It’s the Holy Grail of investors: a fund that goes up in both up markets and down markets. All you need are managers who are good at identifying stocks whose prices will climb – and stocks whose prices will sink.
Result: You can stash your entire portfolio in the stock market—safely. You’ll not only acquit yourself with honor re stocks; you’ll have far less volatility. Forget about rebalancing, forget about asset allocation, stop worrying about corrections and bear markets. The Holy Grail is in your hot little hands at last.
Alas, ambidexterity is a rare gift. Just identifying in advance stocks that will head up is tough enough. And I’m informed that the smarts you need to identify stocks you should bet on are different from the smarts you need to identify stocks you should bet against.
Even so, there’s been a spurt in the appearance of long-short funds in recent years, and today there are at least 56 of them, according to Morningstar—31 of which were launched in the past three years.
Which is the very best?
Let me put a word in for TFS Market Neutral Fund (TFSMX), one of whose portfolio managers, Eric Newman, spoke the other day in Morristown, N.J. The fund is no-load; gets five stars from Morningstar; and is No. 1 over three years of 24 similar funds tracked by Lipper. Since its inception (9/7/2004), it has returned 13.48% a year (to May 31), compared with only 8.17% for the S&P 500. The best recommendation that I can give for the fund is that I myself just bought shares. (OK, only the minimum: $5,000.)
On the negative side, the fund has a net expense ratio of (gulp!) 2.48%. There’s a 2% redemption penalty for shares sold within 180 days. Turnover: 500%. Phone: (888) 534-2001.
Long-short funds come in two types:
The most common variety is 100% long, with short exposure ranging from 0% to 50%, with 30%-45% perhaps being typical.
So-called market neutral funds usually maintain a static ratio of almost 100% to 100%.
TFSMAX happens to be a hybrid: It maintains an unchanging 100%-67% ratio, and considers itself market-neutral.
Says Newman, “Since inception, less than 10% of our return has been because of our market exposure—about 1 percentage point out of the 13.5% annual return. That, along with our relatively high allocation to shorts and our static ratio, makes the market-neutral classification a better fit than long-short.”
Since inception, the fund’s beta has averaged 0.11. The average beta of a long-short fund: 0.32.
A big secondary benefit of long-short funds is that they generally aren’t correlated with the stock market, so they can smooth out your portfolio’s performance (assuming you don’t own just long-short funds!).
Newman pointed out that these days, neither real-estate investment trusts nor foreign stocks diversify a U.S. stock portfolio much—although bonds still do.
Another point Newman made was that long-short funds are decidedly different from one another. Their returns are dissimilar—compared with, for example, the in-the-same-ballpark returns of large-cap blend funds. And Morningstar tends to assign them very different “best fit” indices as matches. They are also ill correlated with one another. All of which suggests that long-short funds should be broken down into further categories.
How to choose a long-short fund? Newman suggested looking for one with a larger number of holdings—which should mean more diversification. And no style drift. (TFS focuses on small caps—where, Newman asserted, inefficiencies are more likely to be found.) Manager stability. And returns from
*alpha, not from beta—from superior stock-picking, not from higher risk;
* from a larger number of profitable transactions, not from just a few big bets.
* with a low correlation with the stock market. A low beta long-short fund, after all, may be strongly correlated with the stock market. Example: a fund that stays mostly in cash and buys stocks modeled on the S&P 500 will have a low beta, but a decent return in an up market.
Compared with long-short hedge funds, Newman explained, long-short open-end funds are less risky—they are typically less leveraged, and are also more transparent and more liquid.
Q. Why does TFS have such a high turnover—500%?
“Because inefficiencies tend to last only three to five months.” (The average turnover of a long-short fund is 242%.)
Q. Is it harder to do well buying longs or shorts—and why?
“Many of our models are ranking models that score each stock in the universe. We buy the highest-ranked stocks, and short the lowest-ranked ones. TFS Capital has specialized in alternative investments since our inception 10 year ago, and so we are able find opportunities on both the long and short sides.”
Are longs or shorts more rewarding?
“We hear from a lot of people that the short side does not add any value. But that isn’t true for us—we are adding alpha on both the long and short sides.”
Q. Why are there inefficiencies? News is late getting out? News is misinterpreted? People have trouble changing their minds?
“Most of our holdings are in the small-cap space. In general, there are less people actively following these stocks (whether they are professional analysts or just individual investors). Information seems to take longer to be priced into the stock prices.”
Q. Are stocks in general more likely to remain underpriced or overpriced? In other words, are longs or shorts more likely to disappoint?
“We hold hundreds of stocks long and hundreds more short. Of course, we aren’t right on every one of those stocks. Our goal is to have each basket of stocks overall add value. We’ve had disappointing stocks both long and short, but the large number of holdings minimizes their impact on the portfolio.”
Q. Do you need similar skills to choose what to buy and what to short? What might be different?
“As quantitative managers, finding undervalued stocks is a very similar process to finding undervalued ones. I imagine it would be hard to find shorts if we weren’t quantitative—people in general tend to paint a positive picture of stocks.” Q. Why are managers, at least in my experience, reluctant to reveal their shorts?
“We are reluctant to reveal our models, which cover both longs and shorts. The inefficiencies we have discovered and capitalize on have limited capacity.”
Q. Once, it was considered “un-American” to short a stock. Is this view going out the window?
“I think people recognize that strong earnings are going to drive long-term stock performance. Strong, well-run companies will continue growing regardless of how many shares are held short.”
Newman, who is 33, graduated summa cum laude from Kenyon College, with a B.A. in mathematics and a concentration in statistics.Ă‚ He then attended Johns Hopkins University as an Abel Wolman Fellow, and graduated with an M.S.E. in mathematical sciences.
