The growth of liquid alternative mutual funds has continued at a rapid pace, and with this growth many advisors and other asset allocators have asked the question of whether the product they can access in a mutual fund is equivalent to what is available in a private hedge fund. David McCarthy, a long-time hedge fund practitioner (and part time academic researcher) asked the same question, and also set out to find the answer. His findings are published in a paper titled “Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long/Short Funds” in the Winter 2014 edition of The Journal of Alternative Investments.
McCarthy has been around hedge funds for over 25 years and is currently the Principal of D.F. McCarthy LLC, a consulting and advisory firm. Prior to this, he co-founded in 2002 Martello Investment Management, a fund of hedge funds and advisory firm and, among other roles, he also served as an Investment Manager for Global Asset Management (GAM) where he managed the firm’s trading based fund of funds.
As part of his work for this particular study, McCarthy evaluated the full list of mutual funds that were included in Morningstar’s Long/Short Equity category as of January 2013, and pared down the universe from 83 funds to 55 funds that fit his definition of a long/short hedge fund. From this group of 55 funds (47 were open for new investments at the time, and 8 were closed), McCarthy began his work.
The 4 Key Findings
I recently had the opportunity to speak with McCarthy about the paper and some of the key findings from his research that are outlined below. At the end of the article, you will find a link to an abstract of the full article, plus a link to the full article on the The Journal of Alternative Investments’ website.
Key Finding #1: Equity Long/Short Mutual Funds and a Sample of Equity Long/Short Hedge Funds Held Similar Actual Equity Exposures as of the Period of Analysis.
It is often thought that mutual fund constraints place restrictions on managers and limit their ability to implement their strategies the same way they would in a private partnership structure. It turns out that is not the case, at least not with long/short equity funds. Long exposures within long/short mutual funds are very similar to those in hedge funds, and short exposures are also similar after correcting for long/short funds that don’t short physical securities.
According to McCarthy, thirteen of the long/short managers did not have any physical short positions at the time of the analysis. He noted, “This is an area where a financial advisor should ask the managers why they don’t have any short positions, or look more closely into the fund and find out if the short positions are being implemented through options or some other derivative instruments.” Excluding these thirteen managers, the mutual funds had very similar short exposure to the representative group of hedge funds used in the analysis.
Key Finding #2: Quantitative Analyses of Equity Long/Short Mutual Funds and Leading Equity Hedge Fund Indexes Showed No Substantial Factor Exposure Differences.
What are the mutual fund managers buying and investing in? Is it the same thing as the hedge fund managers? Yes, as it turns out. McCarthy looked at the factor exposures, such as beta, size, book to market value and momentum, and found no meaningful difference between the factor exposures in mutual funds versus those in long/short hedge fund indices. One slight difference noted was a higher variability of market beta in the hedge funds, which might be accounted for by their more active and/or aggressive positioning around changes in the market environment. The long run beta of the two groups of funds tended to be similar however.
Key Finding #3: Return/Risk Analyses of Equity Long/Short Mutual Funds and Leading Indexes of Equity Long/Short Hedge Funds Showed No Substantial Performance Differences.
This is where the rubber meets the road. Can mutual funds deliver on performance? Here again, the answer is yes. Over the time period reviewed, which was from January 2008 through June 2013, mutual funds delivered performance that was in-line with the returns of major hedge fund indexes. Over this 5.5 year time period, the group of long/short mutual funds generated an annualized return of 0.9% with an annual standard deviation of 9.4%, while the HFRI Equity Hedge Fund Index returned 0.8% with a standard deviation of 10.5%.
This key finding is especially true when isolating the performance of products from large, diversified firms (see Key Finding #4 below).
Key Finding #4: Segmenting Equity Long/Short Mutual Funds by Sponsoring Firm (i.e. Diversified Investment Firm versus Specialized Investment Firm) Did Result in Observed Performance Differences.
One surprising finding was that products from larger, diversified firms tended to perform better than products from more focused firms. Strategies from the diversified firms tended to have higher betas and more volatility, but over the full time period generated returns that were about 2.5% better annually. The one significant exception was in 2008 when the more focused firms lost about 10% less than the products from the more diversified firms, which is partially accounted for by the lower betas of the funds from the more focused firms.
McCarthy admitted that the sample size for this finding was small, with only 9 managers fitting into the diversified firm bucket, but he also noted that there might be some meaningful insights to be gained when looking deeper into this point. Portfolio managers at larger, more diversified firms that launch new products might typically be some of the best managers in those firms. These new products help keep the managers engaged and growing in their career, which in turn may keep them from jumping ship to what could potentially be a more lucrative (and potentially more volatile) job with a hedge fund. Interestingly, this finding is similar to that found in a recent academic study noted on Morningstar in an article titled “More Cooks Improve the Broth.” In that study, they found that team managed portfolios, as well as those from larger fund families, generated better performance than their counterparts.
Bottom line: check the pedigree of the portfolio manager and/or the team managing the strategy. Think about the resources they have available to them and why they launched their strategy in a mutual fund.
More Category Evaluations to Come
McCarthy will be working through and evaluating other alternative categories including the multi-alternative, market neutral and managed futures categories. We will be sure to publish his findings when they are made available. In the meantime, the abstract and full articles can be found using the links below.
A copy of the article abstract can be downloaded here: Article Abstract – Hedge Funds versus Hedged Mutual Funds
The full version of the article is available here: Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long/Short Funds
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