By LARRY SWEDROE
Hedged mutual funds (HMFs), or long/short funds, are the fund industry’s answer to illiquid hedge fund strategies. The premise of long/short funds is that the managers can apply their security selection skills to a broader opportunity set (both long and short, instead of long only). Their hypothesis is that the broader opportunity set should make it easier to outperform long-only funds. Note that some long/short portfolios have overall positive exposures to the market (long positions might be equal to 130 percent and the short positions 30 percent). The common term now used for long/short mutual funds is “liquid alternative” mutual funds.
Despite offering hedge-fund-like investment strategies, HMFs are subject to regulations similar to traditional (long-only) mutual funds (TMFs). In the U.S., HMFs must comply with the Investment Company Act of 1940, provide daily liquidity and disclose their detailed holdings regularly. They have low minimum investment requirements targeting retail investors and are not permitted to charge performance-based fees like their hedge fund (HF) counterparts. For investors the questions are: Are these vehicles substitutes for privately placed hedge funds? Do they offer investors similar market exposures? And how have they performed relative to comparable hedge funds?
Asli Eksi and Hossein Kazemi contribute to the literature on hedge funds with their study Hedged Mutual Funds and Competition for Sources of Alpha, published in the June 2022 issue of the Financial Analysts Journal, in which they examined the performance of HMFs and compared it to TMFs (using the Carhart four-factor model — beta, size, value and momentum), with a focus on the post-2009 period and domestic equity funds (they excluded international and convertible bond arbitrage funds and also sector funds). Their sample of HMFs is from Morningstar Direct, is free of survivorship bias, covers the period 1994-2020, and included 155 long-short and 60 market-neutral funds. Following is a summary of their findings:
There were only 63 market-neutral and long-short equity funds in June 2009; the number of HMFs peaked at 189 in March 2016.
HMFs tended to have positive but insignificant exposure to the size (SMB), value (HML) and momentum (MOM) factors.
The portion of HMFs managed by HF managers (theoretically, more skilled managers) decreased slightly over time. Before 2009, 56 percent of HMFs were managed by HF managers in an average year, falling to 45 percent after 2009. The portion of market-neutral funds managed by HF managers was higher than long-short funds (65 percent versus 40 percent).
Assets managed by HMF funds grew at an annual rate of 33 percent over a five-year window, from $21.86 billion in June 2009 to $91.43 billion in June 2014. However, HMF assets then fell to $52.44 billion in June 2019.
While HMFs generated positive net alphas before the crisis, their abnormal performance vanished in the post-2009 period as their strategies became increasingly crowded. HMFs managed (not managed) by an HF manager generated an annual net alpha of 1.23 percent (-0.94 percent) in the pre-2009 period, but their alpha was -1.57 percent (-2.56 percent) after 2009.
The correlation between the monthly rolling alpha of HMFs with (without) an HF manager and the number of HMFs available in the market was a statistically and economically significant -0.68 (-0.47)—the competition from similar funds hindered their ability to create alpha.
HMFs managed by HF managers generated a significant alpha of 1.00 percent on a pre-fee basis, suggesting that these managers are skilled. Unfortunately for investors, it was insufficient to cover their average expense ratio of 1.87 percent. Relative to TMFs, they did not show any statistically significant outperformance.
HMFs without HF managers had a negative pre-fee alpha, and their post-fee alpha was significantly negative (-2.26 percent). Market-neutral mutual funds had a significant pre-fee alpha of 1.42 percent, though it became insignificant after expenses. Long-short mutual funds had a negative alpha even before fees.
HMFs slightly underperformed TMFs by 0.7 percentage point after fees, though the finding was not statistically significant.
Market-neutral mutual funds provided the lowest annual return (2.91 percent), the lowest volatility (4.64 percent) and the lowest beta (0.12). Long-short mutual funds maintained a higher exposure to the market, with an average beta of 0.52, leading to a higher return (4.97 percent) and volatility (9.08 percent). On the other hand, TMFs had an average market beta of 0.98, with a 9.91 percent return and 15.77 percent volatility.
