SHANA ORCZYK, INVESTMENT ANALYST

January 13, 2009
In February 2006 Morningstar introduced the new category of Long-Short funds. For many people the category has proven to be little help navigating the new world of alternative mutual funds. Today Morningstar boasts a total of 149 funds in the category up from just 45 when it was first established. The explosive growth of this category is a result of the industry’s demand for hedge fund like products in a mutual fund wrapper. Unfortunately, without a deep knowledge of hedge funds the category can be difficult to understand. My aim is to help clear up some of the confusion and provide a better base to navigate the category.

Morningstar considers a fund long-short if the portfolio holds sizable stakes in both long and short positions. This means that directional long-short funds, which may be long biased or short biased, are lumped together with market neutral funds. This does not mean 130/30 or 120/20 funds, which really don’t make any bet on market direction. The grouping of the long-short category can provide some very deceiving results. A recent Wall Street Journal article used the category to discuss the disappointing returns of the alternative universe without really differentiating the category’s components. Alternative funds, like any mutual fund, make more depending on the prevailing market conditions. When considering a fund in the long-short category for your portfolio, it’s important to evaluate the underlying investment strategy.

The four most common strategies used by long short managers are long biased, short biased, directional and market neutral. In the world of hedge funds these categories are all separated for peer comparison. Each strategy provides unique advantages depending on your market outlook. Here’s a quick crash course:

Long-Biased: A long biased fund will always be net long the market. A long biased fund will adjust its short exposure to best exploit the manager’s outlook on the market. If the fund’s manager becomes bearish on the market he/she will likely ramp up short positions to bring the fund’s net market exposure under 100%. If the manager becomes bullish he/she will likely bring down their short exposure, and possibly even leverage the fund, to bring net market exposure over 100%.

Short-Biased: A short biased fund is not the same as a bear fund, which is always short the market with an inverse exposure. A short biased fund will always maintain market exposure of less than 100%, but not necessarily inverse to the market. Similar to a long biased manager, a short biased manager will adjust his/her long positions in an effort to best exploit the prevailing market conditions.

Directional: Most people would not consider directional a separate strategy, but I do. There really aren’t many funds that use a directional strategy because most managers have a natural bias toward being either long or short. There are some funds out there that can and will go net long over 100% or go 100% short showing an inverse relation to an index. This would be the most flexible of the mandates, but its also the most difficult to do because it is inherently based on a macro view and about market timing, which studies have shown to be near impossible to do with any long term success.

Market Neutral: The goal of the market neutral manager is to have no net exposure to the market. While having zero exposure is virtually impossible, the manager is likely to keep the portfolio positions completely even. So if the portfolio holds 100 securities, than 50 will be long and 50 will be short. There are a variety of methods for this neutrality to be achieved, but the most common is pair trading. The simplest way to think of a pair trade is to consider two stocks in the same sector, one is overvalued and one is undervalued. A market neutral manager would go short the overvalued stock and go long the undervalued stock. The goal is to earn the spread on the returns, so even if both stocks move in the same direction, if the analysis is accurate the overvalued stock would fall more than the undervalued and thus still create a positive return for the portfolio. The advantage to using market neutral funds is that they aim to remove market correlations and volatility. So while a short biased or bear fund will likely show negative correlation to its respective benchmark and a long biased fund would always show positive correlation to its respective benchmark, a market neutral fund aims to have zero correlation to its respective benchmark. Most market neutral funds also exhibit low volatility levels in terms of beta and standard deviation.

Each strategy has its place in a portfolio depending on your outlook on the market. Long bias and short biased funds appear to have obvious market implications, however directional and market neutral can be a bit trickier. In my opinion market neutral funds perform best when a market is extremely volatile and/or moving sideways, while a directional fund would be a good choice if the market outlook is cloudy and flexibility becomes an attractive attribute.

I hope this blog sheds some light on the idiosyncrasies of the Morningstar long-short category. I encourage advisors to research the strategies in more detail when evaluating a fund for your portfolio, because not all long-short funds are created equal, and like all funds, some managers are far better at implementing their strategies than others.