What is a long-short mutual fund?
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.
Long and short can be difficult to grasp at first. To be long, a security means to own it and have it in your account. The intention is that the security will rise in value over time and be later sold for a profit. To be short, a security means to have borrowed someone else's holding, sold it, and received the cash. In this case, the short-seller still "owes" the security to the person from whom it was borrowed. The intention for the short seller is to sell the security while its price is declining, then buy back the shares at a lower price to put the shares back in the share-lenders account. The intention here is that buying back at a lower price would leave some cash as profit.
A long-short mutual fund is one comprised of both long and short positions. The intention is long stocks are rising in value while short stocks are declining in value.
Long-short mutual funds are market neutral, dividing their exposure equally between long and short positions in an attempt to earn a modest return that is not tied to the market's swings. Other long-short portfolios that are not market neutral will shift their exposure to long and short positions depending upon their macro outlook or the opportunities they uncover through research.
The strategy seeks capital growth and income. For example, one strategy will invest in a diversified group of assets, such as investing 55-65% of its assets in equity securities (including stocks and equity funds) and 35-45% in fixed income securities (including bonds and fixed income funds), and cash and cash equivalents (including money market funds). For temporary defensive purposes during unusual market conditions or for liquidity purposes, the fund has the option to invest up to 100% of its assets in cash, money market instruments, and other short-term obligations.
Long-short mutual funds, which bet for and against stocks at the same time, offer ways to seek profits, protection or some of both. Many of them do not try to beat the stock market, they try to lock in most of the market's gains while paring losses when it falls; although typically with higher fees.
There are many different kinds of long-short funds. The example I used above uses a middle-of-the-road approach. On the conservative end, a "market neutral" fund uses positions designed to negate market movements entirely. Investors make money only if the manager buys and shorts the right stocks.
Market-neutral funds are not designed to generate big gains. They aim for low correlation, or for moving independently of the broad market rather than with it, a benefit during market volatility when all assets can trade similarly.
There are plenty more strategies than these that extend to different asset classes or use different tools, like options, to achieve their targets.
The biggest drawback are usually the fees. The average expense for the long-short category as a whole is more than 2% of assets per year, compared with an average of 1.3% for U.S. stock funds.
Long-short strategies are best suited to investors who expect low returns from stocks in coming years, because these strategies do not rely solely on market returns. In this environment, the best funds might be those that seek to reduce stock market exposure without eliminating it. The goal is to get most of the market's returns when stocks go up, while paring the losses when stocks tumble.
The problem with these funds is that ambivalent investors might find comfort in them, whereas any investor who is bullish or bearish could likely have better options elsewhere.
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