Lone Pine's long-only bet is risky

Steve Mandel's Lone Pine Capital has approached its current investors about a new long-only stock fund, to be called Lone Cascade. So you thought that mutual funds were entering the hedge fund market? It seems the opposite is happening: Lone Pine is entering the long-only mutual fund world.

A few quick details about the Lone Cascade fund. Lone Pine says it should launch in early January 2005, and will invest in 25-50 stocks which will also be purchased for Lone Pine's hedged long-short portfolios. The fund's marketing materials state that no leverage or currency hedging will be used, stocks will be picked globally with total emerging market exposure limited to 15% of the fund, and positions will be capped at 10% of capital under management. Initial subscriptions will be limited to $2 billion.

Investors can choose between two fee structures. They can pay a 1% annual management fee plus an incentive fee of 10-20% of the outperformance versus the MSCI World Index, depending on the time period the investor commits to. Or, if they really want to take the mutual fund route, they can elect to pay a pure asset-based fee of 1.5-2%, again depending on the length of commitment.

Why would investors want to do this? First, Lone Pine argues that its long stock picks have outperformed the S&P 500 over the last couple of years, returning a total of about 48% versus less than 20% for the S&P.

Second, and more important, Mandel says that shorting stocks is becoming harder:

The constraint on the growth of our existing funds comes from the short side of our balance sheet. The number of compelling short ideas is limited and the recent flood of money into hedge funds has increased the competition for these stocks. We therefore believe that the ability to add value through shorting in the years ahead will be more limited than it has been. Thus, it is our view that a long-only fund can provide competitive net returns with a comparable long-short fund over the intermediate term.

This is a remarkable statement that every hedge fund manager and investor should take note of. Mandel is conceding that alpha generation, particularly on the short side, is becoming harder as hedge fund assets grow, to the point where adding significant scale to long-short portfolios will fail to generate adequate returns.

But note the non-sequiter. Just because alpha generation will be harder on the short side doesn't jusfify an all-long portfolio. Look at it this way. Stock market returns over the next decade could be lousy, due to the US budget and current account deficits, the deflationary impact of China and India, high current equity valuations and global population aging. However good Mandel's long stock picks are, he'll be hard pressed to deliver positive returns in a down market. This might be a truly lousy time to launch a long-only fund.

Lone Pine says its employees will be "significant investors" in the new fund. They'd better hope that global equity markets do OK, or their profits will be far less than the 28% compound return Lone Pine has delivered until now.