The Long and Short of Long/Short Funds

Mutual funds and ETFs take cues from hedge funds, offering a sophisticated investing strategy.

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Fund managers find themselves increasingly challenged to provide investors growth and protection in today's volatile global markets. Some firms, which manage stock and bond mutual funds and exchange-traded funds, are taking cues from hedge funds and including more sophisticated investment strategies in their mix.

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In turn, investors may find themselves sifting through a growing number of alternative products that use these hedge fund-favored combinations. One popular strategy called "long-short" involves taking long positions in stocks (or bonds) with the expectation that they will increase in value, and simultaneous short positions in stocks (or bonds) that are expected to decrease in value. Do such offerings fit into average investors' portfolios?

"It's not the kind of thing that's been well-proven in the investment universe, but there are obviously people out there trying to do it, in large part because there's a tremendous demand for it," says Eric Jacobson, bond fund analyst at Morningstar, in a video interview on his firm's site. There are now enough long/short bond funds—sometimes known as absolute return funds—to warrant a separate Morningstar category outside of the multi-sector category it previously used.

As always, investors must gauge their overall risk tolerance and financial goals and consider expenses and other factors, but the general rule is that alternative investment strategies should be used to compliment traditional mutual funds and ETFs.

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Taking a long position in a stock simply means buying it; if the stock increases in value, you will make money. On the other hand, taking a short position in a stock means borrowing a stock you don't own, then selling it in hopes that it declines in value, at which time you can buy it back at a lower price than you paid for it. You then return the borrowed shares.

In bull markets, long-short funds might lag their long-only counterparts. But during bear markets, these funds tend to have a competitive advantage. Managers might use futures, options, or an inverse stock position for the tactical portion of the portfolio that provides the downside "protection."

Gauging market direction. The democratization of the long/short strategy has lead to specialized products that blend equities, bonds, commodities, real estate, cash, and more. For Rob Stein, who runs the Astor Long/Short ETF Fund, his approach allows him to diversify across non-correlated asset classes and approach investing using broader themes, such as macroeconomic performance over company-specific risk.

"Currencies, energy, precious metals, healthcare, small cap ... our approach is about low correlation to stocks, decision-making based on economic fundamentals, reducing beta, or volatility," says Stein, founder and global head of asset management at Chicago-based Astor Asset Management, now part of Knight Capital Group. The firm, whose clients are investment advisors, runs about $1.2 billion in portfolios solely using ETFs.

[See A Beginner's Guide to Understanding ETFs.]

The long/short approach is sometimes known as absolute return, when cash and an inverse offset are used to potentially limit the downside. But it's a sometimes misleading name that really means "positive" return.

Some funds use options strategies, writing covered calls as an income source, for instance. One such fund is Bridgeway Managed Volatility (BRBPX). Others have a narrower stock-picking approach, such as Quaker Event Arbitrage (QEAAX), which primarily makes long and short bets on equities, but managers focus on stocks and bonds that are involved in corporate events, such as mergers and acquisitions, restructurings, spin-offs, liquidations, and changes in management.

Bond funds expanding. Long/short funds can do a lot of heavy lifting with the convenience of one fund, often covering a variety of sectors and regions. Managers can fold in higher-risk, higher-growth opportunities in emerging markets for non-correlation.