Result: You can stash your entire portfolio in the stock market—safely. You’ll not only acquit yourself with honor re stocks; you’ll have far less volatility. Forget about rebalancing, forget about asset allocation, stop worrying about corrections and bear markets. The Holy Grail is in your hot little hands at last.
Alas, ambidexterity is a rare gift. Just identifying in advance stocks that will head up is tough enough. And I’m informed that the smarts you need to identify stocks you should bet on are different from the smarts you need to identify stocks you should bet against.
Even so, there’s been a spurt in the appearance of long-short funds in recent years, and today there are at least 56 of them, according to Morningstar—31 of which were launched in the past three years.
Which is the very best?
Let me put a word in for TFS Market Neutral Fund (TFSMX), one of whose portfolio managers, Eric Newman, spoke the other day in Morristown, N.J. The fund is no-load; gets five stars from Morningstar; and is No. 1 over three years of 24 similar funds tracked by Lipper. Since its inception (9/7/2004), it has returned 13.48% a year (to May 31), compared with only 8.17% for the S&P 500. The best recommendation that I can give for the fund is that I myself just bought shares. (OK, only the minimum: $5,000.)
On the negative side, the fund has a net expense ratio of (gulp!) 2.48%. There’s a 2% redemption penalty for shares sold within 180 days. Turnover: 500%. Phone: (888) 534-2001.
Long-short funds come in two types:
The most common variety is 100% long, with short exposure ranging from 0% to 50%, with 30%-45% perhaps being typical.
So-called market neutral funds usually maintain a static ratio of almost 100% to 100%.
TFSMAX happens to be a hybrid: It maintains an unchanging 100%-67% ratio, and considers itself market-neutral.
Says Newman, “Since inception, less than 10% of our return has been because of our market exposure—about 1 percentage point out of the 13.5% annual return. That, along with our relatively high allocation to shorts and our static ratio, makes the market-neutral classification a better fit than long-short.”
Since inception, the fund’s beta has averaged 0.11. The average beta of a long-short fund: 0.32.
A big secondary benefit of long-short funds is that they generally aren’t correlated with the stock market, so they can smooth out your portfolio’s performance (assuming you don’t own just long-short funds!).
Newman pointed out that these days, neither real-estate investment trusts nor foreign stocks diversify a U.S. stock portfolio much—although bonds still do.
Another point Newman made was that long-short funds are decidedly different from one another. Their returns are dissimilar—compared with, for example, the in-the-same-ballpark returns of large-cap blend funds. And Morningstar tends to assign them very different “best fit” indices as matches. They are also ill correlated with one another. All of which suggests that long-short funds should be broken down into further categories.
How to choose a long-short fund? Newman suggested looking for one with a larger number of holdings—which should mean more diversification. And no style drift. (TFS focuses on small caps—where, Newman asserted, inefficiencies are more likely to be found.) Manager stability. And returns from
*alpha, not from beta—from superior stock-picking, not from higher risk;
* from a larger number of profitable transactions, not from just a few big bets.
* with a low correlation with the stock market. A low beta long-short fund, after all, may be strongly correlated with the stock market. Example: a fund that stays mostly in cash and buys stocks modeled on the S&P 500 will have a low beta, but a decent return in an up market.
Compared with long-short hedge funds, Newman explained, long-short open-end funds are less risky—they are typically less leveraged, and are also more transparent and more liquid.
Q. Why does TFS have such a high turnover—500%?
“Because inefficiencies tend to last only three to five months.” (The average turnover of a long-short fund is 242%.)
Q. Is it harder to do well buying longs or shorts—and why?
“Many of our models are ranking models that score each stock in the universe. We buy the highest-ranked stocks, and short the lowest-ranked ones. TFS Capital has specialized in alternative investments since our inception 10 year ago, and so we are able find opportunities on both the long and short sides.”
Are longs or shorts more rewarding?
“We hear from a lot of people that the short side does not add any value. But that isn’t true for us—we are adding alpha on both the long and short sides.”
Q. Why are there inefficiencies? News is late getting out? News is misinterpreted? People have trouble changing their minds?
“Most of our holdings are in the small-cap space. In general, there are less people actively following these stocks (whether they are professional analysts or just individual investors). Information seems to take longer to be priced into the stock prices.”
Q. Are stocks in general more likely to remain underpriced or overpriced? In other words, are longs or shorts more likely to disappoint?
“We hold hundreds of stocks long and hundreds more short. Of course, we aren’t right on every one of those stocks. Our goal is to have each basket of stocks overall add value. We’ve had disappointing stocks both long and short, but the large number of holdings minimizes their impact on the portfolio.”
Q. Do you need similar skills to choose what to buy and what to short? What might be different?
“As quantitative managers, finding undervalued stocks is a very similar process to finding undervalued ones. I imagine it would be hard to find shorts if we weren’t quantitative—people in general tend to paint a positive picture of stocks.” Q. Why are managers, at least in my experience, reluctant to reveal their shorts?
“We are reluctant to reveal our models, which cover both longs and shorts. The inefficiencies we have discovered and capitalize on have limited capacity.”
Q. Once, it was considered “un-American” to short a stock. Is this view going out the window?
“I think people recognize that strong earnings are going to drive long-term stock performance. Strong, well-run companies will continue growing regardless of how many shares are held short.”
Newman, who is 33, graduated summa cum laude from Kenyon College, with a B.A. in mathematics and a concentration in statistics.Ă‚ He then attended Johns Hopkins University as an Abel Wolman Fellow, and graduated with an M.S.E. in mathematical sciences.
