Do Hedge Funds Have An Edge Over Alternative Mutual Funds? by Steben & Company
The Case of Equity Long/Short Strategies
Do Hedge Funds Have an Edge Over Alternative Mutual Funds?
The concept of hedge fund returns in a convenient mutual fund format with daily liquidity and no performance fees certainly seems enticing. Yet there is still an allure for hedge funds, whose total assets under management swelled to more than $2.9 trillion1 by the end of 2015. The research team at Steben decided to take a closer look by examining the alpha and beta to the S&P 500 of all equity long/short hedge funds in the BarclayHedge database and all equity long/short mutual funds in the Morningstar database.
We analyzed data from January 2013 to December 2015. We chose this period because it provided a large, comparable data set. Earlier periods had substantially fewer equity long/short mutual funds. Of course a different time period might have produced different results. We analyzed performance net of fund fees and expenses for both mutual funds and hedge funds.
Our study revealed that for equity long/short strategies, portfolio diversification through low beta and positive alpha may be best achieved through hedge funds rather than mutual funds.
The Rise of Liquid Alternatives
[drizzle]Up until the financial crisis, most individual investors held a mix of long-only allocations in traditional asset classes such as stocks and bonds. During the crisis, asset correlations increased substantially and portfolio diversification properties decreased, resulting in large losses for many investors. Investors learned that true diversification often requires a more sophisticated approach that includes uncorrelated asset classes and strategies.
After 2008, investors were allured by the promise of non-correlation with the rapid expansion of the liquid alternatives industry. Assets under management grew from less than $75 billion to more than $350 billion2. These liquid alternative products, including mutual funds and ETFs, were designed to employ non-traditional strategies that were once exclusively available to large institutional investors through private hedge fund offerings.
While much has been written about the potential benefits and challenges of alternative mutual funds, the more important question is whether hedge funds have a performance edge over alternative mutual funds, and if so why?
Alternative Mutual Fund Constraints
At a very high level, alternative mutual funds impose significant restrictions that may constrain trading strategies. This may reduce the investment opportunity set compared to hedge funds that are not required to operate under the same limitations. For example, the daily liquidity requirement can lead alternative mutual funds to focus on widely followed large-cap stocks rather than less efficient areas of the market, where less frequently published research may enable a diligent active manager to attain an investment edge. Mutual funds are also beholden to limitations on leverage and short selling that can hamper the ability to employ strategies such as market neutral, which requires moderate amounts of leverage.
Moreover, since mutual funds cannot pay performance fees to managers, many skilled and experienced hedge fund managers are not interested in offering their strategy in a mutual fund structure. This creates an adverse selection bias in the quality of those remaining managers who do take part in alternative mutual funds. The resulting managers may have shorter track records, may have recently suffered asset outflows, or they may be traditional asset management firms attempting to transition into alternative strategies.
Equity Long/Short Strategies Performance Study
Performance data over the three-year period from January 2013 to December 2015 illustrates the compromises that affect alternative mutual funds. Remember, alpha is the part of a fund return that does not come from its net exposure to the benchmark index (in this case the S&P 500). As such, alpha may be viewed as a measure of a manager’s stock selection skill. In contrast, beta reflects how closely a fund return follows the market index, and is therefore a measure of the net long bias of a fund. In the following charts, we plot the bell curve distribution of alphas and betas for the universe of equity long/short mutual funds and hedge funds.
Alternative Mutual Funds Have Higher Beta
Chart 1 shows that the distribution of betas for equity long/short mutual funds lies to the right of the distribution for hedge funds. This means that, on average, equity long/short mutual funds have a higher beta, and hence, are more long biased than hedge funds in the same strategy. Our study found that the median mutual fund has a beta of 0.51, while the median hedge fund has a beta of 0.28. For a 1% decline in the S&P 500, one should expect a 0.51% decline in the median equity long/short mutual fund and a 0.28% decline in the median equity long short hedge fund, in the absence of any alpha generation. One should therefore expect less downside protection from equity long/short mutual funds in a bear market than from comparable hedge funds.
Alternative Mutual Funds Have Lower Alpha
Meanwhile, Chart 2 shows that the bell curve distribution of alphas for equity long/short mutual funds lies to the left of the alpha distribution for hedge funds. This demonstrates that mutual funds achieved lower alpha and hence exhibited lower stock selection skill than hedge funds over the period. The median alpha of these mutual funds is actually negative -1.10% per year compared to a positive median alpha of +2.81% per year for hedge funds over the three-year period covered by our study.
While we certainly acknowledge that not all hedge funds exhibited stock selection skill, the data suggests that few equity long/short mutual funds produced meaningful positive alpha. Investing in hedge funds is a challenging task. The limitations presented by alternative mutual fund regulations make that task even more difficult. Certain mutual funds will undoubtedly offer investors a more favorable experience, but the aggregate results suggest that mutual funds underperform hedge funds peers.
Our study suggests that equity long/short mutual funds with high beta and low alpha are unlikely to provide the benefits of diversification during bear markets that investors and advisors expect from alternative investments.
Managed Futures Exception
Of course there are exceptions to every rule. Our study focused on equity long/short mutual funds, which is the largest category of liquid alternatives. But if we look at other strategies such as managed futures, then we find that a more compelling case can be made for the mutual fund structure. This is due primarily to the high liquidity of futures markets, which in turn enables the mutual fund to meet daily redemption requirements. Furthermore, the core trend-following strategies used in managed futures mutual funds have historically maintained a low correlation to traditional asset classes such as stocks and bonds. Although many managed futures mutual funds tend to utilize less complex trading strategies than the flagship private hedge funds, many of these mutual funds have lower fees than hedge funds, which may benefit net returns.
So What’s the Conclusion?
Our study reveals that fee restrictions, liquidity requirements and investment constraints have a real impact on net performance for equity long/short mutual funds compared to hedge funds.
Investors with a strong preference for convenience, low cost and liquidity may still find alternative investments in a mutual fund structure attractive. However, we would argue that if portfolio diversification through low beta and positive alpha are the most important investment goals, then our study supports the notion that equity long/short hedge funds may provide the better alternative.
We encourage you to check in with us regularly for upcoming white papers, and educational and topical pieces, including a series of ‘Alternative Perspectives’ that will continue to examine alternative mutual funds compared to hedge funds.
[/drizzle]
