Long/Short Funds Ride Volatility Wave
September 24, 2007
This summer's extreme wave of market volatility was enough to make investors and mutual fund managers seasick.
For those managers at the helm of long/short and market neutral funds, the rollercoaster markets were either painful or gratifying. According to Morningstar, those funds collectively account for a $21 billion slice of the mutual fund market.
Those suffering the effects of the subprime mortgage industry's meltdown-which impacted credit markets and scared equity investors away from a plunging equity market-are trying to gracefully recover.
Those whose funds performed well are celebrating and gloating about how their funds did exactly what they were intended to do, which is, ride out the storm without capsizing.
But those huge waves did sink one fund group. On Aug. 21, Geronimo Financial of Denver, quietly told shareholders it would close its three mutual funds at the end of September. The funds, the $8 million Geronimo Multi-Strategy Fund, $3 million Geronimo Sector Opportunity Fund and the $4 million Geronimo Option & Income Fund, have been underwater performance-wise, with all three posting negative performance year to date, according to Morningstar.
A call to Geronimo's top executive seeking comment was not returned.
"You've gone through a period of time that got wacky," said Barry James, president of the James Advantage Funds which manages the $43 million James Market Neutral Fund, the second-oldest such fund, which debuted in 1998.
There were two days in August in which "hedge funds were in full panic mode and sold, sold, sold, making it an especially difficult time for some," James noted. Those funds that base stock selections strictly on valuations were burned.
The James Market Neutral Fund, which has returned nearly 3% year to date, did well by staying true to its market-neutral position, said Brian Shepardson, one of the fund's team of managers. "In theory it should work in all types of markets and have no style drift." In addition, the fund doesn't use leverage, which can add to managers' woes.
At TFS Capital in West Chester, Pa., an Aug. 31 letter to investors from the firm's portfolio managers acknowledged the poor performance of the firm's mutual funds, including the $144 million TFS Market Neutral Fund. That fund's year-to-date performance through Sept. 11 clawed its way back into the black, rising 2.09%.
"It was a very difficult market to navigate through," admitted Rich Gates, co-portfolio manager of the fund, who said that August turned out to be the perfect storm. "When hedge funds closed out their positions, it hurt us."
In its letter, TFS' managers noted that the fund had significant overlap with the positions hedge funds had been holding and were frantically selling out of in August. The managers promised to make adjustments that would reduce the likelihood of overlap with other quantitative managers in the future.
The silver lining is that for those funds suffering losses, it shows that their managers were able to pick the very same securities that the top hedge fund managers had picked, Gates said. "The more skillful you are, the worse the returns," he added.
"This market has tested everyone's risk models and performance," said Guy Benstead, a partner with Cedar Ridge Partners in Greenwich, Conn., and co-portfolio manager of the $8.6 million Forward Long-Short Credit Analysis Fund that Cedar Ridge sub-advises. The fund has the distinction of being the sole fixed-income fund in Morningstar's universe of long-short mutual funds.
The key to who perished and who survived was the use of leverage, Benstead said. The Forward fund has less than 1% leverage, he added. The fledgling fund, which maintains long positions in municipal bonds, corporate and high-yield bonds and preferred stocks, and shorts the Treasury, agencies and corporate bond sectors, debuted Dec. 29, 2006 and is down 12.2% year to date through Sept. 11.
The municipal market, which simply "came unglued" in July and August, was particularly hard hit by technical repricings of securities, he said. Technical dislocations can and do happen, as was evidenced in 2005 after Hurricanes Katrina and Rita exacted their toll, he said.
The good news is that the market is on the road to mending itself and risk premiums should stabilize, Benstead added.
Just over a year old, the Janus Adviser Long/Short Fund, from Janus Capital in Denver, did extremely well at weathering the storm, producing an enviable year-to-date performance of 13.64%.
Dan Kozlowski, one of the three portfolio managers who runs the Janus fund, attributes the fund's success to several things. "We did what we said we would do and had classic good stock picking on our short [positions]," he said.
The fund is contrarian by nature. Managers seek out companies facing some kind of challenge or controversy or where other investors are "disinclined to play." In addition, the fund is unconstrained and can invest anywhere in the world and within all market capitalizations and uses options to reduce risk. "We don't predict the direction of the market, so we're net long," he said. The fund's promise to investors is to be, roughly, 50% net long at all times.
The fund will typically take long positions in stocks with unrecognized value, undervalued growth and/or those in special situations, while it will offensively take absolute short positions in stocks it believes are fundamentally undervalued, and relative short positions in stocks to hedge its long holdings.
"This is an easy market to lose your discipline in," Kozlowski said. "If you're not hedged in up markets, you won't be hedged in down ones."
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