The Long and Short of Managing Volatility

Are long-short funds the right fit for the current market outlook?

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As the market continues to seesaw, Americans have been pouring into investments that promise shelter and stability. One common destination of these asset flows has been long-short mutual funds. As their name implies, these funds carve out both long and short positions. Broadly speaking, they count on their longs to anchor their portfolios during strong markets and expect that their shorts will pick up the slack during rough times. As a result, while their hedges prevent them from gaining eye-popping amounts in bull markets, they generally won’t face huge losses in bear markets either. On the back of safe-haven demand, the number of long-short funds has exploded. Currently, there are 105 distinct long-short funds in Morningstar’s database, up from 61 at the end of 2006. Meanwhile, they attracted $10.5 billion in new investments last year. That dwarfs the $2.6 billion they attracted in 2007. Clearly, then, these funds have experienced an uptick in popularity. The more important question is: Do they work?

[See U.S. News's list of The 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

Russel Kinnel, Morningstar’s director of mutual fund research, says that long-short funds can occasionally be a valuable tool in investors’ portfolios, but he suggests that they limit their exposure to the strategy. “Long-short funds can be useful ways to get some returns in up or down markets,” he says. “You have to be very selective, though, because most of them are overpriced and will likely disappoint.” As of the end of April, the average long-short fund had an expense ratio of 2.13 percent. By comparison, the average expense ratio for a large value fund was 1.24 percent.

Still, as volatility continues to carry the day, long-short providers say that their ability to smooth out the ride makes their funds well worth the money. “We’ve been in for a while now one of these sideways market periods,” says Ed Peters, a partner at First Quadrant, the subadvisor for the Managers AMG FQ Global Alternatives fund. “In an environment like this, just buying and holding equities, for instance, is not going to give you a great return. A long-short strategy is trying to do well in basically all market environments. It should be a pure-alpha kind of fund.”

For investors looking to put money in long-short funds, there are a number of factors to consider. Chief among them is how the funds use their short positions. Essentially, shorting is a bet that a given security will perform poorly. Funds that short securities gain money when those securities decline in value and sustain losses when they appreciate in value. Some long-short funds stake out shorts in similar corners of the market to the ones that they’re long in. This strategy, which is a pure hedge, is the safest iteration of the long-short model.

On the other hand, despite long-short funds’ reputation as a hedging instrument, many managers will have their shorts be completely distinct from their longs. While these funds do to a certain extent manage volatility through sheer diversification, they also run the risk of the securities they’re long in losing value even as the ones they’re short in appreciate. In other words, the funds can simultaneously lose money on both the long and short ends. In cases like that, “you’re really kind of doubling down on the manager’s investment prowess,” says Kinnel. “And you have to realize that there are going to be times when they are right, but there are also going to be times when their shorts will beat there longs. … That’s just the nature of that setup.” Even the most conservative long-short funds can lose out given the right mix of ingredients. “There’s sort of an implication that you’re getting a free lunch,” says Kinnel. “That’s not possible, obviously.”

With that in mind, U.S. News has profiled three-long short funds. Each takes a different approach to asset allocation and to risk.

Hussman Strategic Growth (HSGFX). This is a stock picker’s fund. Manager John Hussman fills the portfolio with names he expects will offer solid growth potential and uses shorts as a hedge against rough markets. Essentially, Hussman will short a mix of broad indexes that, when combined, form a benchmark for the fund. Currently, the fund is fully hedged, meaning that it allocates the same amount to its short positions as it does to its long positions, leaving its net exposure to the market at zero percent. “The intent there is not to speculate on the downside,” Hussman says of the fund’s approach to shorting. “It’s literally to remove the impact of market fluctuations on the portfolio.” In instances when the fund is fully hedged, all of its returns stem from the difference between the performance of the stocks it’s long in versus the mix of shorted indexes. For instance, if its picks are up 10 percent and the indexes are up 8 percent, the fund’s return is 2 percent. On the flip side, if the market is down 10 percent but its picks lose only 8 percent, it’s still up 2 percent. In other words, as long as its long positions outperform the fund’s benchmark, its returns are positive.

The fund, which opened its doors in 2000, has been in the black each year since then except for 2008, when it lost 9 percent. While the fund has protected against downside risk, it has also, by the nature of its hedges, missed out on most of the market’s upswings. In 2009, for instance, it gained 4.6 percent. By comparison, Schwab’s S&P 500 index fund was up 26.3 percent last year. But in difficult markets, Hussman’s fund has held its own. Case in point: Year-to-date, it’s up 5 percent.

Highland Long/Short Healthcare Fund (HHCCX). Managed by Michael Gregory, this fund takes a long-short approach to the healthcare sector. “A long-short strategy is designed to deliver consistent returns at lower risk and exposure to the overall market,” says Gregory. “In order to fully capture the investment potential of healthcare reform, we believe a long-short strategy is required.” Unlike Hussman’s fund, this one doesn’t use its shorts as a pure hedge. Instead, it shorts specific companies that it expects will do poorly. While the possibility exists that it could lose out on both ends, it’s done a good job of managing volatility. Its performance (although its relevant track record is short since the fund only adopted a long-short strategy in May) has also been encouraging. Between May 1 and July 16, the fund lost 0.4 percent, which compares favorably to the 10.3 percent hit that the S&P 500 took during the same time period.

The fund is currently examining the implications of healthcare reform and looking to the shifting dynamics as a means of informing its investing decisions. “The way that we would look at a portfolio in the context of reform is to identify those businesses that are going to be beneficiaries of 32 million new customers and the attendant volume yet will not be asked to foot a disproportionate share of the bill through less reimbursement,” says Gregory. “On the short side, we would look for companies that are not going to have a significant volume benefit from these new customers but are going to be asked to foot a significant portion of the bill due to disproportionately high fees that are levied upon them through less reimbursement.” This has led the fund to favor hospitals on the long side and to short commercial insurers.

Managers AMG FQ Global Alternatives (MGAAX). This fund, which has long and short positions in both stocks and bonds, uses country and currency selection to drive most of its returns. Within its stock sleeve, it has net zero exposure to the market, meaning that all of its long positions are counterbalanced by shorts. Its long exposure is in different countries than its short exposure, which opens it up to the possibility of heavy losses should the markets in its long countries decline as the ones in its short countries improve. Currently, the fund’s long countries for stocks include France, Germany, Italy, Spain, and the United States, while its shorts include Canada and Hong Kong. The fund also takes out long and short positions in bonds. Like with stocks, it has zero percent net exposure to the bond market. It’s currently long in Japanese and U.S. debt and short in Canadian and United Kingdom bonds. Basically, its goal is not to use its shorts as a means to hedge against its longs, but instead as a speculative way of adding returns to the portfolio. “We go long the countries we think are going to perform the best and short the ones that are going to underperform,” says Peters. Despite its risks, the fund, which launched in 2006, has been in the black every year so far, including in 2008, when it managed to secure a 4.8 percent return.