Most long/short managers really running long-only portfolios, says Cartesian

Investors should challenge their long/short hedge fund managers to prove that they are not running closet long-only portfolios, according to Cartesian Capital, the Edinburgh-based investment boutique established as a joint venture with Resolution Asset Management.

Andrew Kelly, co-manager of the Cartesian UK equity long/short fund, is convinced that many hedge fund managers focus almost exclusively on their long book and struggle to generate alpha in flat or falling markets.

He believes some simply short their benchmark index as a short cut hedge against their long book, which he argues removes the opportunity for short alpha and is potentially dangerous when markets are rocky, which they are widely predicted to be in the coming months.

Kelly suggests that investors have been lulled into a false sense of security by the bull market, which has cloaked managers' inability to make money from shorting. He says it is no coincidence that there is a strong correlation between the performance of many hedge funds and the mid-cap index, in which he believes most managers invest the bulk of their long book.

However, he says the two-month period to the end of June 2006 provided a clear insight into this long-only bias, when many UK equity hedge funds fell by 4 to 5 per cent, closely mirroring the performance of the mid-cap index. By contrast, the Cartesian UK equity long/short fund was flat.

The fund recently passed its first anniversary with a return of 21.4 per cent net of costs and fees, according to HSBC, the administrator and independent valuer of the fund. This places it second in a peer group of 33 UK-focused equity long/short funds for the 12 months to May 31, according to Lipper. Alpha from the short book has slightly exceeded that from the long book, with a standard deviation of just 6.06 per cent since launch.

'The recent downturn clearly showed that many hedge fund managers are simply running closet long-only portfolios,' Kelly says. 'They usually do well when the market performs well - but what happens when the index falls? As it stands, they are only making money from longs.

'Markets are going to be rocky over the next few months, and investors need to be confident they are backing someone who can make money in that environment. Investors should challenge their managers to prove that their performance is not coming purely from the long book because they will suffer when things become more difficult.'

Edinburgh-based Cartesian was launched in late 2005 and now has nearly GBP250m in assets under management, including more than GBP100m in its flagship retail fund, the ResolutionAsset Cartesian UK Opportunities Fund. The firm won its first major institutional client last year.

The firm is partnership is a 50/50 joint venture, with David Stevenson and Kelly providing the intellectual capital and fund management skills and Resolution delivering distribution and marketing as well as operational, risk and compliance functions.

Stevenson trained as a chartered accountant with KPMG and was involved in corporate finance before moving into venture capital with Dunedin. He spent 12 years with SVM before leaving to co-found Cartesian in 2005. Kelly qualified as an actuary at Standard Life, then Europe's largest mutual assurer, and worked in its investment division for four years as a UK equity analyst before joining SVM in 1996.

Resolution Asset Management is part of the group created by the merger of Resolution Life and Britannic Group, completed in September 2005. Resolution's total funds under management totalled some GBP59bn at the end of May.