ALTERNATIVE PERSPECTIVES

Do Hedge Funds Have An Edge Over Alternative Mutual Funds? The Case of Equity Long/Short Strategies

May 2016

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Do Hedge Funds Have an Edge Over Alternative Mutual Funds?The concept of hedge fund returns in a convenient mutual fund format with daily liquidity and no performance fees certainly seems enticing. Yet there is still an allure for hedge funds, whose total assets under management swelled to more than $2.9 trillion1 by the end of 2015. The research team at Steben decided to take a closer look by examining the alpha and beta to the S&P 500 of all equity long/short hedge funds in the BarclayHedge database and all equity long/short mutual funds in the Morningstar database.

We analyzed data from January 2013 to December 2015. We chose this period because it provided a large, comparable data set. Earlier periods had substantially fewer equity long/short mutual funds. Of course a different time period might have produced different results. We analyzed performance net of fund fees and expenses for both mutual funds and hedge funds.

Our study revealed that for equity long/short strategies, portfolio diversification through low beta and positive alpha may be best achieved through hedge funds rather than mutual funds.

The Rise of Liquid AlternativesUp until the financial crisis, most individual investors held a mix of long-only allocations in traditional asset classes such as stocks and bonds. During the crisis, asset correlations increased substantially and portfolio diversification properties decreased, resulting in large losses for many investors. Investors learned that true diversification often requires a more sophisticated approach that includes uncorrelated asset classes and strategies.

After 2008, investors were allured by the promise of non-correlation with the rapid expansion of the liquid alternatives industry. Assets under management grew from less than $75 billion to more than $350 billion2. These liquid alternative products, including mutual funds and ETFs, were designed to employ non-traditional strategies that were once exclusively available to large institutional investors through private hedge fund offerings.

While much has been written about the potential benefits and challenges of alternative mutual funds, the more important question is whether hedge funds have a performance edge over alternative mutual funds, and if so why?

1. Source: HFR Global Hedge Fund Industry Report2. Source: Morningstar. Historical assets held in publicly offered US alternative ’40 Act mutual funds and ETFs,

as defined by the Morningstar US Open-Ended Multi-Alternative Category for the period ending December 31, 2014.

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Alternative Mutual Funds and Hedge Funds Are Structurally Different

Alternative Mutual Fund Hedge Funds

Liquidity Daily Liquidity Typically monthly or quarterly; may be

subject to lock-ups

Pricing Daily NAV Typically Monthly NAV

Tax Reporting 1099 K-1

Availability Available to most investors

Limited to accredited investors and qualified

purchasers3

Minimum Investment Low, typically <$10,000 High, typically >$100,000

Fees Typically higher than traditional mutual funds;

no performance fees

Higher management fees and performance fees

Use of Leverage Borrowing limited to 33% of assets

Unlimited

Regulation Subject to the Investment Company Act of 1940

Fewer regulatory constraints

Alternative Mutual Fund ConstraintsAt a very high level, alternative mutual funds impose significant restrictions that may constrain trading strategies. This may reduce the investment opportunity set compared to hedge funds that are not required to operate under the same limitations. For example, the daily liquidity requirement can lead alternative mutual funds to focus on widely followed large-cap stocks rather than less efficient areas of the market, where less frequently published research may enable a diligent active manager to attain an investment edge. Mutual funds are also beholden to limitations on leverage and short selling that can hamper the ability to employ strategies such as market neutral, which requires moderate amounts of leverage.

3. An accredited investor is an individual with yearly income of more than $200,000 ($300,000 with spouse) in each of the last two years or net worth of more than $1 million, excluding primary residence; a qualified purchaser is an individual with a liquid net worth of at least $5 million.

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Moreover, since mutual funds cannot pay performance fees to managers, many skilled and experienced hedge fund managers are not interested in offering their strategy in a mutual fund structure. This creates an adverse selection bias in the quality of those remaining managers who do take part in alternative mutual funds. The resulting managers may have shorter track records, may have recently suffered asset outflows, or they may be traditional asset management firms attempting to transition into alternative strategies.

