The long and short of long/short equity performance in this year’s tumultuous first quarter is that some funds came up long but many funds fell short.

Long/short equity is a hedge fund strategy consisting of buying undervalued securities expected to rise and shorting overvalued securities expected to decline. This strategy can also employ leverage and derivatives to lessen market volatility. The goal is to produce positive returns from both rising and falling prices while maintaining a lower correlation to the overall market. In theory, this should generate competitive risk-adjusted returns while minimizing or hedging against losses in market downturns. The plethora of long/short mutual funds and exchange-traded funds has made this approach accessible to retail investors.

Many investors hoped the long/short equity fund universe would come through in the clutch when stocks crashed in March. By and large, it didn’t.

“Looking at first-quarter results, you can quickly make the assumption that they underperformed and disappointed,” says Erol Alitovski, a liquid alternatives analyst at Morningstar.

And things didn’t improve much in April. Data from Morningstar Direct shows the long/short equity category was down 8.2% this year as of April 30, making it the worst-performing group among Morningstar’s seven liquid alternative categories. The S&P 500 lost 9.3% during that period. So while long/short equity barely outperformed the broader equity market on a relative basis, the amount was so small it doesn’t even qualify as a moral victory.

But the long/short equity strategy has its merits, and this article will look at why this category recently scuffled and what investors should consider if they want to invest in this space.

First, the bad news. There has been a huge performance dispersion among long/short equity mutual funds. According to Morningstar, the top performer gained nearly 40% this year through April, while the worst performer lost more than 61%. In between, there were significantly more losers than winners—only 13 funds were in positive territory, and roughly 45 funds registered double-digit losses.

And long/short equity mutual funds as a group were the worst-performing category during the one-year period through April, as its negative 5.1% return trailed the aggregate average return for all liquid alts categories by 200 basis points.

Alitovski points to a couple of reasons for this. First, the long/short category’s emphasis on undervalued stocks put it on the wrong side of the market as growth and momentum stocks continued to significantly outperform.

“The combination of technical and fundamental factors contributed to value’s underperformance, and a large subset of long/short managers have a sensitivity to the value factor,” Alitovski explains. He adds that many funds suffered as their long bets went south in March.

And during the period when the S&P 500 inched its way to an all-time high on February 19, many long/short managers were losing money on their short bets because it’s hard to make money shorting stocks during a relentless bull market.

Alitovski notes that investors should consider the longer-term results before deciding whether this strategy is for them. The long/short equity category’s annualized 10-year return of 4.1% (through April 30) was the best among Morningstar’s seven liquid alts categories, but it significantly trailed the 11.7% average 10-year return on the S&P 500.

Then again, long/short equity isn’t designed to shoot out the lights during bull markets. Employing strategies designed to lower the correlation to the overall equity market will inherently limit the upside in bull markets (while hopefully limiting the downside in bear markets).

“I don’t think they [long/short equity managers] can add outperformance over equity markets,” Alitovski says. “But when you take their beta exposure into account, I think they can add alpha on a risk/reward perspective.”

One way to look at it, he says, is if a long/short equity fund has a 0.5 beta and the market returned 10% over an annualized five-year period, and if this fund returned less than 5%, that means it underperformed expectations.

Market Conditions
Alitovski says long/short managers tend to do better in slightly volatile market environments. “You don’t want a super-low volatile environment because that means prices aren’t moving much, making it hard for long/short managers to add value,” he explains. “But you don’t want super-high volatility because that means prices are moving in the same direction.”

Sal Bruno, chief investment officer at IndexIQ, believes long/short equity should be seen as a strategic holding in a portfolio’s alts sleeve. “I think it’s more strategic because you want the managers themselves to be tactical within your long/short.”

The IQ Hedge Long/Short Tracker ETF (QLS) tracks an index that seeks to replicate the risk/reward profile of long/short hedge funds. Rather than tracking individual managers, the index comprises ETFs that go long or short on particular sectors or investing styles.

“For example, are these managers tilted more toward growth or value, because growth has been a winning trade,” Bruno says.

The QLS fund was down nearly 12% in this year’s first quarter while the HFRI Equity Hedge Index dropped 13%. But it had 2.1% five-year average annual returns while the HFRI index gained only 1.3%.

And The Winner Is? . . .
According to Morningstar, the best-performing long/short equity mutual fund so far this year was the ABR Dynamic Blend Equity & Volatility Fund (ABRVX), which returned 39.6% through April 30. That fund also had the top annualized three-year return of 15.9%. Here’s the rub: It might not be a long/short equity fund.

That same fund was rated by Lipper as No. 1 in its large-cap core funds category for one-year performance. And Taylor Lukof, the founder and CEO at ABR Dynamic Funds, thinks the fund should be classified as a managed futures product. In fact, the company’s other mutual fund, the ABR Dynamic Short Volatility Fund (ABRSX), was tops in Lipper’s alternative managed futures category.

“When people look to long/short equity, they’re looking for positive correlation in a bull market and a negative correlation in a bear market or crisis,” says Lukof. “The problem is that most long/short equity strategies don’t necessarily deliver.”

He says his ABR Dynamic Blend Equity & Volatility Fund is a long-volatility product—all its alpha is derived from volatility signals while it simultaneously uses equities as a hedge.

“This fund is very differentiated from the normal long/short equity,” Lukof adds. “Our correlation is very dynamic.” He says it can go from a beta of 1 to the equity market to “significantly negative in a crisis event.”

He posits that the best way to use his company’s two products is by combining them as a 75/25 long/short blend—75% in the ABR Dynamic Blend Equity & Volatility Fund and 25% in the ABR Dynamic Short Volatility Fund.

“That blend is up about 25% this year, but it was also up about 25% last year,” Lukof says. “We’ve given people an equity-like return in bull markets while still ‘owning’ the crisis. Anyone who was up 25% this year probably wasn’t up 25% last year.”