Hedge Fund Investing Chapter 5 Part 2: Long/Short Equity Risk and Returns

In Part 1 we covered how long/short equity funds work, the five strategy types, and how they construct portfolios. Now let’s look at the business side: fees, redemptions, historical performance, and how investors evaluate these managers.

Fund Terms and Conditions

Long/short equity funds charge the usual hedge fund fees: 1-2% management fee and 15-20% performance fee. But the terms around getting your money back vary a lot by strategy.

Here’s a typical variable bias fund setup:

• Minimum investment: $1 million
• Subscription: Monthly (you can put money in monthly)
• Redemption: Quarterly (you can take money out quarterly)
• Notice period: 65 days before the quarter ends
• Lockup: None
• Leverage: 1.5x to 4x
• High-water mark: Yes (manager only earns performance fees on new highs)

The liquidity of the fund matches the liquidity of what it trades. Quantitative market neutral funds trade the most liquid securities, so they can offer monthly redemptions. Event-driven funds hold more illiquid positions and may require annual redemption with initial lockup periods. Risk arbitrage falls somewhere in between.

That 65-day notice period is worth understanding. If you want your money back at end of March, you need to tell the manager by late January. Miss that window and you wait until next quarter. It’s not like selling a mutual fund where you get your cash in three days.

Flows and Performance

The strategy grew fast. From $250 billion in AUM in 2002 to about $700 billion by end of 2007. The 2008 crash hit hard. By end of 2011, AUM had recovered to only $550 billion, still below the 2007 peak.

Flows were positive in all but four years between 1990 and 2010. The worst period was late 2008 through early 2009, when investors were pulling money out at the same time positions were losing value. A double hit. But the strategy bounced back strongly in the second half of 2009 and through 2010-2011.

Quarterly performance was mostly positive over full business cycles. Equity market neutral and risk arbitrage had fewer down quarters than the broader long/short equity category.

For context, as of early 2012 the largest long/short equity funds were:

Tiger Global Management, a long/short equity fund, outperformed all large hedge funds in 2011 with a 45% return. Out of the top 100 hedge funds ranked by Bloomberg Markets, at least 17 were long/short equity.

What Does a Long/Short Equity Manager Look Like?

Funds come in all sizes and stages. You have newly launched firms with a single fund and you have legendary operations with decades of track record.

The book profiles three examples:

Edenbrook Capital Management is the new kid. Launched in late 2011/early 2012 by Jonathan Brolin, who had 16 years of investing experience. Focus: concentrated, small-cap value investing with identifiable catalysts. The firm takes a private-equity-style approach to public markets. They look for stocks with 4-to-1 upside-downside ratios and work with management teams to unlock value. Long-term holding periods of one to three years.

Algert Coldiron Investors (ACI) is the established player. Founded by two former managing directors from Barclays Global Investors. Partners have worked together for 17+ years. They run quantitative market neutral equity strategies. Their edge: deep research program with ties to academic finance. They believe a strategy’s success depends on constant evolution as markets change and competitors enter.

Renaissance Technologies is the legend. Founded by Jim Simons in 1982. Former math professor at MIT and Harvard. The firm employs about 275 people, manages over $15 billion, and averaged 35%+ returns on its main fund since 1989. They use sophisticated quantitative methods to find patterns in stocks, currencies, and commodities. Computer models exploit temporary mispricings. Simons stepped back from daily management in 2010 but remains chairman.

You can research any SEC-registered manager yourself at www.sec.gov/answers/formadv.htm. Every registered advisor files a Form ADV with details about their business.

Measuring Returns and Evaluating Risk

Funds report monthly returns net of all fees and expenses. From that monthly data, investors calculate:

Return metrics:

• Annualized returns
• Best and worst months
• Rolling 1-year, 2-year, 5-year returns
• Return since inception

A real example from the book shows a variable bias fund with annualized returns of 10.11%, best month of +13.66%, worst month of -12.85%, and a 5-year rolling return of 61.88%.

Risk metrics:

• Sharpe ratio (return per unit of risk, given a risk-free rate)
• Sortino ratio (like Sharpe but only penalizes downside volatility)
• Annualized standard deviation (how much returns bounce around)
• Maximum drawdown (biggest peak-to-trough loss)
• Value at Risk (VaR) at 90%, 95%, and 99% confidence levels
• Calmar ratio and Information ratio

For that same variable bias fund: Sharpe ratio of 0.59, standard deviation of 13.71%, maximum drawdown of -20.07%, and only 63.33% of months were positive. VaR at 95% confidence was -5.63%, meaning in a typical bad month you could expect to lose up to 5.63%.

Investors evaluate managers two ways:

1. Time series analysis - Is this manager consistent over time? Are risk metrics stable or getting worse?
2. Cross-sectional analysis - How does this manager compare to peers running the same strategy?

The big picture comparison: long/short equity as a category has outperformed the S&P 500 with about half the volatility and a better worst-case month. But the strategy has higher correlation to equity markets than global macro, and slightly lower returns than global macro for the same period.

Summary and Outlook

Long/short equity gives investors a range of choices, from conservative market neutral to aggressive event-driven. Adding any of these strategies to a traditional portfolio can lower volatility and improve risk-adjusted returns.

But managers face real challenges. Markets are volatile. Counterparty and operational risks are real. Financing is not always stable. Returns have been lower than in the past. Institutional money is still flowing in but at a slower pace. And smaller funds face the extra challenge of just surviving as a business while also managing money.

The bottom line: this is the most accessible hedge fund strategy because it’s built on the same stocks and analysis that traditional investors use. The difference is the tools. Leverage, short selling, and flexible mandates let skilled managers extract returns that a long-only investor simply cannot. But “skilled” is the keyword. Not everyone who shorts a stock knows what they’re doing, and the extra tools come with extra risks.

Previous: Chapter 5 Part 1 | Next: Chapter 6

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.