Long-short funds can help mitigate volatility

Alternative long-short mutual funds — also known as market neutral funds — can offer retail investors broader investment flexibility than traditional long-only funds.

With market neutral funds, fund managers try to minimize risk using both long and short positions.

A long-short strategy “offers a way to sleep easy at night and remain invested while stomaching the kind of ups and downs that you typically see during market cycles,” said Michael Kimmel, portfolio manager, U.S. equities, with Picton Mahoney Asset Management.

He offers an example of a long-short trade with similar broad market exposure: discount retailers in the United States. Dollar Tree Inc., he said, has seen its stock rise by 70% since it announced it would be increasing prices in its stores in November 2021. On the flip side, Dollar General Corp. doesn’t have any new initiatives and slipped 7% over the same period.

Pairing them (going long Dollar Tree and short Dollar General) mitigates “the impact of what happens within the broader equity market. And what you’re doing is isolating the ability of the portfolio manager to generate alpha by capitalizing on both positive and negative stock views of a company,” he explained.

Not all pairs are so perfect, he said, with most long-short funds focusing on a larger sector such as consumer discretionary or financial. Company pairs would be in the same sector, but not necessarily operate such similar businesses.

Over three years, a portfolio that is 54% equity, 36% bonds and 10% market neutral has performed similarly to a standard 60-40 portfolio, but with “greatly reduced” volatility, said Tommy Nguyen, manager and head of global equities with Desjardins Global Asset Management.

Nguyen said his firm’s market neutral ETF is long and short the same dollar amount, “so your net exposure is effectively zero.”

Kimmel said his firm’s long-short funds aim to “replicate market-like returns, with only half of the exposure to the overall market compared to a traditional mutual fund or ETF.” Specifically, his funds tend to hold about 150% long stocks, and “then we short approximately 100% that are not favoured by our investment process.”

Kimmel noted that investors want market-like returns, but can have trouble sticking to their strategies in the face of upheaval. Long-short strategies are designed to have lower sensitivity to equity markets and less volatility.

“By adding a long-short strategy at the expense of your existing equity mix, you’ll have less downside exposure in case things get rough. But you should still be able to generate equity-like returns over time in case your market call’s incorrect,” Kimmel said.

While long-short strategies can potentially earn profits in both bull and bear markets, there are risks. Kimmel said a fund manager’s thesis on both sides could be “simply incorrect.” Investors can also lag the market given the lower equities exposure inherent to long-short funds.

“In a rip-roaring bull market, if you have $100 invested in the bull market that’s up 20%, that’s obviously better than having $50 invested in that same market,” he said.

A third risk, Kimmel said, is “de-grossing”: when funds must close both their long and short positions when the price of the stock sold short begins to rise rapidly. They do this to manage risk and maintain the fund’s net exposure. If many funds held a similar short position, this mass selling puts pressure on the market, and could lead to losses for the fund. (De-grossing occurred with GameStop stocks in 2021, for example.)

For advisors, long-short funds provide clients hedging tools for more diversification for their portfolios with products that mitigate risk, especially in a volatile market environment, Nguyen said.

Other benefits, Kimmel said, include long-term capital appreciation and smoother equity returns.