Morningstar Advisor - April/May 2012 - (Page 45)

Three Traits of a Successful Long-Short Equity Manager by Josh Charney Many investors seek the long-term return potential of the stock market but bail out when volatility creeps up a few notches, only to miss out on any sort of recovery. The difficulty for advisors is how best to damp volatility in their clients’ portfolios, so that it’s palatable during turbulent times while still ensuring that their clients will have adequate funds to meet their goals. A long-short equity mutual fund may be just the solution. Because these funds can short securities, managers can hedge the portfolio and boost returns in a down market. But buyers beware. The average long-short manager lost money in 2011, while the S&P 500 was up. Several long-short managers have handily beaten the market, however, on both a total-return and risk-adjusted-return basis over longer periods. Here are three traits that separate the good managers from the bad. 1. Proven Short-Seller Despite the large number of funds that short (Morningstar tracks more than 70 long-short equity funds), very few managers are good at it. Screening on a manager’s short performance is difficult (funds are not required to segregate long and short performance), but one way to determine a manager’s shorting acumen is to see how much alpha a fund provided during a market’s rough patch, which is when a shorting strategy should pay off. Of the 26 long-short funds that existed in 2008, only nine exhibited positive alpha. Wasatch Long/Short FMLSX is an example of a fund that follows the right approach. The managers look for clear reasons for why valuations may soon fall and look for technical breakdowns before they pull the trigger. If the thesis turns out to be wrong, and the short goes against them, they will cover or trim the position, as they did with technology stocks in the third quarter of 2010. Diamond Hill Long Short DIAMX, on the other hand, is an example of a fund with a history of shorting problems. Its struggles in 2008 and 2010 forced management to change the way it approached shorting in 2011. Before, it shorted securities based primarily on high prices. Consequently, the fund shorted stocks that continued to rocket up in 2010. Management adjusted its strategy to accommodate more lofty valuations in stocks with upbeat fundamentals, but timing has not yet made its way into the fund’s shorting process. 2. Macro-Aware When selecting a long-only manager, choosing a skilled market-timer is often not high on the priority list. More often, managers are judged on how they perform against their peers, so managers with laserlike focus on their sector or style of expertise are often preferred. But long-short managers can go anywhere and have the freedom to raise or lower market exposure, which affects the funds’ total return. Therefore, a long-short manager adds value not just by picking the right stocks but also by timing the market. Marketfield’s manager constructs its portfolio around a handful of macroeconomic themes and then figures out how to best trade those themes. (We profile manager Michael Aronstein on Page 56.) 3. Excellent Risk Management Related to shorting and macroeconomic investment processes is a manager’s ability to manage risk. While most long-only managers’ only tool is to move to cash, a long-short manager can hedge long market exposure either by selling positions (reducing gross exposure by increasing the cash stake) or by taking offsetting short positions (through options, futures, and ETFs). Some managers do not use short positions to hedge (Diamond Hill Long-Short, for example). Rather, the shorts serve as directional bets. This can present a problem when the market is getting more risky but management lacks enough short ideas (or when there is a shorting ban on certain stocks, as there was on financial stocks in 2008) to bring down overall market exposure. Quaker Akros Absolute Return AARFX is an example of a fund with better-than-average risk-management skills. It lost only 2.9% in 2008 by quickly reducing market exposure. In contrast, the market was down 37%, and the average long-short fund lost 15.4%. Manager Brady Lipp is a long-term, value-oriented stock-picker, but he uses all the tools available to him (cash, futures, ETFs, and options) to vary market exposure. Besides market risk, another source of risk in long-short equity portfolios is correlation among investment themes. Seemingly unrelated investment theses can be related, even if one is long and the other is short. For example, entering 2012, Marketfield was bullish on high-quality U.S. companies and bearish on emerging-markets stocks. These bets could both turn against the fund in the event of a risky-security-driven market rally. To counter this risk, management attempts to diversify the rest of the portfolio among more-unrelated investment themes. Josh Charney is an alternative investments analyst with Morningstar. Advisors should also investigate a manager’s shorting background. Pay close attention to specific experience related to short-selling. A manager with exclusively long-only experience may not be an ideal candidate for a long-short fund. Managers tend to be better at short-selling if they couple their security valuation and selection with some sort of timing discipline. Most hedge fund managers use technical indicators, such as momentum. The reason they do is that a losing short position becomes a larger part of the portfolio because the stock is going up (and can keep going), while a losing long position becomes a smaller part of the portfolio and can only go to zero. A badly timed short position can be much more costly than a poorly timed long call. These days, stocks both within and across sectors are more highly correlated than ever (as measured by the CBOE S&P 500 Implied Correlation Index), so a long-short manager needs a greater grasp of the fundamental macroeconomic environment. Most long-short managers, such as the team at Pyxis Long/Short HEOAX, state that they are fundamental stock-pickers, but even Pyxis Long/ Short alters its market exposure using exchangetraded funds based upon its managers’ macroeconomic outlook. A few long-short managers actually start the security selection process with macroeconomic research. Marketfield MFLDX is a good example. MorningstarAdvisor.com 45 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Contents
Contributors
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

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