What is a long-short mutual fund?

By Joseph Nguyen AAA
A:

A Long-Short Fund is a mutual fund that holds investments long and in addition it sells securities it does not own (short). The goal of a long-short fund is to find investments anticipated to go up, and find investments anticipated to go down, and invest in both in an attempt to increase returns. For example, if an investor puts $100 into a long-short mutual fund, the fund manager will generally take the whole $100 and invest long in assets he thinks will do well. Then the manager will use this equity as margin to open a short position and sell assets he thinks will do poorly. When he shorts these assets he will receive cash, say $30 for this example. He would then use this $30 to invest long into more assets, so in total he would have $130 long portfolio and $30 short portfolio, effectively using your $100 initial investment to make $160 worth of investments. This type of long-short fund in the example is called a 130/30 mutual fund.

Traditionally, the majority of mutual funds are long-only, meaning if something was considered undervalued, it would be invested in, and if a security was thought to be overvalued, the only thing investors are able to do is to avoid investing in it. Long-short funds allow the manager more flexibility to act on his analysis. However, investors should be aware of the risks associated with investing in this type of mutual fund. If the fund manager made good investments, the combination of a long and short portfolio would leverage the funds return upwards. On the other hand, instead of just picking stocks that managers think will go up, they also have to predict which stocks are going down, which means the managers stock picking skill is very important. If mutual fund historical performance is any indication, it is extremely difficult to find a fund manager that consistently outperforms the market in long-only funds. Finding one that can predict stocks that go up and stocks that go down may be even more challenging. (Learn more about which management style might best fight your investment goals, read Mutual Fund Management: Team Players Or All-Stars?)

This question was answered by Joseph Nguyen.

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