Long-Short Funds
“Market neutral” and long-short funds have the objective of protecting investors when the market drops. Management typically engages in short selling (betting stocks are going down) coupled with traditional long-term investments. Whenever you buy a security, you are going “long;” selling “short” is the opposite of going long. Selling short is the selling of a security the seller does not own in the belief it can be bought back at a lower price. The short seller is betting the security is going to later drop in price (when it is bought back by the short seller).
Disadvantages of short selling are: [1] potential losses are unknown (e.g., a $10 stock can only drop to zero; however, the same $10 stock could reach $20, $40, or $400 a share—the higher the price, the more the short seller loses—the seller must eventually buy back the stock); [2] since a security is being borrowed (from a brokerage firm), interest is being charged on the money used by the brokerage firm to buy the security that is then sold to the short buyer, and [3] interest charges accrue until the short seller covers the position by buying the security back.
There are ~ 275 funds classified as “long-short.” The typical expense ratio for this category is ~ 2%. There are significant differences between fund strategies. Long-short funds are sometimes confused with market neutral funds. Market neutral funds balance their short and long positions, giving them a net market exposure of zero; long-short funds either have a consistent long bias or adjust the long-short mix tactically over time.
Long-Short Funds [through 2011]
|
Year |
Return |
Year |
Return |
Year |
Return |
|
2011 |
-3% |
2007 |
8% |
2003 |
21% |
|
2010 |
4% |
2006 |
9% |
2002 |
-7% |
|
2009 |
12% |
2005 |
7% |
10 years |
3.9%* |
|
2008 |
-19% |
2004 |
10% |
15 years |
4.8%* |
Market neutral funds, by contrast, usually invest an equal portion of their assets in “long” (owning the stock) and “short.” Long-short funds do better than their market-neutral rivals when the market is rising (most assets are “long” stocks). In down markets, investors should expect to gain very little, if any. During negative periods, market neutral funds should hold up better because they have pretty much hedged everything.