As any sophisticated analyst knows, return and risk are two sides of the same coin: if the returns of a long/short fund are driven by the portfolio manager’s stock picks, so will be the risks. The portfolio manager will live or die on their ability to identify in advance the individual winners and losers.
If the portfolio reflects a certain factor bias, that bias could help or hurt depending on whether or not it is in favor. To return to our previous example, imagine a portfolio manager has a value bias. A long-only value portfolio will trail the market in a year when growth is in favor, like 2017 or 2015. However, the long/short value manager who is long value stocks and short growth stocks would be doubly exposed to such a factor bet.
Because portfolio managers are unconstrained in a long/short strategy and can essentially double their bets, the performance across long/short funds varies widely. The dispersion between “first and worst” can be quite wide. It is dangerous to use “the average long/short” fund as a proxy for the asset class when the returns and risks are so divergent. The table below illustrates this:
Source: Morningstar Direct, Zephyr StyleADVISOR. Annualized return, beta, and R2 were calculated vs. the S&P 500 and only for those 71 funds with a three-year track record as of 9/30/17.
While the dispersion in performance is wide, long/short managers do tend to share certain tendencies. Long/short managers tend to have higher than average expense ratios and trade more frequently. According to Morningstar, the median long/short manager has an annual turnover ratio of 163%, and the most active fund has an eye-watering turnover ratio of 7,042%. It is fair to say an investor must have a lot of faith in that particular manager’s process in order to justify a turnover ratio of 7,042%.