You have to wonder why anyone would want to launch a domestic long/short equity fund these days. The S&P 500 Index has climbed 15 percent in the last 12 months. Buying a low-cost index tracker like the SPDR S&P 500 ETF(NYSE Arca: SPY) or the iShares Core S&P 500 ETF (NYSE Arca: IVV) seems like a no-brainer.
Despite this, alternative asset managers persist. First Trust Advisors recently debuted the First Trust Long/Short Equity ETF (NYSE Arca: FTLS), an actively managed exchange traded portfolio that exploits forensic accounting to find its investment targets. What's that, you say?
Well, as First Trust's Ryan Issakainen puts it, the fund's managers use a proprietary methodology that measures the aggressiveness of a publicly traded company's accounting practices. Firms with low-quality earnings (read: “aggressive accountancy”) tend to be associated with lower future stock returns compared to more conservative companies. Higher-quality earnings, in this model, portend better returns. FTLS buys high-quality stocks while shorting the low-quality ones.
Over FTLS' brief life, there seems to be something to the quality notion. The fund was launched on Sept. 9 and, through Nov. 20, has outdone the S&P 500 by nearly 60 basis points (0.57 percent, to be exact) with significantly less volatility.
The question is, of course, can this last?
History seems to favor long/short strategies. Just take a look at the 20-year track record of long/short hedge funds. Cumulatively, long/short plays have bettered the S&P benchmark by 62 percent with a third less volatility. (See Chart 1.)
A caveat here. Hedge funds labeled as “long/short” could be trading in myriad investments, including equities, bonds, currencies or options. We need to take a closer look at equity-only portfolios. And we should concern ourselves with publicly traded products.
Searching for long/short equity portfolios in the mutual fund or ETF realms requires some discernment. There's a lot of dirt in the long/short category. Some funds labeled “long/short” are, in fact, market-neutral portfolios—meaning they target a zero beta. Not so with true long/short products: Beta, while potentially mitigated by short sales, isn't eliminated entirely.
