What are hedge funds and why did they outperform in the sell-off?

After enjoying the rarity of 12 positive months last year—and a sequence of strong weeks to open 2018—the U.S. market then posted its first correction in two years, with the lion’s share of the losses accruing in the first week of February alone.¹ This decline was more jarring than most. The Cboe Volatility Index, or VIX, had remained subdued for months, even reaching record-low, single-digit readings in mid-2017, but it spiked to an intraday high exceeding 50 on February 6, 2018.²

Until recently, being fully invested in U.S. stocks proved to be a profitable strategy for most of the past decade. Diversifying into other major asset classes has been a relative drag, as has hedging market exposure. However, the recent correction has prompted some investors to take another look at alternative strategies designed to limit losses during downturns.

Hedge funds have long played this risk-management role in the portfolios of accredited investors. But just what are hedge funds? And why have they done better than their unhedged peers in falling markets?

Rather than being confined to long exposure, hedge funds are private investment vehicles that can take long and short positions in a broad range of assets. The original hedge fund—a long/short equity fund—remains the category’s quintessential strategy, a style now available in select mutual funds, too.

Long/short managers buy positions in stocks that they expect to go up over time, and short—that is, borrow and sell—segments of the market that they expect to decline. The result is a fund that can pursue potential gains as stocks rise while also seeking to limit losses in market downturns. In addition to drawing on fundamental research of individual companies for investment decisions, long/short managers can also refine the fund’s overall systematic risk, or net market exposure—dialing it up, and paring it back, as macroeconomic conditions warrant.

Pairing long and short equity positions in a portfolio sounds good in theory, but how has it panned out in practice? Relatively well, as it turns out. Equity long/short funds outperformed the market during this year’s February sell-off. The first eight days of that month saw U.S. stocks fall 9%, while Morningstar’s long/short equity fund category declined only 5%, reflecting a downside capture ratio of 0.6. This tendency of long/short funds to partially protect investor capital extends to other episodes of market declines, too. In fact, equity long/short funds have fared better than their unhedged counterparts in each of the last six market pullbacks. During the correction of late 2015 and early 2016, they demonstrated a downside capture ratio of 0.6. When investors got spooked by the prospect of a slowing Chinese economy in the summer of 2015, long/short funds captured only half of the broader market’s decline. There is, of course, an opportunity cost to hedging your portfolio’s market exposure for greater downside protection: When unhedged equities enjoy an extended bull run, most long/short managers lag the broader market and their long-only peers.

Long/short equity was once available only to institutions, such as endowment and pension funds, and ultra-high-net-worth families and individuals. Now that the strategy has migrated into the mutual fund marketplace, long/short equity has become more broadly accessible today.

That’s good news for ordinary investors who don’t expect this bull market to continue indefinitely. U.S. stocks have had an impressive multi-year run; however, markets are uncertain, almost by definition. If “uncertainty and danger are always closely allied,”³ then investors would do well to recognize that complacency could prove costly once an extended market upswing inevitably turned south. Old age in and of itself may not necessarily represent a clear and present danger to this market cycle, but in a time of unusual and innumerable uncertainties, there’s plenty of cause for investors to move forward with caution today. Thankfully, investing in a portfolio of both long and short positions may help limit the reliance on rising market prices to drive positive returns.

Learn more about alternative investments here.

1 Morningstar, 2/28/18. 2 finance.yahoo.com/quote/%5EVIX/history?p=%5EVIX, 2/28/18. 3 Supernatural Horror in Literature, H.P. Lovecraft, 1927.