Insights

What are you really getting from your long short hedge fund?

5 November 2014

Put simply, a long short hedge fund looks to maximise total returns by taking long positions in stocks the manager expects will increase in value, and short positions in stocks expected to decrease in value. In this way, the fund reduces market risk and also presents the opportunity for investors to profit in both up and down markets.

What’s really important to understand about hedge funds is that, like managed funds, they are not an asset class. Given that hedge fund managers have ultimate flexibility in choosing investment strategies within their fund, funds can vary greatly and offer something different to investors, so it’s important to understand exactly what you are recommending to your clients.

 

 


Metrics are key

Metric

What does it measure?

How does it relate to long short hedge funds?

Correlation coefficient

Measures the degree to which two things’ movements are related. The coefficient moves between -1 and +1, where -1 means a negative correlation, ie. the two things move in opposite directions, and +1 means they are perfectly correlated/move together.

A true long short fund should have a correlation well below 1 to the underlying asset classes it holds, given the manager has discretion to invest in long and short strategies to minimise risk.

Drawdown

Measures the peak-to-trough decline of an investment during a specific period. Usually quoted as a percentage between the peak and trough.

Drawdown is a good indication of a fund’s volatility and downside protection. A successful long short fund should have a smaller drawdown (less volatility) relative to long only managers. For example, in terms of the largest drawdown in the Australian market, the peak slump for the AFM Equity Fund Index (-25.22%) was significantly less than the largest drawdown for the S&P/ASX 200 Accumulation Index
(-47.19%)*.

Standard deviation

A common measure of risk, standard deviation measures the volatility of an investment by measuring its deviation from the average, eg. a highly volatile stock will have a high standard deviation.

A long short hedge fund should have low volatility when compared with long only equity funds.

Sharpe ratio

Measures risk-adjusted performance, calculated by subtracting the risk-free rate (such as the RBA cash rate) from the rate of return of a portfolio, then dividing the result by the standard deviation of the portfolio’s returns.

Hedge funds aim to have a Sharpe Ratio of 1 or greater - the higher the ratio, the better the risk-adjusted performance#.

Best and worst months

The best and worst months in a fund’s performance history.

An extreme difference between the highest and lowest months indicates a high level of volatility.

Rounding out the picture

Clearly, the analysis of metrics only provides part of the picture. Further considerations include the experience of the team (eg. track record, length of time working together), leverage fund liquidity, and risk controls used (eg. gross and net exposure limits, stop-loss limits).

Ultimately, for many advisers the addition of a long short hedge fund can be a prudent way of lowering volatility in a portfolio. And determining the true nature of a specific fund need not be time consuming. It is crucial, however, to ensure the fund you choose delivers on its stated objectives.

Andrew Aitken is Head of Distribution at Bennelong Funds Management.

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