High net worth individuals, university endowments, and public pension funds have heavily invested in long/short equity hedge funds. But is the long/short equity asset class benefiting investors? The pitfalls of expensive financial products are well documented in the academic literature; however, the research on the subject of the “high cost of active management” is primarily focused on long-only stock-picking equity allocations. Less research has been done on alternative asset classes, which has largely avoided excess academic criticism over fees and performance.(1)
One component of alternatives that I study in this short piece is long/short equity. This research project attempts to assess the investment merit of long/short equity allocations. My study is far from perfect, as the sample period I examine is relatively short, the data I examine are not perfect, and my methods are not flawless. However, my core results, albeit imperfect, are worth consideration: a simple combination of passive indices have outperformed the median long/short equity fund from 2006-2016. Moreover, the analysis in this paper suggests that there is a lack of persistence among top quartile long/short equity managers, which would suggest endowments, pensions, and other investors may benefit from avoiding active long/short management altogether.
Am I getting my bang for the buck with Long/Short Equity?Photo by NeONBRAND on Unsplash
Long/short equity funds advertise limited drawdowns, an ability to time and hedge against market volatility, and, of course, manager skill. On the long side, expert managers promise to curate portfolios of the most attractive equities. The short side promises insurance in times of market downturn – as well as the ability to bet against frauds and bankruptcies. This two-pronged approach attracted significant capital inflows into these strategies in the 1990’s; at the beginning of the decade, long/short capital comprised less than 10% of hedge fund assets, but by 2000, that number had reached 45% (Lamm, 2004).
The central question of this paper is whether long/short equity funds have met this promise – or whether these promises sound better than they work.In addition, I ask a basic question: Are there superior lower-cost alternatives?
Research has shown that passive investing is generally superior to active management for long-only mutual funds. The findings include that 70% of active money managers fail to beat their benchmark on average and just 2.3% deliver excess returns of more than 2.5% (Fama and French, 2010).Mutual fund managers are not the only ones making bad investment decisions, however. Evidence suggests that other financial experts also destroy value.
Brokerage accounts advised by financial advisors achieve lower net returns and inferior risk-return tradeoffs than self-directed accounts (Hackethal, Haliassos, and Jappelli, 2012); Expensive investment consultants who advise the world’s biggest pools of money have shown limited ability to pick funds (Jenkinson, Jones, and Martinez, 2013); the best metric for picking mutual funds is the expense ratio (Kinnel, 2010). The general lesson of academic research into active management is that the less you pay experts to manage your money, the more you keep.
But little research has tested this premise when it comes to long-short equity strategies (here is an example I know of). I compare the returns of long/short equity strategies to simple stock/bond balanced portfolios to test whether these active strategies outperform a passive alternative that replaces the long side with a passive stock index and the short side with a passive bond index.I also test performance persistence to see if the long/short managers who exceed the benchmark have proven skill in doing so.
My analysis used data from Preqin’s hedge fund database. I used monthly returns on 538 hedge funds which identity as long/short funds over the period 12/31/2005 to 12/31/2016. I obtained data on the Vanguard Total Stock Market ETF (VTI), Vanguard Total Bond Market ETF (BND), Vanguard Extended Duration Treasury ETF (EDV), and iShares TIPS Bond ETF (TIP) from CapitalIQ. For the passive portfolios, all statistics in this paper were calculated using annual rebalancing.