of 0.8, the top quintile funds appear to be almost as volatile as
the market.
Standard deviation, which measures the variability of a
portfolio’s return, is the highest for the top quintile. These funds
have had large performance swings.
Downside capture ratio measures how a particular fund has
performed versus its benchmark when the benchmark dropped.
A downside capture ratio of 100 indicates that a fund has lost as
much as its benchmark, whereas a downside capture ratio of 50
indicates a fund lost half as much as its benchmark when the
benchmark dropped.
The highest performing funds had high downside cap­ture ratios
relative to the other quintiles (except for the fifth quintile), which
shows increased downside risk potential. Inves­­­­tors selecting
these funds may be disap­pointed if the funds do not effectively
dampen portfolio volatility.
Alpha measures the value a portfolio manager adds to a return
rather than the performance attributable to general market
movements. Unfortunately, the highest returning funds did not
have the highest alpha. These funds generated their returns by
assuming higher market risk.
Figure 1: A Pattern Emerges—Top Performers Take on Risk to Achieve High Returns
Return
Net Exposure
Beta
Standard Deviation
Downside Capture
Alpha
1st Quintile
12.9
75.8
0.8
10.4
74.0
-0.7
2 Quintile
8.3
71.7
0.5
6.4
45.8
0.0
3rd Quintile
6.2
54.0
0.5
6.3
44.1
-0.9
4th Quintile
4.5
58.9
0.4
6.2
45.7
-2.3
5th Quintile
1.8
68.6
0.5
6.3
77.7
-6.1
nd
Best Quintile
Worst Quintile
Source: Morningstar, median data for the three-year period ended 3/31/15.
BRI NG I N G LO N G/SH O RT EQU IT Y IN TO FO CUS 2/4
12
8
15.2
13.7
High Batting Averages Demonstrate Strong
Historical Performance
4.8
4 Rather than looking at28.1
recent high returns, it’s important to look
0 for consistency of returns over the long-term in order to evaluate
how a fund has historically performed. The danger is that today’s
-4 top performer could be tomorrow’s worst performer.
-8
Figure 3: High Batting Averages Demonstrate Strong Historical
Performance
80
Batting Average (vs. Category Average)
Returns dispersion of the best and worst funds in the
Morningstar Long/Short Equity category is significantly
greater than other major asset classes over a five-year period
(see Figure 2). Unfortunately, this performance dispersion
makes fund selection considerably more challenging and
increases the potential for downside risk, which is something
many investors are trying to minimize by adding long/short
strategies to their portfolios. However, performance dispersion
24
is also an indication that a manager has an opportunity to
20 out­perform, especially if the manager has had consistent,
14.1
16 strong returns relative to the category over a longer time period.
Batting Average vs. Category Average
70
60
50
40
30
15.9
20
13.4
16.7
14.3
13.8
10
-10
-5
0
0
5
Annualized Return (%)
10
15
20
Source: Morningstar, three-year period ended 3/31/15.
One popular way to examine performance consistency is to look
Long/Short
Equity
Large Growth
Large Value
batting
average, which
measures a manager’s
-12 at a fund’s
track record of meeting or beating a benchmark over a period
Morningstar
Category Average
Rangeaverage
of Returns of 50 demonstrates
of time.
A manager
with a batting
matching or outperforming a benchmark’s returns 50% of the
time, while a batting average of 65 demonstrates matching or
outperforming a benchmark 65% of the time.
Figure 3 shows the three-year batting averages of funds in the
Morningstar Long/Short Equity category. The batting averages
and annualized returns are highly correlated. As such, investors
may get a level of comfort that the manager has consistent
performance over time.
Small Growth
Small Value
Rather than looking at recent high
returns, it’s important to look for
consistency of returns over the longterm in order to evaluate how a fund has
historically performed.
80
70
Figure 2: Long/Short Equity’s Performance Dispersion is Significantly Wider than Other Major Asset Classes
60
8.8%
7.0%
Category
Average
Batting Average
Performance (%)
Performance Dispersion Makes Fund Selection
Critical
6.2%
50
6.1%
5.0%
40
13.2
14.4
24.9
-6.2%
30
13.9
17.2
20
-8.3%
-8.9%
10
-11.0%
0
-16.1%
Long/Short Equity
Return Relative to Category Average
-10
Large Growth
-5
Large Value
Range of Returns
Source: Morningstar. Dispersion of returns versus the Category Average over the five-year period ended 3/31/15.
