Investors seeking to hedge their portfolios in today’s volatile market via all-in-one mutual funds might be better off doing it themselves.
It would be hard to find a mutual fund investment category with a wider division of returns than Morningstar’s Long-Short Equity this year. The category’s hedged funds, which are supposed to protect against downturns by shorting, or betting against, certain stocks, have become utterly unpredictable.
fund (ticker: BIVRX), which bets on value stocks and against growth, is up 46.7% this year, while the
RiverPark Long/Short Opportunity
fund (RLSFX), which bets on high-growth stocks and against low-growth ones, is down 46.3%. Of the 77 long-short funds, only 18 have positive performance in 2022, and most have poor long-term returns. (Even if you wanted to chase Invenomic’s hot performance, the fund is closed to new investors.)
Is there a simpler way to hedge a portfolio in today’s volatile market? Long-short funds tend to be expensive and don’t do a tremendous amount of shorting. The average annual long-short equity fund fee is 1.95%, including shorting costs. Excluding them, the cost is 1.52%. An investor can simulate a long-short fund with two separate funds for less—and more effectively.
The potential benefits of such a strategy are twofold. The stock market is down this year, and many experts think a recession is inevitable, so a hedge against further downside can help protect your portfolio. Plus, a two-fund long-short strategy can target specific market trends like the value-versus-growth stock performance dichotomy we’ve seen this year, which Invenomic has exploited.
Let’s say you like value stocks now but are bearish on the market overall. Consider that the
exchange-traded fund (VTV) has an annual 0.04% expense ratio, while the
Direxion Daily S&P 500 Bear 1X
ETF (SPDN) charges 0.49%. The former tracks the CRSP U.S. Large Cap Value Index; the latter provides the daily inverse of the
rising when the S&P 500 falls and vice versa.
A simple 50-50 portfolio of these two ETFs would cost only 0.27%, and would be up 5.3% in 2022, with the Vanguard ETF down 0.7% and the Direxion short ETF up 11.3%. The average long-short mutual fund is down 4.5% this year.
|Step One: Pick a Long Fund|
|Fund / Ticker||Expense Ratio|
|Vanguard Value / VTV||0.04%|
|Step Two: Pick a Short Fund|
|Fund / Ticker||Expense Ratio|
|AdvisorShares Dorsey Wright Short / DWSH||3.68%*|
|AdvisorShares Ranger Equity Bear / HDGE||5.20*|
|Direxion Daily S&P 500 Bear 1X / SPDN||0.49*|
|Leuthold Grizzly Short / GRZZX||2.98*|
|Invesco S&P 500 High Beta / SPHB||Short Int.*|
|ProShares Short QQQ / PSQ||0.95*|
|Step Three: Find The Right Long-Short Balance||50% Long / 50% Short YTD Return||75% Long / 25% Short YTD Return|
|Vanguard Value + AdvisorShares Dorsey Wright Short||4.9%||2.1%|
|Vanguard Value + AdvisorShares Ranger Equity Bear||7.6||3.4|
|Vanguard Value + Direxion Daily S&P 500 Bear 1X||5.3||2.3|
|Vanguard Value + Grizzly Short||8.7||4.0|
|Vanguard Value + Short of Invesco S&P 500 High Beta||6.0||2.5|
|Vanguard Value + ProShares Short QQQ||10.6||5.0|
Note: Returns through May 27. *Funds that short directly have higher fees on the surface from their short interest expense, which they can recoup via cash investments. You can do the same if you short the Invesco ETF directly. ProShares and Direxion use short derivatives, which embed shorting costs.
Though effective in 2022, such an ETF pairing would be a blunt instrument, and investors can hone their strategies more effectively. For one thing, a 50-50 long-short split isn’t what most long-short funds do. To be in Morningstar’s Long-Short Equity category, a fund will “typically have beta values to relevant benchmarks of between 0.3 and 0.8.” Beta indicates the sensitivity a fund has to the market. A 0.8 beta indicates an 80% sensitivity, so that if the market rises or falls 10%, the fund rises or falls 8%.
A 50-50 long-short pair would be close to a 0 beta, or 0% market sensitivity. To have more upside potential, you could have 75% of your portfolio in a long fund and 25% in a short fund, and target a beta of about 0.5. The 25% short hedges 25% of your long portfolio, leaving you 50% net long. You could also switch from shorting the S&P 500 to shorting tech—a poorly performing sector in 2022—by shorting the tech-laden
Nasdaq 100 Index
ProShares Short QQQ
ETF (PSQ), up 22% this year.
The nice part is you have complete control over the exposure. Additionally, using two separate funds enables you to harvest tax losses if the long or short fund is declining—a likely scenario, as the funds move in opposite directions. You can’t do that with a single long-short fund.
Of course, in a strong bull market, the strategy will probably underperform, but having beta exposure should capture some of the upside.
More-sophisticated strategies are possible if you short funds or individual stocks yourself, instead of relying on an inverse fund like Direxion’s or ProShares’. Yet there are shorting costs and risks because the potential downside for short positions is unlimited. If, say, an ETF rallies 200%, you’ve lost double your investment, although diversified ETFs rarely go up so much.
“Very high-beta stocks tend to underperform in the long run, so I would advocate that [investors] short an index ETF” like
Invesco S&P 500 High Beta
(SPHB), says Harin de Silva, a portfolio manager at Allspring Global Investments who specializes in long-short strategies.
One appeal of shorting high-beta stocks: A little goes a long way. A 20% short position is plenty, with 80% long in another fund. That’s because high-beta stocks fall more in downturns, so you need a smaller short position to hedge. For instance, during the pandemic crash in 2020’s first quarter, Invesco S&P 500 High Beta fell 37.4% while the S&P 500 dropped 20%.
To refine your strategy, you could purchase an actively managed mutual fund or ETF on the long or short side that will adjust its exposures based on market conditions. This way, you aren’t relying on value stocks to outperform the broad market, as in the previous example.
There are three actively managed short funds that have proved effective in downturns:
Leuthold Grizzly Short
AdvisorShares Ranger Equity Bear
(HDGE). Dorsey Wright Short employs a simple strategy of shorting the 75 to 100 companies with the weakest price momentum. If growthy tech stocks are doing poorly, it shorts them, but if the market turns and value stocks start to underperform, it adjusts to short them instead.
The fees on AdvisorShares Dorsey Wright Short—3.68%—seem exorbitant until you realize the management fee is 0.75% and 2.46% goes to short-interest expenses, which any short investor has to pay.
There is also a hidden bonus from shorting. When investors short a stock, they borrow its shares and sell them, hoping to buy them back later at a lower price. They can invest the cash they receive from selling the shares and receive interest on it.
Rising interest rates, like we have now, are bad for stocks but great for cash investments, which yield more to cover shorting expenses. It’s another reason that now could be a good time to employ this strategy.