Equity Long Short Funds: Do They Provide Excellent “Return-Free Risk?”

Some thoughts on the equity long / short hedge fund segment from reader and industry insider Jaeson Dubrovay.

Jaeson has been involved with the hedge fund world since 1990, here’s why he believes the bloom is off the rose for ELS funds and what the challenges are going forward. Enjoy! 

– Josh

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Equity Long Short Funds

Do They Provide Excellent “Return-Free Risk?”

  Contributory factors for ELS underperformance over last 5 years (Jun 2012)

• Meaningful institutional assets continue to be invested in hedge funds
• Institutional investors have lower return/risk expectations than HNW
• Investments are primarily directed to the “Kindred Hundred” (top 100 funds)
• Managers focus on capital preservation and maintain low gross exposures
• This leads to crowding as larger funds deploy capital where they can (due to size)
• Stock ETFs have effectively reduced available float = higher volatility
• Sporadic short selling bans (mostly Europe) add to volatility due to uncertainty
• Larger organizations and AUM dilute the manager’s attention to stock-picking
• Managers less involved in investing/trading due to client servicing demands
• Managers invest in secondary ideas in order to deploy capital and diversify
• Managers go from “running a fund” to “running a business” = capital preservation bias
• Manager’s large investment in fund magnifies capital preservation bias
• Focus is on short-term performance and position-level liquidity
• Tension between capital preservation mindset and one eye on the equity indices
• Prime brokers/leverage providers tighter on financing terms: both pricing and tenor
• Short-interest rebates contribute minimally to performance due to low interest rates
• HF that do well in bull markets have “too much beta”
• HF that don’t keep up with bull markets suffer from redemptions
• 2/20 at lower return levels is onerous (2% management fee is fixed/incentive fees minimal)
• Fundamental analysis has not worked in the current “risk-on / risk-off” market
• Macro factors overwhelm idiosyncratic factors
• Lower dispersion among stocks nullifies the benefits from taking idiosyncratic risk
• Current deleveraging inflection point may take longer than anticipated to digest
• Markets generally tend to exhibit irrational behavior during inflection points
• Current market focus is on liquidity and a shorter investment horizon
• Recent “gating¹” of FoHF may draw attention to the difficulties managers have in liquidating funds

Reasons why ELS funds may experience challenges going  forward

• ELS funds tend to have higher betas than most other strategies (0.60 – 0.80)
• Crowded trades caused by inflows increase correlation among hedge funds
• No separation between alpha and beta makes these funds expensive at 2/20
• Illiquidity, lack of transparency and high fees make long only investments more attractive
• Funds that incorporate technical and/or macro views may do better than those that don’t
• ELS has had flat performance over last five years – investors rely too much on past performance
• Equity markets have reported moderate returns over the last five years – with higher volatility
• Asset allocation studies by large institutional investors may begin to favor equities again
  • Moderate returns/high volatility (equities) preferred over no return/moderate volatility (hedge funds)
  • Sizable outflows will make hedge funds unstable with even more focus on liquidity
  • Manager talent pool may shrink as some successful managers will elect to close the fund and manage their own capital

¹ Salient and Morgan Creek (4Q2012) *** Thanks Jaeson, great food for thought.