Mutual funds around the world broke into the hedge funds market with their innovative and sophisticated long-short funds. In a long-short fund, “long” refers to stocks owned outright, while “short” refers to short-selling stocks that an investor believes will tumble. The strategy gives a manager flexibility to be bullish in one market sector and bearish in another. Long-short funds typically hold mostly long positions and tweak the portfolio’s percentage of short positions depending on market conditions. These funds make a directional bet, and if a manager’s stock selection is on target, he can do well in both, market rallies and corrections. Institutions and hedge funds routinely use both long-short and market-neutral tactics for capital appreciation and preservation.
While long-short managers typically focus on equities, their hedge fund counterparts invest in everything from currencies and commodities to airplane leases and hurricane insurance. The ability to sell stocks short is the main difference between long-short funds and standard mutual funds. Long-short and market-neutral funds are most often used to diversify a portfolio. Another difference between hedge funds and mutual funds is the ability to get your money. Mutual fund investors have access to the net asset value of their fund on a daily basis, either by phone or the internet and can withdraw money easily. Most hedge funds have significantly longer lock-in periods during which investors cannot get their money, making them a very illiquid investment.
Mechanism
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, these funds look for stocks that will outperform other equity investments. However, to eliminate general market risk, managers also look for stocks that they believe will under perform 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 long 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. These 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 equity mutual funds.
In a bull market, long-short funds will in all likely-hood under perform traditional stock mutual funds because their short positions will dampen returns. On the other hand, they will perform well during bear or volatile markets, since their short positions often provide strong positive performance when overall stock prices are falling.
When should you use this?
Asset allocation plays a prominent role in investors’ strategies, because it potentially produces improved risk-adjusted returns. A further step that investors can take to enhance their portfolio’s risk/return relationship is to invest in a long-short mutual fund. Most fund managers try to position these funds as a separate asset class itself, while this may or may not be correct, using it to reduce the risk from your equity exposure is possible.
However, one of the biggest risks such a fund runs is while shorting stocks, as this may increase the risk due to the potential for unlimited losses if the prices continue to rise. The flexibility these funds give allows the opportunity to achieve positive results in both long and short situations. These funds offer more protection in down-market environments. If the long and short positions completely offset each other, the portfolio is said to be market neutral. In other words, it should not be affected by bull or bear markets, but only by the manager’s skill.
Since there are numerous risks related to short selling, many long-short portfolios constrain such risks by using pair trades. Hence, while these funds do cut down on your overall market exposure risk by taking contrary positions and you may stand to gain a lot, if the fund manager chooses incorrectly you may also stand to loose. The real value is that these funds do something different than the rest of your portfolio and those investors who already own shares and are exposed to the equity market, may want to add this to their arsenal.