Total return funds fail to deliver

Australian Financial Review, Managed Funds Quarterly, November 2008

If this is the perfect environment for long/short funds – those that can take short positions, and hence benefit from declines in share prices as well as increases – then the managers who promote them have gone strangely quiet.

The AFR approached five managers of long/short funds for comment for this article, and found none who were willing to speak.

There are two likely reasons for this. One is that the performance of long/short funds, far from being insulated against market turmoil, has if anything been worse. According to Mercer, the median return from an Australian long-short fund in the 12 months to September 30 was -27.2%, compared to -25.5% for long-only funds. The worst performer, the SSgA Australian Long Short Equity Trust, was down 36.6%, and the best, the GMO Australian Long Short Equity Trust, down 16%.

The other reason, though, is that these funds have had one hand tied behind their back by the Australian Securities & Investments Commission (ASIC), which on September 19 banned naked short selling. (Naked short selling involves selling a share which you not only don’t own but don’t have an immediate means towards getting, in the assumption that you’ll be able to find the stock to cover the trade in time for settlement. Covered short selling means selling a share where you have what ASIC calls a “presently exercisable and unconditional right to vest” – in other words, a binding stock lending agreement for that stock. Covered short selling is still permitted.)

And it’s in September that the real damage has taken place for these funds. The State Street product incurred a 17% loss – more than half of its one-year decline – in September, and nobody lost less than 8.6%. Long/short funds badly underperformed long only funds in September, and one could make an argument to say that this is chiefly because their whole investment methodology was suddenly denied to them. In an environment like this, though, nobody wants to be the fund manager to publicly berate the regulator. After all, ASIC’s approach was widely applauded in a panicky market, and had precedent in the US and UK.

Still, it’s tricky to find evidence that long/short funds have been doing what they’re meant to do even before the ASIC ban. If we look at the previous month’s data, mapping returns up to August 31 – so before the short sell ban – then long/short funds did indeed look better than long only funds based on one year numbers (a 9.9% loss compared to a 12.6% loss). But over the quarter to August 31, the outperformance went the other way, with long-only funds doing better. And in any event, if long-short funds are really supposed to insulate from downturns, even by the end of August they clearly weren’t doing so with any great success.

The strange thing is, it’s only if you look back to the long-term numbers that long/short funds start to look better – in other words, including the bull run (in which surely long-only funds would be expected to do better) as well as the turmoil (which is supposed to be when long/shorts come into their own). Over three years, the median long/short fund is up 6.3% and over five years, a more than healthy 14.3%. Both those numbers trump long-only funds, where the median is 5% and 13.4% respectively. The best in class, the BGI Equitised Long/Short Fund, is up 19.7% a year over five years, better than any long-only fund tracked by Mercer, and a remarkable return considering it’s lost 34.3% over the last 12 months alone.

So what’s happening? The pattern suggests that even long-short managers are better at picking stocks that go up than stocks that go down. ASIC certainly didn’t help long-short managers with its recent intervention, but the data suggests that Australia still lacks managers who can benefit in down markets consistently whatever the behaviour of the regulator.