By launching a long-only fund called Lone Cascade, Lone Pine Capital has not only given up hope of generating alpha on the short side, but has also taken a risky bet on the market. However good its stock picking (within reason), it’s hard to see how Lone Cascade will make money in a down-market.
This observation elicited two responses.
One response was to argue that ultimately it’s always possible to make money on the long side if your holding period is long enough. So if shorting is becoming increasingly hard, it’s fine to adopt a long-only strategy. Personally, I don’t buy that. Current predictions of long-term returns from the US equity markets are unusually pessimistic; just read Hussman’s and Grantham’s letters (which I’ve linked to from the Market Resource Page) and this analysis of Mauldin’s book Bull’s Eye Investing. There’s good reason why investors should want to limit their market exposure.
The second response was more interesting. By abandoning short-selling, Steve Mandel is not committing investors to a long-only portfolio. Limited partners in Lone Cascade can hedge their long exposure by shorting exchange-traded funds (ETFs) or buying put options themselves. Since hedging with market indices is non-alpha-generating, there’s no reason why hedging Lone Cascade should be done by Lone Pine rather than its limited partners.
Although this seems like a fairly technical and limited issue, it’s actually critical to the fund management industry. Individual investors would think differently about the risks and uses of mutual funds if they were encouraged to invest in mutual funds on the long side while hedging their net market exposure by shorting ETFs.
The spread of do-it-yourself hedging using ETFs would have three consequences.
First, it would effectively open hedge funds to anyone with a margin account. All you’d have to do would be to choose a few mutual funds and a few index ETFs to short. Voila! A managed account in E*Trade or Ameritrade. The current SEC rules that restrict access to hedge funds to "qualified" (ie. wealthy) investors would effectively disappear over night.
Second, it would expose the real (pathetic) performance of most mutual fund managers. Most investors don’t really know how much value their mutual fund managers add or destroy. But if you were running a market-neutral portfolio consisting of long-only mutual funds and short positions in index ETFs, it would become painfully clear how badly most mutual fund managers trail their benchmarks on an after-fees, after-tax basis. (They probably under-perform the market by 2-3 percentage points per year, and that's excluding taxes.) Year after year, your portfolio would be plain and simply down. Which would probably lead smart investors to do the opposite: with the introduction of active ETFs, you’ll be able to go long the index and short the active manager. Interest in the Magellan Fund would rocket…
Third, the introduction of do-it-yourself hedging would throw an uncomfortable spotlight on hedge fund fees. Look at it this way. You can buy the Legg Mason Value Trust (MUTF:LMVTX) and pay an annual fee of only 1.7%. If you shorted the S&P 500 ETF SPY, 0.1% of the value of your short position would be eaten up by the annual fee on SPY. So your net annual fee would be 1.6%. For that, you’d get a superb fund manager and a low volatility portfolio with limited market risk.
Does the possibility of do-it-yourself-hedging let Steve Mandel off the hook for Lone Cascade? I don’t think so.
Many of Lone Pine’s limited partners will find it hard to perform the hedging themselves. Separating long and short positions into separate accounts exposes the investor to margin calls on the short-side. Limited partners won’t know what Lone Cascade’s net long exposure is on any given day (ie. how much of the fund is in cash). Nor will they know which countries the fund is invested in at any given moment. So in practice getting the hedge right – choosing the right ETFs in the right proportions – will be harder for the limited partners than for Lone Pine itself.
And finally, it’s not clear that Lone Pine should abandon the short side. Even if it can’t find individual stocks to short, it could add value by selecting overvalued asset classes on the short-side. (US small cap growth, perhaps?) And having the option to short stocks as well as ETFs would give it alpha-generating potential should the right circumstances arise.
By devolving the task of hedging, Lone Pine is therefore placing a tough burden on its limited partners and curtailing its own alpha-generating potential.
But perhaps the impact on Lone Pine will be overlooked as the introduction of do-it-yourself hedging changes the fund management industry.