Hedging-style mutual funds come up short
Funds promise shelter in stormy markets, but shareholders still get soaked
NEW YORK (MarketWatch) — Mutual funds that use short-selling and other hedging tactics are billed as attractive ways for retail investors to access the sophisticated market-beating approaches available to institutional and wealthy investors.
Now, with the market seeing its greatest turmoil in decades, how well have these specialized funds fared?
The results are mixed. While these portfolios have done better than the market, they perhaps haven’t performed as well as they should.
There are two main types of stock mutual-funds that use shorting strategies: “market neutral” and “long-short” funds that take a so-called 130/30 approach.
Figures from research firm Lipper Inc. show that market neutral funds are down 7.1% this year as of Oct. 23, while long-short funds have tumbled 32.3%%.
While that compares favorably to a roughly 37% decline for the Standard & Poor’s 500 Index (SPX:
S&P 500 Index
Delayed quote data
Delayed quote data
SPX 876.77, -31.34, -3.4%) , it’s also true that these funds haven’t lived up to their full potential.
“You can play the relative performance game all you want,” said Harry Milling, mutual fund analyst at investment researcher Morningstar Inc. “Have they proven that they hold up better [than other stock funds]? Yes. But these funds aren’t really fulfilling their mandate.”
Negative, not neutral
Market neutral funds, as their name suggests, are supposed to perform independently of the market. The funds go long some stocks, while shorting, or betting against, others. Returns should be steady, if unspectacular — in the single digits regardless of market conditions. As the Lipper figures show, that hasn’t happened.
One market neutral manager says the funds are hurting from the market swift and sudden dislocation.
“We’ve been affected less by the market and more by liquidations from hedge funds deleveraging,” said Larry Eiben, chief operating officer of TFS Capital, which manages TFS Market Neutral fund (TFSMX:
TFSMX, , ) .
“When people stop looking at value and are still just liquidating, the prices tend to get out of whack,” he said.
Eiben said that this disruption to value has hurt TFS Market Neutral, which through Thursday was down 9.5% so far this year, after suffering a 13.6% drop in the third quarter.
“The fundamentals aren’t being rewarded,” said Christine Johnson, director of alternative strategy at DWS Investments, Deutsche Bank (DB:
DB, , ) group. DWS Disciplined Market Neutral (DDMAX:
DDMAX, , ) is one of the few funds with positive returns this year, up 1.5%.
She added that one reason why most market neutral funds are in negative territory is because they are highly leveraged. The massive deleveraging process sweeping the global markets — sometimes called the “Great Unwind” — has hurt these funds, she added.
Despite not living up to their stated goal, market neutral funds are still doing better than all but one stock category: dedicated short bias funds — which are exclusively short-selling strategies — are up 64% on average, Lipper reported. Diversified U.S. stock funds, meanwhile, had lost 37.5% on average as of Oct. 23.
Funds that use 130/30, or sometimes 120/20, strategies see returns that are tied more closely to the market because they have fewer short positions, 30% or 20% of their portfolios.
“We’re meant to enhance [market beating returns],” said Lee Spelman, client portfolio manager for 130/30 strategies at JPMorgan Funds. JPMorgan is the industry leader in 130/30s, and has the largest such offering, U.S. Large Cap Core Plus Select Fund (JLCAX:
JLCAX, , ) , which Spelman said has nearly $4 billion in assets.
Spelman said the fund’s strategy is to beat the U.S. market by three percentage points. As of Oct. 23, U.S. Large Cap Core Plus Select’s Class-A shares had lost 35.4%, or 2.7 percentage points better than the S&P 500.
Lipper includes 130/30s in its long-short category, a stable of uniquely structured funds that can have higher ratios of short positions and won’t perform in lockstep with the overall market.
Milling, the Morningstar analyst, still has doubts. He points out that these long-short funds are among the more expensive fund industry offerings, averaging more than 1.25% in annual fees.
“If you’re paying the extra fee for these funds to make sure part of your portfolio isn’t hemorrhaging, then they’ve failed,” he said.
According to Spelman, JPMorgan’s U.S. Large Cap Core Plus Select has delivered twice the return of its equivalent long-only counterpart, but charges 20% more in fees. “The additional fees are relative compared to the higher alpha,” she said.
An alternative to alternatives
Keeping part of a portfolio in areas that have unrelated performance to the broad market is “essential,” Milling said. How much of the portfolio is given to such alternative strategies depends on an investor’s circumstances, he added. And he questions whether market neutral funds are the best way to achieve this independence.
These funds are mostly too new to have much of an established record, Milling said. About half of the category doesn’t even have three-year performance numbers. “They just have not proven themselves,” he said.
Investors looking for a fund that has shown an ability to deviate from the U.S. market should consider Prudent Global Income Fund (PSAFX:
Prudent Gl Inc;No Ld
Delayed quote data
Delayed quote data
PSAFX 11.68, -0.04, -0.3%) , Milling said. The fund is classed as a World Bond offering, and Milling said it’s largely a play on the U.S. dollar, investing in foreign bonds and stocks of gold mining companies. The fund is down 6.1% for the year through Oct. 23.
“It’s a bond fund, a steadier fund,” said Milling. “It’s about capital preservation and preserves the spending power of the dollar on a global basis.”
Among long-short funds, Morningstar’s recommends that investors check out Diamond Hill Long-Short Fund (DIAMX:
DIAMX, , ) , which has lost 23.2% so far this year, and Calamos Market Neutral Income Fund (CVSIX:
CVSIX, , ) , down 15.7%.
Morningstar analysts also have a favorable opinion of Hussman Strategic Growth Fund (HSGFX:
HSGFX, , ) , a long-short offering that was down 8.3% as of Oct. 23. Morningstar calls John Hussman a “skilled investment manager whose value-based macro-calls are frequently spot-on.”
Sam Mamudi is a reporter for MarketWatch in New York.