Only 64 percent of HMFs actively hedged their long equity positions through short-selling stocks, while 36 percent created their short positions through exchange-traded funds or derivatives, suggesting that these funds aim to provide a low-beta investment opportunity rather than creating alpha from the short side.
HMFs creating short positions using individual stocks charged a higher expense ratio and delivered an average alpha of 0.57 percent before fees, mainly from short stock positions. However, it was not enough to cover their high expense ratio, resulting in significant negative alpha after fees.
Long-short HMFs performed especially poorly, with an average alpha of -2.37 percent compared to -0.25 percent for market-neutral funds. The performance difference between the two styles mainly came from the post-2009 period — the number of long-short funds increased at a much higher rate than market-neutral funds, indicating that competition from funds with a similar style may have lowered the alpha of existing funds.
Although most of their analysis was based on average individual funds, they also examined the performance of equal- or value-weighted fund portfolios and found comparable results with fund portfolios. They also found that the performance of value-weighted portfolios was considerably lower than that of equal-weighted portfolios for HFs or HMFs with an HF manager — larger funds did worse (scale negatively impacted performance).
Flows to HMFs were negatively related to investor sentiment, implying that investors used these funds as a hedge against downside risk rather than seeking alpha.
Systematic strategies provided by the Chicago Board Options Exchange (CBOE) Indices offered similar downside protection at a lower cost—portfolios with allocations to CBOE’s S&P 500 5% Put Protection or 95-110 Collar Indices offered similar downside protection to a value-weighted HMF index while providing better risk-adjusted performance.
The results were robust to testing using the seven-factor (beta, size, a bond market factor, a credit spread factor, and three option-based factors for bonds, currencies and commodities) hedge fund model of Fung and Hsieh.
Eksi and Kazemi’s findings are consistent with those of Rodney Sullivan, author of the 2021 study Hedge Fund Alpha: Cycle or Sunset?, who found that when adjusted for risk to stock/bond markets, hedge fund managers as a group have shown a marked decline in risk-adjusted alpha following the global financial crisis (GFC), generating persistently negative alpha since 2008. They are also consistent with those of Nicolas Bollen, Juha Joenväärä and Mikko Kauppila, authors of the 2021 study Hedge Fund Performance: End of an Era?
Investor takeaways
In our book The Incredible Shrinking Alpha, Andrew Berkin and I provided several explanations for why active managers, and hedge funds in particular, were finding it persistently more difficult to generate alpha: Academic research was converting what was once sources of alpha into beta (common traits that could be easily accessed at low costs); the skill level of the competition was persistently increasing (the paradox of skill problem); the pool of victims who could be exploited was shrinking; and the amount of dollars chasing a shrinking pool of alpha opportunities was increasing (the problem of crowding, as assets in hedge funds increased about tenfold since 2000 to over $4 trillion). Eksi and Kazemi’s study provides supporting evidence that the ability to generate alpha has dramatically declined and that crowding provides at least one explanation.
The evidence demonstrates that the performance of HMFs that implement HF strategies has deteriorated over time as their assets under management grew. The result has been that they have not been able to generate net alpha in the post-GFC period even when HF managers manage them. In addition, while they have provided some diversification benefits for conservative investors seeking to lower their portfolios’ exposure to equity markets, this benefit came with negative alphas. Investors could have achieved the same benefits with simple systematic strategies that use CBOE’s S&P 500 5% Put Protection Index or 95-110 Collar Index for downside protection.
These findings beg the question: Why do investors continue to pour money into hedge funds? Perhaps it’s the need to feel part of “the club” that has access to these funds. Those investors would be better served to follow Groucho Marx’s advice: “I wouldn't want to belong to a club that would have me as a member.”
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