An Anatomy of Long-Short Equity Funds

Abstract

An intriguing, perhaps surprising observation in the mutual fund industry is that long-short equity funds have had disappointing growth in the last two decades, although all regulatory restrictions on mutual fund short selling had been lifted by 1997. We shed light on this puzzle by conducting the first systematic study of long-short equity funds’ portfolio compositions, cash holdings, and capital flows. Our analyses reveal that: 1) long-short mutual funds hold substantially more cash (unexplained by margin requirements) than their long-only peers and have an average market beta of 0.6; 2) due to cash dilution, long-short funds slightly underperform their long-only peers in total returns despite earning an alpha of 5% a year on their risky holdings; and 3) long-short funds face much higher flow-performance sensitivities and more volatile flows, and are more prone to use cash to absorb capital flows. We propose a coherent way of thinking about these findings.

Keywords: Long-Short Equity Mutual Funds, Cash Holdings, Portfolio Beta, Fund Performance, Flow-Performance Relations