Equity Long/Short Strategies Performance StudyPerformance data over the three-year period from January 2013 to December 2015 illustrates the compromises that affect alternative mutual funds. Remember, alpha is the part of a fund return that does not come from its net exposure to the benchmark index (in this case the S&P 500). As such, alpha may be viewed as a measure of a manager’s stock selection skill. In contrast, beta reflects how closely a fund return follows the market index, and is therefore a measure of the net long bias of a fund. In the following charts, we plot the bell curve distribution of alphas and betas for the universe of equity long/short mutual funds and hedge funds.

Alternative Mutual Funds Have Higher BetaChart 1 shows that the distribution of betas for equity long/short mutual funds lies to the right of the distribution for hedge funds. This means that, on average, equity long/short mutual funds have a higher beta, and hence, are more long biased than hedge funds in the same strategy. Our study found that the median mutual fund has a beta of 0.51, while the median hedge fund has a beta of 0.28. For a 1% decline in the S&P 500, one should expect a 0.51% decline in the median equity long/short mutual fund and a 0.28% decline in the median equity long short hedge fund, in the absence of any alpha generation. One should therefore expect less downside protection from equity long/short mutual funds in a bear market than from comparable hedge funds.

Chart 1: Three-Year Beta ComparisonJanuary 1, 2013 – December 31, 2015

Hedge FundsMutual FundOverlap

Perc

ent o

f Obs

erva

tions

0%

10%

20%

30%

(1.5

)

(1.3

)

(1.1

)

(0.9

)

(0.7

)

(0.5

)

(0.3

)

(0.1

)

0.1

0.3

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2.5

Fund Beta

Source: BarclayHedge – All Equity long/short hedge funds, Morningstar – All equity long/short mutual funds.

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Alternative Mutual Funds Have Lower AlphaMeanwhile, Chart 2 shows that the bell curve distribution of alphas for equity long/short mutual funds lies to the left of the alpha distribution for hedge funds. This demonstrates that mutual funds achieved lower alpha and hence exhibited lower stock selection skill than hedge funds over the period. The median alpha of these mutual funds is actually negative -1.10% per year compared to a positive median alpha of +2.81% per year for hedge funds over the three-year period covered by our study.

Chart 2: Three-Year Alpha ComparisonJanuary 1, 2013 – December 31, 2015 (Annualized)

Perc

ent o

f Obs

erva

tions

Fund Alpha

0%

10%

20%

30%

40%

-35%

-30%

-25%

-20%

-15%

-10% -5% 0% 5% 10%

15%

20%

25%

30%

35%

40%

45%

Source: BarclayHedge – All equity long/short hedge funds, Morningstar – All equity long/short mutual funds.

Hedge FundsMutual FundOverlap

While we certainly acknowledge that not all hedge funds exhibited stock selection skill, the data suggests that few equity long/short mutual funds produced meaningful positive alpha. Investing in hedge funds is a challenging task. The limitations presented by alternative mutual fund regulations make that task even more difficult. Certain mutual funds will undoubtedly offer investors a more favorable experience, but the aggregate results suggest that mutual funds underperform hedge funds peers.

Our study suggests that equity long/short mutual funds with high beta and low alpha are unlikely to provide the benefits of diversification during bear markets that investors and advisors expect from alternative investments.

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Managed Futures ExceptionOf course there are exceptions to every rule. Our study focused on equity long/short mutual funds, which is the largest category of liquid alternatives. But if we look at other strategies such as managed futures, then we find that a more compelling case can be made for the mutual fund structure. This is due primarily to the high liquidity of futures markets, which in turn enables the mutual fund to meet daily redemption requirements. Furthermore, the core trend-following strategies used in managed futures mutual funds have historically maintained a low correlation to traditional asset classes such as stocks and bonds. Although many managed futures mutual funds tend to utilize less complex trading strategies than the flagship private hedge funds, many of these mutual funds have lower fees than hedge funds, which may benefit net returns.

So What’s the Conclusion?Our study reveals that fee restrictions, liquidity requirements and investment constraints have a real impact on net performance for equity long/short mutu-al funds compared to hedge funds.

