"The Long and the Short of It"
The market cannot seem to make up its mind these days. Just when we experience a bullish rally with some positive weekly returns, the bears return and the market falls back. Technical traders would say that the markets are currently range-bound. When stock markets are range-bound, what are investors to do in order to make money? Should we become active traders and try to time the market? That is a very risky and difficult endeavor; one in which we do not specialize, nor wish to specialize. Instead, one way to provide portfolio growth through equity investing during these uncertain times is through alternative asset classes. An alternative asset class that we like to utilize in your portfolios is the long/short equity fund.
During the 1990’s mutual fund managers devised strategies coined long/short strategies or neutral market strategies. Similar to hedge funds, these funds were able to capitalize on both the long buy side of the market as well as the short sell side of the market. As a tactical asset class money manager whose main focus is risk management, we believe long/short equity funds can help to dampen volatility in our client portfolios while providing upside capital appreciation.
Volatility is rampant in today’s financial markets fueled by uncertain economic times. It has not been uncommon to have large market upswings and downswings in the same week. Volatility is a key attribute of investment risk and plays a vital role in compiling portfolios. Overall, the greater the investment’s volatility, the greater the swings are in the investment’s performance. The greater the number of volatile investments in a portfolio, the more volatile the overall portfolio will be. These large swings in portfolio performance are what we try to avoid. Long/short funds due to their ability to play both sides of the fence lower volatility.
When we determined which long/short equity fund best fit our client portfolios we looked to certain attributes. We wanted to select a manager with a significant tenure that displayed an ability to perform over an entire market cycle during both bullish and bearish market periods. The manager’s long term performance needed to rank highly amongst its peers. Low expense ratios were necessary for investments as high fees could dampen returns. We needed to find a manager that fit our investment philosophy so that it could be a core holding in portfolios. Another necessary requirement was an investment that had low correlation to the equity market, so as to provide portfolio diversification. Finally, the investment had to possess significantly less volatility than the S&P 500.
We found these attributes in the Hussman Strategic Growth Fund (ticker HSGFX, herein referred to as the “Fund”). Dr. John Hussman founded the Fund in July of 2000. Per the Fund’s prospectus, “The Fund seeks to achieve long-term capital appreciation, with added emphasis on the protection of capital during unfavorable market conditions.” From January 1, 2001 until August 31, 2010, the Hussman Strategic Growth Fund significantly outperformed the S&P 500 index; the index it benchmarks itself against for long-term performance. See exhibit A below.
* SPY is an ETF that seeks to mimic the performance of the S&P 500
Any investment manager can outperform the fund’s benchmark for a one year period. The Fund has not only outperformed the S&P 500 over the last 9.67 years, but it has also outperformed both the weighted average return of its peers in the long/short Morningstar category and the S&P 500 in the last 3 and 5 year periods. Over the last 10 year period, the Fund’s annualized return ranks it in the top 11% of all long/short equity funds according to Morningstar.
In addition to this outperformance, the Fund’s expenses are very low when compared to its peers. As of July 15, 2010, the expense ratio is 1.02%, lowered in June from 1.04%, reflecting increased asset flows. According to Morningstar, the long/short equity category average expense ratio is 2.09%. In addition, HSGFX charges no sales load or 12b-1 marketing fees. Dr. Hussman went a step further to disclose the amount of commissions paid as a percentage of assets in the article published on his website ‘Mutual Fund Brokerage Commissions and Trading Costs’. Although the Fund is still more expensive than a passive strategy (i.e. ETF), the skill required in managing the Fund coupled with it historic performance provides great value to our client portfolios. Many mutual funds are reluctant to disclose commission fees and we appreciate the additional disclosure provided by Hussman.
