25 November 2013
As most of our readers and clients know we rarely use mutual funds but in some cases a strong case can be made for certain ones. My Portfolio Guide, LLC was granted an interview with the management of the Long Short Opportunity Fund (LSOFX). The following interview covers a fund that we believe has an interesting story and more importantly...a strategy that can make sense for certain investors:
My Portfolio Guide, LLC (MPG): First off…thank you for the opportunity to meet and learn more about your investing strategies. Our first question is perhaps best intended to simply set the table for our clients and readers of our newsletter:
Briefly explain why investors in typical advisory relationships should even consider using a hedge fund or alternative strategy as part of their portfolio allocation?
Long Short Advisors (LS): The simple answer is to provide downside protection in an increasingly volatile world where equity markets are near all-time highs and bond yields remain near all-time lows. A typical investor has their money allocated to a traditional blend of 60% long-only equities and 40% long-only short bonds, and has generated a fantastic high single digit return from this allocation over the past thirty years. Unfortunately for these investors, the current state of the bond market dictates that these returns are not repeatable over the next decade.
We believe the bond allocation of a traditional 60/40 blend could tread water at best given the current trajectory of bond yields.
Long-term equity volatility is unlikely to change, making a larger allocation to stocks similarly imprudent, especially at today’s record highs
Thus, investors need to diversify into alternative strategies that have the ability to benefit not only from continued overall market strength, but also potential market weakness.
MPG: Of all the hedging and alternative investment strategies out there and now available to mainstream investors, what are some of the primary reasons to consider a "long/short" type approach?
LS: There has been a lot of talk since the beginning of the current bull market in March of 2009 that long/short equity strategies no longer work, and there is no reason to pay more than the cost of a long-only market ETF to access a strategy that has recently underperformed. We would warn investors and advisors alike to take a step back and realize that long/short equity funds “hedge”, and thus should and will underperform the general equity indices during a prolonged bull market. However, a full cycle involves a bull market and a bear market.
If you look back over the past 15 years which included over two full market cycles, long/short equity hedge funds represented by the HFRI Equity Hedge (Total) Index have actually outperformed long-only U.S. stocks, long-only U.S. bonds and an investor’s typical 60/40 blend. Further, they have done so with essentially the same risk profile of a 60/40 blend, signifying that the incremental return was a function of stock selection, not increased risk as many incorrectly assume. Another way of summing this up is basically achieving significantly higher alpha as well as Sharpe ratio.
The key here is that long/short equity hedge funds outperformed a passive 60/40 blend over the past 15 years during a record bull market in bonds. Over the next five to 10 years, the bond market is likely to see a bear market while there is no change on the horizon for the ability of a long/short equity manager to add value. Thus, it could be argued that long/short equity managers could outperform by even more in the coming years…
MPG: One of the more common questions we have received over the years with regard to “long/short” strategies is that going long equities while being short equities obviously seems to negate any net gain. How do you answer this common misperception?
LS: No matter what kind of market investors face (bull, bear, flat, volatile, etc.), there are stocks that outperform and stocks that underperform. Long-only managers only have the ability to take advantage of half of the market that outperforms the average every year. Long/short managers, on the other hand, have the ability to take advantage of the entire market, profiting from long bets on stocks that outperform, as well as profiting from short bets against stocks that underperform. Why would you want to ignore half of the market?
The key here is that the data shows that investor returns suffer when market volatility forces them to