Investors with a strong preference for convenience, low cost and liquidity may still find alternative investments in a mutual fund structure attractive. However, we would argue that if portfolio diversification through low beta and positive alpha are the most important investment goals, then our study supports the notion that equity long/short hedge funds may provide the better alternative.

We encourage you to check in with us regularly for upcoming white papers, and educational and topical pieces, including a series of ‘Alternative Perspectives’ that will continue to examine alternative mutual funds compared to hedge funds.

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The views expressed in this material are those of Steben & Company (“Steben”) and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events, or investment advice. Investors are cautioned to consider the investment objectives, risks, and charges of funds before investing. This does not constitute an offer to sell or solicitation of an offer to buy any security. Performance referenced herein is provided for illustrative purposes only and past performance is not indicative of future results. The information is provided for educational purposes only. Steben does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, and accepts no liability for any inaccuracy or omission. No reliance should be placed on the information and it should not be used as the basis of any investment decision. This information may not be reproduced or distributed without the prior written consent of Steben & Company. RISK CONSIDERATIONS: Managed futures, hedge funds, and funds of hedge funds and other alternative investments are not suitable for all investors. Their investment programs are speculative and performance can be volatile. An investor could lose all or a substantial amount of their investment. They involve a high degree of risk and often engage in leveraging and other

speculative investment practices that may increase the risk of investment loss. In addition, they can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees which may offset any trading profits. Diversification does not ensure a profit or guarantee against a loss. Alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Trading may occur outside the United States which may pose greater risks than trading on US exchanges and in US markets. Additionally, alternative investments often entail futures, forwards contracts and swaps trading, which involves substantial risk of loss and may be volatile. Other risks inherent in an investment in alternatives include short sales, options, derivatives, junk bonds, emerging markets and limited regulatory oversight.There may not be a secondary market for an investor’s interest in alternative investments, and none may develop. There may be restrictions on transferring interests in some types of alternative investments.

Alpha: A measure of risk-adjusted performance. A higher alpha indicates a security has performed better than expected with its given beta (or volatility.) See Beta.Beta: Measures a fund’s sensitivity to market movements by comparing a fund’s excess return (over a benchmark) to the market’s excess return. By definition, the beta of the market is 1.00. For example, a beta that is lower than 1.00 would normally indicate that a fund’s excess return is expected to be above the market’s excess return in a down year and below in an up year. However, beta is a measure of historical volatility and cannot predict a fund’s actual performance.Diversification: A portfolio strategy designed to reduce exposure to risk by combining a variety of investments. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.Equity Long/Short: A type of investment strategy that involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value.Hedge Fund: A managed portfolio of investments that uses advanced investment strategies such as leveraged,

long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Most hedge funds are often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they sometimes require investors keep their money in the fund for at least one year.Leverage: The use of various financial instruments or borrowed capital, such as margin, to increase the risk and potential return of an investment.Liquidity: The ability to convert an asset to cash quickly. Also known as “marketability.”Managed Futures: A form of alternative investment that takes long and short positions in futures contracts, currency forward contracts, government securities, and options on futures contracts. Managed futures are operated by licensed Commodity Trading Advisors, or CTAs, who are regulated in the United States by the Commodity Futures Trading Commission and the National Futures Association, or NFA.Mutual Fund: An investment vehicle that is made up of a pool of capital collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.

Definitions

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Gaithersburg, MD 20878www.steben.com

240.631.7600

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About Steben & Company

Steben & Company is a leading alternative asset manager. We specialize in multi-manager

products including a fund of hedge funds and managed futures strategies. Our investment

philosophy is defined by high conviction, actively managed exposures with a focus on

more liquid, lower beta strategies. Our funds are designed to provide investors with the

potential benefits of diversification and absolute returns regardless of market direction.

We seek to employ a repeatable investment process that incorporates rigorous due

diligence, manager selection, portfolio construction and ongoing risk monitoring. Through

our unique combination of resources and capabilities, Steben offers financial advisors

and investors distinguished investment opportunities that have traditionally been limited

to institutional investors.

Steben is an alternative investments innovator with more than 25 years of continuous

operating experience.