Thursday, December 07, 2006

Long/short mutual funds

There is an interesting article in the latest Business Week (Dec. 11, 2006) provocatively titled A New Way To Beat The Market? It describes a category of mutual funds that acts like a long/short hedge fund. Let's take a look:

To beat the market, mutual fund managers often ramp up risk, making outsize bets on stocks they expect to outperform. Now some quant jocks say they've hit upon a less risky approach: A strategy called 120/20, which, ironically, combines two risky strategies, leverage and short sales.

Here's how it works: For every $100 the manager invests in stocks, he sells "short" $20 worth of stocks on which he is bearish, making a bet these stocks will fall. The manager then invests the proceeds from the short sales in his bullish picks, amplifying those bets. As a result, a 120/20 portfolio has about 100% of its money in the market. (Some managers build 130/30 or 135/35 portfolios, pushing short sales to 30% or 35%.)

This type of funds brings makes the long/short strategy available to the masses which can only be considered a good thing. To a certain extent, it's a good description of what I try to do in my own accounts, except I'm willing to go net short if the situation warrants (I'm currently out of all short positions except for a tiny amount in QID). The online version mentions only one example, OADEX. I don't have the print version in front of me, but if memory serves, it had a few more names from Goldman Sacks and ING. From the Business Week article one somehow gets the impression that this type of product is a new invention. In fact, there are a number of other funds with more than a few years of track record.

Interested readers may want to check out the list below. Besides OADEX, I got the next three names for an old Jeff Saut missive which has been a weekly must read for me. HSGFX is a personal holding and Hussman's writings has also been a personal favorite. In general, you'll find that you have to pay for this kind of strategy in the form of loads, high annual expenses or both. HSGFX is the cheapest of the bunch, although its performance has been lagging. But again, the way to evaluate these funds is to look at the long term, risk-adjusted returns.

The short description for each fund was copied from the profile page of Yahoo Finance.

Old Mutual Analytic U.S. Long/Short A (OADEX)
The investment seeks above average total return. The fund normally invests at least 80% of net assets in equity securities of companies whose securities are traded in U.S. markets. It generally invests in medium and large-cap companies. The fund may invest in long and short positions of publicly traded equity securities. Its long equity exposure equals to approximately 120% of assets and short equals to approximately 20%.
Quaker Strategic (QUAGX)
The investment seeks long-term growth of capital. The fund invests at least 65% of the total assets in U.S. common stocks of companies and invests up to 25% of its total assets in "special situation" securities. It invests in equity securities of companies with a high probability for superior growth. The fund limits short sales to no more than 25% of the total assets. It will not acquire more than 10% of the outstanding voting securities of any one issuer.
Diamond Hill Long-Short (DIAMX)
The investment seeks long-term capital appreciation. The fund primarily invests in common stocks that the management believes are undervalued. It normally invests in the companies with a market capitalization greater than $500 million. The management utilizes a two-step security selection process to find intrinsic value regardless of overall market conditions.
ICON Long/Short (IOLIX)
The investment seeks capital appreciation. The fund invests in equity securities traded in U.S. markets. It invests in long position equity securities identified as undervalued and take short position in equity positions identified as overvalued. The size of each long or short position will be determined by analyzing the tradeoff between the attractiveness of each position and its impact on the risk of overall portfolio.
Hussman Strategic Growth (HSGFX)
The investment seeks long-term capital appreciation, with added emphasis on capital preservation in unfavorable market conditions. The fund typically invests in common stocks, except for modest cash balances that may occasionally arise due to the day-to-day management of the portfolio. When market conditions are favorable in the view of the investment manager, it may use options to increase its investment position. When condition are unfavorable, the fund may use options and index futures to reduce its exposure to market fluctuations.

This is a 5-yr relative graph. _GSPC is the S&P 500 index. HSGFX has had extremely low volatility in the past three years at the expense of returns. IOLIX looked good in this graph because of a quirk in the way Yahoo does comparison plots. Its record doesn't go back 5 yrs so it was normalized to HSGFX when data first became available. According to the Business Week article, OADEX adopted the long/short strategy in February, but evidently they didn't change the fund symbol. I don't know if the other funds also had similar style changes. Looking at the 2006 results, IOLIX and QUAGX are below their May highs while S&P/DIAMX/OADEX are above. This should reveal something about their respective hedging strategies.