Dr. Hussman’s Fund’s strategy is essentially a risk management equity strategy despite the ‘long/short’ category it is labeled. Per the Fund’s prospectus: ‘when market conditions are unfavorable, the Fund may use options and index futures to reduce its exposure to market fluctuations. When market conditions are viewed as favorable, the Fund may use options to increase its investment exposure to the market.’ At Legacy Wealth Management, we seek to manage overall portfolio risk via suitable asset classes given the market environment and therefore, Hussman’s management style fits well with ours. Although the fund can utilize options against individual stocks, Dr. Hussman mostly utilizes call and put options on major indices. Stock market exposure can be increased through leverage with call options and can be hedged to lessen downside risk through put options. Hussman does not short individual stocks unlike other long/short equity managers. As we believe portfolio success is ultimately based on proper asset class investing versus individual equity investing, Hussman’s utilization of options on markets versus individual equities fits in harmoniously with our overall investment strategy. In addition, he utilizes his website to update his investors weekly on the current market environment and the holdings in the Fund. This additional investor communication is unique and matches our intentions of keeping our clients informed of the investment decisions we have made in their portfolios.
Another important factor when deciding which long/short equity fund to pick was its correlation to the equity market. Correlation is a statistical measure of how two securities move in relation to each other. A correlation of 1 means two asset classes move identically while a correlation of -1, means they move in opposite directions. If the Fund aimed to match the performance of the S&P 500 index it would be categorized an index fund, or an ETF, and would have a correlation with the S&P 500 index very near 1. Since the Fund is an active risk managed strategy that attempts to beat the S&P 500 index over the long term, we would expect a lower correlation. In the current market environment, many equity classes have moved together on both the upside and the downside moves, including small to large cap U.S. equities, and large international equity indices. The high correlation amongst these equity classes, means owning them provides little diversification to a portfolio. Some long/short equity funds even provide relatively high correlation to the S&P 500, or the market. For example, another successful long/short equity fund over the long term that also started in 2000 is the Diamond Hill Long/Short equity fund (ticker DIAMX). In the table below you can see the wide gap in correlation figures of the Fund and DIAMX for both the extended and shorter term periods. In fact, Hussman has become less correlated with the market during 2010 versus the extended period while Diamond Hill’s correlation has increased. The low correlation of the Fund to the S&P 500 index as measured by SPY, the ETF that seeks to mimic the S&P 500, provides great diversification to our clients’ portfolios. See Exhibit B below.
In order to lessen portfolio volatility we can utilize investments that have less volatility than the overall market, as measured by the S&P 500. We utilize the measure of standard deviation to determine the investment’s volatility risk. Standard deviation is a statistical measure that captures the range, or variability, of returns around an investment’s mean (average) return. Per Yahoo finance as of 7/31/2010 the following investments have had the following standard deviations. Again we utilize DIAMX as another long/short equity fund example, especially due to its similar fund life as mentioned above. See Exhibit C below.
Both of the Long/Short funds have less volatility as measured by their standard deviations over both the 3 and 5 year period in relation to the S&P 500 index as measured through the ETF, SPY, that tracks that same index. Hussman has nearly half the volatility of Diamond Hill. As risk management advisors ourselves, we try to seek returns for our clients with less volatility so as to not experience the huge highs and huge lows of investment returns. Another way to appreciate the volatility as measured by investment returns is to look at fund performance during the lows of fiscal year 2008 and the highs of 2009. As seen in Exhibit D below, the range in values is lowest for HSGFX against both its index benchmark as measured by SPY and its peer DIAMX. The lower volatility provides for smoother returns over the shorter periods and longer periods, and lowers investor and investment manager anxiety.
The current economic and investment market landscape provides room for both the bears and the bulls to make their cases. While unemployment remains high and credit activity lower than usual, corporate balance sheets are strong and emerging market growth continues. We find it paramount to be extremely diversified during these times of economic and market uncertainty. We believe the long/short equity market strategy can provide a great diversifying asset class to your portfolios, and the Hussman Strategic Growth Fund best fits our criteria for investment as discussed above. And therefore, we anticipate the Fund remaining a core holding in the investment portfolios we manage for the foreseeable future.