Using Risk Factors to Understand Long/Short Equity Mutual Fund Returns: Part 3

In the final article in this series we review our efforts to account for the long/short nature of long/short equity (LSE) mutual funds and discuss whether a commodity factor could add insight. Finally, we give our conclusions from the study.

Option-Like Features and a Commodity Factor

Following the work of Chen and Passow[1], we tested the “optionality” (the long/short abilities) of LSE funds by using at-the-money and out-of-the-money calls and puts. We found, similar to Chen and Passow, that modeling the optionality of LSE funds did not add value to our understanding of LSE fund returns. This indicates that the fat-tail risk in LSE funds is not as evident as in market-neutral funds, which have a lower volatility. Risk in LSE funds is more strongly reflected by their volatility compared to market-neutral funds, which generally exhibit low volatility but can have higher fat-tail risk[2].

Again following Chen and Passow, we included a commodity factor–the GSCI index–and found that this factor did not add to our understanding of LSE returns. This is in contradistinction to Chen and Passow, who did find evidence of explanatory power for the GSCI index in their LSE hedge fund study. The reasons for this difference could be several and at a minimum could include that Chen and Passow’s work analyzed LSE hedge funds, while this study focused on LSE mutual funds.

Conclusions

In this study we found that for most LSE mutual funds, 50%-80% of returns can be explained by using standard risk factors such as capitalization, book-to-value ratio, dividend-yield ratio, and volatility. The explanatory strength of these factors is such that an option overlay (used to examine the impact of the funds’ long/short abilities) adds no value in terms of understanding the funds’ returns. So, as with many other equity mutual funds, LSE fund returns can to a significant extent be explained using standard risk factors.  However, this does not make LSE funds good candidates for passive exchange-traded fund manufacture. We write this because of the strong interactive (read nonlinear) role the volatility factor plays in almost all LSE funds. While the Amenc et al.[3] study of smart-beta funds also included a volatility factor, we are not aware of any “index-based” product that provides a factor tilt such as value versus growth and a low-volatility tilt such as that provided by using one of the MSCI Minimum Volatility indices. For LSE funds the management of this risk factor/volatility interface sits squarely in the portfolio manager’s hands.

We also showed that many funds do have positive alphas, but their alphas for the most part are not statistically significant, i.e., in reality they are no different than zero.  None of the funds we studied had a statistically significant negative alpha.

The fact that just about all of the LSE funds we studied had an alpha equivalent to zero should come as no surprise. LSE mutual funds are constrained in ways that make it much more difficult to capture and hedge positive alpha; these constraints do not exist for hedge funds. This means there needs to be a greater emphasis by LSE mutual fund purchasers on a consistency of returns, higher risk-adjusted return such as measured by the Lipper Leader for Consistent Return or the Sharpe ratio, and downside-protection metrics such as maximum drawdown and downside deviation.

The fact that there are “low” volatility tilts paired with one or more positive tilts on other factors explains why LSE mutual funds tend to return less than long-only equity mutual funds when the stock market is up and why they perform better than long-only funds when the stock market is down. It is this often-unstated call-option-like feature of LSE funds that is one of the strongest reasons for purchasing them.

Finally, since many LSE funds can be characterized in general as factor models with little or no alpha, what sets them apart from smart-beta products? Smart-beta products offer downside protection and upside benefits–the aforementioned call-like option–and have the “benefits” of being index products. We will examine this topic in a future series of articles.