Rising Market Could Challenge Long-Short Mutual Funds

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The New York Sun

It is said that the army is always ready to fight the last war. They are not alone. Money managers, too, have a way of launching new products aimed at taking advantage of last year’s trends.

A case in point is the proliferation in the past three years of long-short mutual funds. These are mutual funds that not only buy stocks but are also set up to sell them short, thus making a bet that the stock price will fall. There are so many of these vehicles now that Morningstar has an entire category dedicated to them.

According to Morningstar’s Todd Trubey, there are now 41 long-short funds, only 23 of which have been around long enough (3 years) to receive a rating. To find out more about the sector, we talked to Eric Newman, co-manager of the TFS Market Neutral Fund, currently ranked number one in its category.

He credits two events for causing the surge in long-short funds. First, there was a regulatory change in 1998 which facilitated the opening of such funds. Second, the bear market of 2000 to 2002 gave a big advantage to those who could short stocks — primarily the hedge funds — who consequently recorded hugely above-average performance.

Because hedge funds did so well relative to most money managers, who at best sold stocks and parked the cash in money market instruments, all kinds of investors sought out these investment pools. The only problem was that for most individual investors, the minimum required to invest in hedge funds — normally $500,000 to $1 million — was too high. That issue has been in part remedied in recent years as some funds of funds have emerged that require only $25,000.

Nonetheless, other concerns about hedge funds still put off individuals. Hedge funds have not been regulated in the past, and therefore reveal little about their use of leverage and their investment positions. As Mr. Newman points out, investors who lost money in Amaranth Advisors, which recently was gravely wounded by trading losses on natural gas positions, would have had no way of knowing that the manager had made such extreme bets. Also, some small investors are not happy to have their money tied up for two or three years, which many funds require.

Enter the long-short mutual funds which, like all such products, are regulated, and which twice yearly publicly report their positions. These funds have tapped into an investor pool which is sophisticated enough to appreciate the greater flexibility afforded a manager who can go short or long, and which may appreciate other features such as reduced volatility.

From the managers’ point of view, there is another aspect to launching such a fund that is appealing. For regulatory reasons, hedge funds are not allowed to advertise. (This would appear to encourage the secrecy that the government finds so distasteful, but no one ever accused a regulator of being logical.)

For some groups that have only gotten into the business in the past few years, such as TFS Capital, this is a real problem. As the hedge fund industry exploded from a clubby few hundred to over 8,000, it became harder for managers to get noticed. Opening up a mutual fund, which would be managed along similar lines and which could ballyhoo good performance, was an attractive opportunity to make some noise.

This was part of the enticement for TFS. The firm was founded in 1997 by three fellows formerly at Capitol One Financial, best known as an issuer of credit cards. The TFS crew was then joined by Mr. Newman, also from Capital One. The team’s background is in computer modeling and risk analysis (lots of advanced degrees in mathematics and computer sciences), and it is this expertise that they have brought to the investment arena.

Their management process involves taking advantage of market discrepancies through computerized trading models.They claim to have proprietary programs which have been rigorously back-tested, and which are continually being updated. Beyond that they will not divulge, for fear their competitors will take note.

After running separate accounts for a period of time the TFS folks opened a hedge fund in 2001, which has a $100,000 minimum, and currently has assets of about $40 million.

Because the partners gained confidence in their approach over time, but had trouble being heard in the chorus of new competing funds, they then opened a mutual fund, which today has about $35 million in funds. That’s not uncommon in the category, according to Mr. Trubey. Though there are five funds with assets of more than $1 billion, more than half have less than $100 million.

Being ranked number one in practically anything is pretty noticeable, so the Market Neutral Fund has made a bit of a splash. The mutual fund is managed along the same lines as the hedge fund, but for liquidity reasons invests in stocks with somewhat larger market capitalizations, averaging $700 million.

“A lot of the inefficiencies we’re looking for occur in small cap stocks” explains Mr. Newman. “We hold baskets of longs and baskets of shorts” he says. “The largest holding would be about 1.5% of the portfolio, but most are much smaller. We have in total 190 long positions and 165 short holdings.”

Since inception, the firm’s strategies are working well. “We’re generating alpha in our longs and shorts” says Mr. Newman. “Overall, we have a small net long position. We want to offer people some upside potential and some downside protection.”

Through the end of last month, the fund’s one-year gain was 14.8% compared to 10.8% for the S&P 500. As of Tuesday, the fund was ahead 12.2% year-to-date, compared to 8.3% for the S&P 500.

The real challenge for TFS, and for other long-short funds, will be to continue to outperform and to attract new funds if the market stays on its upward course. Those models are going to have to work overtime to beat out a bull market. We know they are armed to fight the last war, but will they also win the next one?


The New York Sun

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