0
Small Growth
Annualized Return
5
Small Value
10
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Confusion Across the Long/Short Equity Category
Figure 4: Morningstar Style Box™ Breakdown of the Long/Short
A wide array of investment strategies of funds in the Morning­
star Long/Short Equity category is driving diverging returns
and contributing to investor confusion. A review of common
characteristics shows there is little consistency in the way the
funds are managed and have performed. In fact, it appears
as though many of the funds have attributes that are more
representative of other categories.
Equity Category
•Investment Strategy
Funds in the Morning­star Long/Short Equity category are
significantly varied in their investment strategies—and the
more variables, the more potential for performance dispersion.
Some funds only trade futures, others are only in real estate,
and some use levered and inverse ETFs! There are also funds
that invest in the health care sector and others that only
invest in emerging markets. Strategies of some of the funds
within the category include the following examples:
Large Growth 18.4%
Large Blend 38.8%
Small Growth 2.1%
Small Blend 1.9%
Small Value 0.7%
Mid Growth 10.2%
Mid Blend 12.6%
Large Value 9.5%
Mid Value 5.8%
Source: Morningstar as of 6/1/15.
–Quantitative
–Derivatives
The Bottom Line
–Fundamental equity
We believe that many funds in the Morningstar Long/Short
Equity category are closer to long-only funds masquerading as
lower volatility vehicles, which is causing investor confusion. As
such, investors may be taking on more risk rather than dampen­­
ing overall portfolio volatility by investing in the category.
–Macro
–Multi-manager
–Sector
•Benchmark
Investment mana­gers are using 28 different benchmarks in
the category. This makes it incredibly difficult to compare
funds to each other, especially when the benchmarks are
not common. Thankfully, more than half of the funds in the
category use the S&P 500 index as their benchmark, which
is understand­able and realistic.
•Morningstar Style Box™ Breakdown
It is difficult to compare funds when they have different style
characteristics (see Figure 4). Additionally, different style
characteristics make working a particular fund into a model
portfolio challenging.
•Turnover
Turnover refers to how often a portfolio trades in a given
period of time. In many instances, a lower turnover is more
desirable. Investors examining funds within the category
may be surprised to find out that some of the funds have
turnovers of over 1,000%! High turnover can lead to higher
fees, unstable returns, and higher taxes through short-term
gains distributions.
Learn more at www.alger.com or speak with your financial advisor,
Rather than focusing on the highest performers, investors
may be well-served by looking for funds with characteristics
that demonstrate the ability to dampen overall portfolio
volatility and produce better risk-adjusted returns. We believe
investors should seek long/short equity funds with the
following characteristics:
nAverage net exposure of less than 60%, which demonstrates
the fund is hedging market risk
nLow beta, standard deviation, and downside capture ratio,
which shows the fund is not taking undue risk
nA multi-year track record of consistent portfolio returns and
a high batting average to reduce swings in performance
nA clear and understandable investment strategy, benchmark,
turnover, and Style Box classification
I NS NG
BRI
I G HI N
TS G LO
4 /4
N G/SH O RT EQU IT Y IN TO FO CUS 4 /4
The views expressed are the views of Fred Alger Management, Inc. as of July
2015. The views and strategies described may not be suitable for all investors.
Alger has used sources of information which it believes to be reliable; however,
this publication is not intended to be and does not constitute investment advice.
These views are subject to change at any time and they do not guarantee the
future performance of the markets, any security or any funds managed by Fred
Alger Management, Inc. These views should not be considered a recommendation
to purchase or sell securities. Individual securities or industries/sectors mentioned,
if any, should be considered in the context of an overall portfolio and therefore
reference to them should not be construed as a recommendation or offer to
purchase or sell securities. References to or implications regarding the perform­
ance of an individual security or group of securities are not intended as an
indication of the characteristics or performance of any specific sector, industry,
security, group of securities or a portfolio and are for illustrative purposes only.
Fred Alger Management, Inc. may not correctly predict movements in the
direction of a particular market or of the stock market generally, and the anticipated
results shown in any of the examples in this publication may not result in increased
performance or reduced risk.
Risk Disclosure: Investing in the stock market involves gains and losses and
may not be suitable for all investors. Investment return and principal value of an
investment will fluctuate so that an investor’s shares, when redeemed, may be
worth more or less than their original cost.
The S&P 500 index is an unmanaged index generally representative of the U.S. stock
market without regard to company size. Investors cannot invest directly in any index.
Index performance does not reflect deduction for fees, expenses, or taxes.
The Morningstar Long/Short Equity Category includes open-end funds that hold
sizable stakes in both long and short positions in equities and related derivatives.
Fred Alger Management, Inc. 360 Park Avenue South, New York, NY 10010 / www.alger.com
800.992.3863 (Retail) / 800.223.3810 (Institutional)
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