He notes that during mostly bullish times investors tend to forget that downturns can be long and brutal. It took over eight years for stocks to recover losses from the bursting of the dot-com bubble in 2000. In fact, there have been at least two periods lasting 15 years or longer in the last century where the stock market did not deliver positive returns.
While he is not predicting a similar scenario now, Motamed believes the opportunities for short sellers are expanding. “As we look at valuations, growth rates, interest rates, political unrest and central bank influence, we believe that the dramatic swings of the last three years will become more common moving forward,” he observes.
Amid the rise in passive investing, many stocks included in popular indexes rise to the top even though their financial characteristics aren’t all that impressive. Eventually, those stocks fall when the market tumbles and investors become less enamored of them. Those are the kinds of securities Motamed likes to short. On the other hand, some companies that aren’t a prominent part of an index fall off the radar screen despite having much stronger financial profiles. Those may become candidates for the long side of his portfolio.
Passive investing has also created some predictable market distortions that could hurt passive investors but work to the advantage of short sellers. For example, Motamed has observed that when a company moves from one popular small-cap index into a mid-cap index, its stock will go down an average of 12%, largely because passive asset allocators tend to devote a smaller piece of the pie to mid-caps than they do to small caps.
Another less-recognized advantage of a long/short fund is its ability to buy stocks when the market is down. When that happens, the fund generates cash through its short positions and can use it to establish long positions at lower prices. By contrast, long-only funds may need to sell stocks at unfavorable prices to meet redemptions and thus they have more limited room for buying in down markets.
Hedge Fund Alternative
The Invenomic Fund is one of a growing number of alternative mutual funds in a category that covers a broad range of offerings using strategies beyond long-only investing. They typically have higher expense ratios than long-only mutual funds for a variety of reasons. Many of them are smaller, leaving fewer investors to shoulder costs. They may also employ strategies that are expensive to execute, and trade securities more frequently than a typical fund.
In the Invenomic fund, the expense ratio is 2.73% for institutional class shares, which have a $50,000 investment minimum.
While that may be high for the mutual fund world, long/short funds are much more liquid and less expensive than the traditional hedge funds they mimic. Hedge funds usually charge a performance fee of 20%; also, they allow only quarterly redemptions and have high investment minimums of $1 million or more. They are furthermore less transparent, and less regulated, than mutual funds.
Yet both hedge funds and alternative mutual funds are designed to produce different returns than traditional asset classes do, particularly during difficult times in the stock market. They also aim to reduce overall portfolio risk and mitigate the effects of severe drawdowns in the equity market. Motamed thinks an 80/20 split between long-only equity funds and the Invenomic Fund would be a good strategy to achieve those goals, generate strong returns and add an element of capital preservation to portfolios.