The Long and Short of It: Long/Short Funds Gain Traction

Rob Silverblatt

Yield-starved investors who aren't quite ready to recommit to traditional stock mutual funds are increasingly looking at long/short funds, according to Standard & Poor's. "Given the persistent low interest-rate environment and a lingering aversion to equities fueled by vivid memories of losses during the financial crisis, more investors appear to be open to learning more about new alternative asset products," S&P Capital IQ notes in a recent report.

At the extremes, long/short funds can come in two varieties. In the first category, a manager goes long (that is to say, bets in favor of) in securities he thinks will succeed and shorts (bets against) securities he thinks will lose value. This, of course, comes with substantial risks, as there are two directions in which the fund can lose money. But there are also benefits. "If you think the market is going to be volatile or you think we're going to see some pullbacks from the levels that we're at now, then a fund that has some flexibility to play both sides can [help]," says Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.

The second extreme is that the fund shorts securities that are similar to the ones in which it has long positions. In that scenario, the short positions serve as a hedge to cushion the blow when the long bets fail. "[These funds] provide typically a non-correlated performance to the rest of your portfolio, the benefit to that being that you may have parts of your portfolio that zig while others zag, and these tend to go in between them," says Jeff Tjornehoj, head of Americas research at Lipper.

[Read: Blurring the Lines Between Hedge Funds and Mutual Funds.]

In its report, S&P Capital IQ highlights two funds: Wasatch Long/Short and PIMCO StocksPLUS TR Short Strategy. The Wasatch fund falls into the first category of long/short funds. "Comanagers Michael Shinnick and Ralph Shive conduct fundamental analysis to identify undervalued long stocks and overvalued shorts with specific catalysts for near-term price declines," Morningstar analyst Mallory Horejs wrote last year.

Meanwhile, the PIMCO fund takes a different approach. Manager Bill Gross takes long positions in bonds and uses derivatives to short the stock market. In practice, this makes it a so-called "bear market fund"--an investment that will thrive when the market tanks and tank when the market thrives. For instance, the fund gained 47 percent in 2008 but has lost money in every subsequent year.

Tjornehoj says that investors in bear market funds should expect to see results like that. "When the rest of your equity portfolio is moving full [speed] ahead, as we've seen for the last few years, these portfolios are getting knocked down further and further," he says. "But if you tend to believe, as most investors do, that equities improve [over time] ... then these funds would be a drag on your portfolio."

[Read: What to Expect From Bond Mutual Funds in 2013.]

But Rosenbluth says the PIMCO fund can work for investors who have a negative outlook for the stock market. "If you're bearish on the U.S. equity market, it's a ... fund to take a look at," he says. "The fund makes sense for someone who thinks we can fall into another bear market."

Traditionally, institutional investors have dominated the long/short market. In recent years, though, retail investors have become increasingly interested in long/short funds and other alternative investments. "Demand for alternative investments has inspired fund companies to offer a broader array of product choices over the past three or so years," according to the S&P Capital IQ report.

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Rosenbluth cautions that investors should do their homework before investing in a long/short fund. "I think for certain investors, it could make sense for their strategy," he says. "They should do their [research], understand the strategy of the fund, understand the costs of the fund. If after all that effort, they think the fund fits within their strategy, then yes, it makes sense."