Several prominent market-neutral or long-short investment managers are still hurting from the past three months.
Many long-short managers, which aim to profit from going long on stellar stocks and selling short equity albatrosses, typically use traditional stock valuation factors such as price-to-earnings and price-to-book value ratios in their mathematical models to cull the winners from the losers. Unfortunately for them, when the market ran into turbulence in late July and August, investors sought safe haven in some of the largest - but expensive - stocks that these models had rejected as overpriced.
Then, after the Federal Reserve Bank began easing interest rates in late September, investors rushed to buy small-capitalization, high-octane stocks that had been neglected in favor of large-cap stocks for most of the year. Because these stocks usually represent fast-growing companies, market-neutral managers with a traditional, value approach were once again left in the cold. This trend was heightened when the Fed loosened interest rates again in October.
As a result, some long-short managers got hit with a double whammy.
The spread between value and growth stocks was the widest in about 25 years, and low-priced stocks underperformed high-priced stocks to a degree rarely seen in the last three decades, some experts said. This trend reversed itself in October.
For the first 10 months of the year, the Russell 1000 Growth index was up 18.23%, while the Russell 1000 Value index was up 6.84%. At the same time, the S&P/ BARRA Growth index was up 23.76%, while the S&P/BARRA Value index was up 5.86%.
Market-neutral managers with a value tilt discovered that "what doesn't work for his long only, also would not work for his short only, so it's a double whammy," said Daniel Knight, portfolio manager at Columbine Asset Management, Colorado Springs, Colo. The firm, which manages about $130 million in long-short portfolios, also hit a downdraft in the third quarter, returning -1.5% in August, -0.8% in September and -1.8% in October, against the benchmark Treasury bills.
Even many of those long-short managers that emerged unscathed from the market's meltdown in August got bruised in September or October. "I was not sleeping as well in September as in August,"said Schorr Berman, president and chief investment officer of MDT Advisers Inc., Cambridge, Mass.
The firm, which runs approximately $190 million in long-short strategies, popped champagne corks at the end of August when the S&P 500 was down 14.4%, and the firm's Optimum Q Market-Neutral portfolio was down just 11 basis points, he recalled. But the portfolio got hit in September, losing 8% vs. the S&P 500's 6.41% gain, Mr. Berman said.
In October, the firm recovered somewhat, with its long-short strategy reporting a 1.2% gain, while the market clambered up 8.1%.
Even Aronson + Partners, the Philadelphia-based firm that does have a momentum or growth element to its strategy, had a "crappy September," acknowledged Theodore Aronson, managing partner.
Its long-short strategy produced 3.57% in August, was down 4.34% in September and logged a 74-basis-point return in October, he said. The benchmark T-bills, meanwhile, posted 0.43% in August, 0.41% in September, and 0.41% in October.
Meanwhile, Rosenberg Institutional Equity Management, Orinda, Calif., which manages about $1.4 billion in long-short investment strategies, lost about 1.5% in September and about 3% in October, after logging a gross return of 5.5% (before fees) in August, said Will Jump, director of market-neutral strategies.
"The kind of portfolios we build have a value bias to them, and that was a particularly painful exposure to have in September and October," he said.
Despite the pain, most long-short managers are planning to stay the course. A few, however, including MDT, have decided to lower their tolerance for pain by fine-tuning their model to accept less risk, Mr. Berman said.
Of course, not all market-neutral managers have suffered long term from the shorter blips.
INVESCO, for example, which manages $960 million in long-short strategies, logged a 9.5% return in the 10 months ended Oct. 31, vs. 4.3% for the benchmark Treasury bills, said Donald Young, managing director and head of the firm's structured products group, New York. An equitized version, with an S&P 500 futures overlay, logged a 20.4% return in the first 10 months, vs. 14.6% for the S&P 500 benchmark. The firm's long-short strategy returned 2.96% in August, lost 2.98% in September, and returned 0.9% in October.
The INVESCO strategy probably did well because the firm has a much lighter value flavor in its strategy than other market-neutral managers, Mr. Young said. The firm tries to minimize the risk of overexposure to a style, industry or the market as a whole, preferring to spend all of its "risk budget" on stock selection, Mr. Young said.
Moreover, unlike many other market-neutral firms, INVESCO focuses on picking winners and losers from the 500 largest companies.
Meanwhile, Roseland, N.J.-based Jacobs Levy Equity Management's long-short portfolios were up 9.02% this year through Oct. 31, compared with 4.17% for the benchmark Treasury bills, said Bruce Jacobs, principal and co-chief investment officer. The firm earned 7.8% in August, was down 2% in September and lost 5% in October. The market's surprise comeback in September eliminated opportunities for selling short laggard stocks, Mr. Jacobs noted, commenting on the strategy's hiccups in September and October.
The firm uses a "multiplicity of ideas" in its model, instead of a value tilt, Mr. Jacobs pointed out.
At the same time, Los Angeles-based Salus Capital Management Inc. logged a 10.04% return for the year ended Sept. 30 and was up 0.5% in the third quarter of 1998, said Bradford J. Ebner, president. The firm, which runs about $450 million in long-short portfolios, focuses primarily on large-cap stocks, with virtually no exposure to technology stocks, and shuns a value approach, although it does take some traditional measures of stock valuation into consideration, Mr. Ebner said. "A diversified model helps, because if one part of the model is not working well, another part is," he said.