The Long and Short of Playing Both Sides

If you're looking for a convenient way to own stocks, mutual funds and exchange-traded funds are an excellent choice. Whether you want to buy the whole market with a fund such as Vanguard Total Market ETF (AMEX: VTI  ) or focus in on particular sectors with funds such as Energy Select SPDR (AMEX: XLE  ) or iShares Emerging Markets (AMEX: EEM  ) , you'll almost certainly find what you're looking for.

Yet no matter what sectors your mutual fund or ETF focuses on, nearly all stock funds are subject to overall market risk. If the broader stock market falls in value, then it's extremely likely that your fund's price will decline as well. While some stocks are less correlated with the overall market, it's still difficult to put together a portfolio of stocks that will perform completely independently of the stock market as a whole.

As a result, stock funds tend to do poorly when the market falls. Even though one can argue that a fund has been successful if it drops less sharply than a broad market index such as the S&P 500, some investors want to earn positive returns regardless of the market's average returns. In response, some money managers have developed funds that seek to provide returns that don't rely on the overall market's return. Known as long-short or market-neutral funds, these investments won't necessarily behave like your typical stock mutual fund.

The concept of long-short funds
The idea behind long-short funds is relatively simple. In theory, the easiest way to hedge the risk of the overall market is to take two separate approaches to making investments. First, as with any other stock mutual fund, long-short fund managers look for stocks that they believe will outperform other equity investments and then add those stocks to their portfolios. However, to eliminate general market risk, managers also look for stocks that they believe will underperform other equities and then sell shares of those stocks short.

The theory behind long-short funds is that regardless of the overall market's direction, a fund that chooses its investments well will be successful. If the market rises, then the stocks in the fund may provide exceptional returns, while the stocks the fund sold short will fall or at least not rise as much as the market. On the other hand, if the market falls, the stocks that the fund sold short will be the ones to provide a good return and hopefully make up for any money the fund loses on the stocks it bought.

Gauging success
Before you can evaluate whether long-short funds have succeeded in accomplishing their objectives, you first have to understand their overall objective. Long-short funds have two general goals. First, they try to earn a rate of return that exceeds the average historical return of stocks. Second, they seek to make the fluctuations in value less volatile than those of traditional stock mutual funds.

What that means is that investors in long-short funds have to ignore overall market returns completely. In a bull market such as the one that started in 2002-03, long-short funds will almost always underperform traditional stock mutual funds because their short positions will dampen returns. On the other hand, long-short funds perform exceptionally well during bear markets, since their short positions often provide strong positive performance when overall stock prices are falling. Therefore, comparing the performance of a long-short fund with the returns of the S&P 500 can be extremely misleading and isn't a fair measure of the fund's success.

So does it work?
The universe of long-short funds is relatively small. Before securities laws were amended in 1997, a prohibition on mutual funds earning too much income from short-term positions made it functionally impossible for a long-short mutual fund to operate. As a result, the track record for these funds isn't long enough to draw any firm conclusions.

However, looking at the limited data available reveals a mixed picture. Although one fund, the Diamond Hill Long-Short Fund (FUND: DIAMX  ) , has performed quite well, with an average return of about 12% over the past five years, its peers haven't been nearly as successful. Franklin U.S. Long Short (FUND: FUSLX  ) , for example, has actually lost money in the most recent five-year period.

Although many hedge funds that use this strategy have been successful, it isn't clear that the concept has yet been translated into the mutual fund universe. One problem with the strategy is that it's more expensive than a traditional mutual fund; these costs reveal themselves in higher expense ratios than typical equity mutual funds carry, as well as in relatively high levels of portfolio turnover. Even with the high level of fees, the compensation available to long-short managers in the hedge fund universe is even higher, and so it may be that mutual fund companies have difficulty securing the most talented managers to run these funds.

Long-short mutual funds represent an interesting concept in investing. Given the emphasis on short-term performance, they will likely remain somewhat unpopular until the next substantial market drop, at which time people will point to their having outperformed traditional mutual funds as a justification for adding them to their portfolios. As a long-term strategy, however, the idea has merit, but it's too early to tell whether mutual funds can match the success of their hedge fund cousins.

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Fool contributor Dan Caplinger has worked with investors in hedge funds but hasn't recommended their mutual-fund counterparts. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy stays stable in moving markets.


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