Hedge funds have always been the Rolls-Royce of the investment world -- a sign of status and wealth for those able to buy their way in. With their lofty minimums, hedge funds have remained squarely out of reach for the common investor. But now the huddled masses yearning for these investments have a new tool at their disposal -- mutual funds that act like hedge funds.
The long and short of it
In recent years, fund companies have tried to capitalize on the popularity of hedge fund strategies by creating mutual funds that invest in a similar manner. The most common of these are long-short funds. Unlike most mutual funds, which exclusively hold stock positions, these funds typically short, or sell, a certain percentage of the portfolio, for which the manager receives cash. This cash is then sometimes invested back into the portfolio in long positions, resulting in a net exposure that can vary widely.
You can find long-short funds offered by several fund families. Franklin Templeton
One variety of long-short funds that has been gaining favor lately is the 130/30 fund. This strategy shorts 30% of the fund's assets and takes on a 130% long position. This structure is appealing because it allows fund managers to invest more than 100% of the fund's assets through the magic of leverage.
Using a long-short strategy also allows a manager to take additional bets on the market. Fund managers can bet not only on which stocks will do well, but also on which ones will underperform -- something not done with traditional long-only strategies.
Coming up short
However, as noted in a recent BusinessWeek article, the increasing popularity of long-short funds and a surge in private equity deals is making short selling more difficult. This increased demand for certain popular stocks has made borrowing more expensive. Commonly shorted stocks can cost anywhere from 2% to 40% a year, making it much more difficult for a short seller to make a profit. There has also been a marked increase in volatility for many of these stocks, as private equity firms have stepped into the game. All of these factors have contributed to a number of long-short strategies shutting down in recent months because of lack of opportunities. Many other managers have responded by altering their strategy to short indexes rather than individual stocks.
But aside from these issues, there is a more fundamental problem with long-short strategies: Most of them don't do very well. While there are a lot of investment managers and mutual funds out there, the number of such managers and funds that can beat the market on a consistent basis is a lot smaller. This holds true for long-short funds as well. In fact, a quick look at some Morningstar data shows that the long-short fund category has significantly underperformed the market and the average large-cap mutual fund the past few years:
|
Fund Category/Index |
One-Year Return Through June 2007 |
Five-Year Return Through June 2007 |
|---|---|---|
|
Long-Short Fund Category |
7.65% |
4.87% |
|
Large-Cap Blend Fund Category |
19.50% |
10.29% |
|
S&P 500 Index |
20.59% |
10.71% |
Source: Morningstar Principia
In fact, the only years in which the long-short fund category has beaten the S&P 500 Index in the past decade have been the bear market years of 2000-2002. In every other year, these funds have trailed the market, usually by wide margins. This would make sense, since these funds are taking on short positions and betting that certain stocks will go down. So when stocks in general do well, these funds can falter.
Playing it safe
If you have your heart set on playing like the big boys in the hedge fund league and want to own a long-short fund, keep in mind that just because these funds engage in hedge fund-like strategies, it doesn't mean you are guaranteed hedge fund-like returns. In fact, if the market has an up year, your long-short fund is much more likely to lag. Most investors are better off sticking to broad-market mutual funds or exchange-traded funds such as Spiders
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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. JPMorgan Chase is an Income Investor recommendation. The Fool's disclosure policy is short on looks, but long on smarts.
