Fee-Only Financial Planner
Jon Luskin is a fee-only CERTIFIED FINANCIAL PLANNER™ (CFP®) Professional and pledged fiduciary at the independent financial planning firm Define Financial. He has been recognized as one of the financial planning industry’s top young advisors by InvestmentNews magazine. For his master's thesis on investment management, Jon showed how university endowments can generate more wealth (and take on less risk) by adopting low-cost investment strategies. Jon's original research on investing has been published in the academic peer-reviewed Financial Planning Association’s Journal of Financial Planning.
Jon blogs about financial planning minutia at JonLuskin.com. When not practicing financial planning, Jon also enjoys homebrewing, bbq’ing, Brazilian jiu-jitsu, and camping.When not practicing financial planning, Jon can be found teaching safe cycling skills to the youth of San Diego, or volunteering with San Diego’s canine rescue organizations. Jon also enjoys homebrewing, bbq’ing, cycling, hiking and camping.
BA, Sociology, California State University-Northridge
MBA, American Jewish University
Certificate, Personal Financial Planning, University of California, Los Angeles - Extension
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Fee-Only & Fiduciary
For general information only and is not intended to serve as specific financial, accounting or tax advice.
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There is already a great answer explaining what a long-short mutual fund is. Allow me to answer a question that wasn't asked, but should be answered:
"Should I use a long-short mutual fund to invest?"
Why not? Because you're likely not going to get relatively good investment returns.
Why is this the case? To be successful, a money manager using a long-short strategy must be exceptionally skilled. Unfortunately, this is rarely the case. In the end, you're likely better off using a conventional, low-cost invest strategy such as a broad market index fund (like an S&P 500 index fund, etc.).
There are a few reasons why:
1.) Cost: Using an actively-managed fund is rarely cheap. This means you pay a lot of money to a manager that may (or may not) beat the performance of a typical low-cost index fund. It is highly unlikely that paying a money manager a tidy will enable him to outperform an index fund.
What are the odds that the money manager that you pick will outperform an easily accessible low-cost index fund? About 17%. Said another way, you have about an 83% chance the low-cost diversified index fund will outperform active strategies - active strategies such as a long-short fund.
2.) Limited Upside, Infinite Downside: When you traditionally invest in stocks, there are two directions the value of your stock could can move: up or down. But, it's the degree of this movement that matters.
When investing in stocks, you have literally unlimited potential for your invest return to increase forever, indefinitely. In short, you are looking a return potential of infinity.
That sounds pretty good, right? Who wouldn't want an investment return with the potential to be infinity? But, you could also lose your entire investment. Here's an example:
Bob invests $100 in the stock of COMPANY A. COMPANY A goes bankrupt. Bob loses $100.
Charlie invests $100 in the stock of COMPANY B. COMPANY B invents a new widget. This sends the price of the stock soaring. Charlie's investment return is literally infinity.
When you traditionally invest in a stock, it is a risk worth taking. You could lose $100, but your investment return can literally be infinity.
Investing in stocks traditionally is known as going "long" a stock. This is the "long" portion of the long-short mutual fund.
When you short a stock, you now have limited upside potential and infinite downside. That's not a very attractive investment. Let's use an example to drive this point home:
Larry shorts the stock of COMPANY A. Since COMPANY A goes, bankrupt, Larry gets $100.
Mark shorts the stock of COMPANY B. Since COMPANY B invents a new widget, sending the price of the stock soaring, Mark faces infinite capital calls. This means that Mark must keep putting more money into his investment account - just to see that money disappear as the price of COMPANY B stock continues to rise.
In summary, when you go long a stock (the conventional way to invest), you have infinite return potential and only risk the amount of your original investment (i.e. $100). When you short a stock, you have limited upside (the current price of stock), but infinite potential for loss. That's simply not a good deal.
3.) Active Manager Success Fades with Assets: If you've come across a successful actively-managed mutual fund, chances are that tomorrow the fund will be a loser. Why is this case? And why does this happen? Too much money.
Warren Buffett - one of the most successful investors of the world - now has this very same problem: too much money. You see, there are only so many good investment opportunities available. So, what happens when an investment manager has more money to invest than there are good things to invest in? Does the manager just sit on the cash waiting for the next great thing to come along? Unfortunately not. Mutual fund managers must invest the cash they have. And if, they have more cash than there are good things to invest in, those managers are forced to invest in not-so-great investments.
Let's use an example to illustrate this point:
Michael the Mutual Fund manager is given $100,000 to invest. He finds a great investment opportunity: COMPANY X stock. Michael the Mutual Fund manager invests the $100,000 in the stock of COMPANY X. The stock price of COMPANY X goes soaring - and Michael the Mutual Fund manager looks like a genius.
Because of his success, Michael the Mutual Fund Manager is featured in all sorts of financial media publications. Because of all the attention, investors clamor to invest in Michael's mutual fund. Michael the Mutual Fund Manager now has an additional $100,000,000 to invest.
Unfortunately for the new investors, there simply aren't any good investment opportunities available. But, Michael the Mutual Fund Manager must invest the $100,000,000 he was given. He's not allowed to simply sit on that much cash. So, Michael the Mutual Fund Manager invests in COMPANY Y, and COMPANY Z. This is despite Michael knowing that COMPANY Y and COMPANY Z aren't great investments. But, Michael has no choice. He must invest the money he has.
The results are predictable. Michael's Mutual Fund now shows poor performance. The new investors in Michael's Mutual Fund are disappointed. Those new investors would have been better off with a low-cost index fund.
To wrap it all up, a long-short mutual fund is simply not an appropriate investment for practically everyone because of:
2.) limited upside, infinite downside
3.) manager performance wanes over time