Recent stock market gyrations are sure to leave investors wringing their hands. If only one could make money either way — when stocks are down as well as up.
The pros do this, using short sales, options and futures contracts that rise in value when stock fall. But it’s complicated, can be expensive, and requires constant vigilance that’s generally too much for small investors to take on. Many hedge funds are designed to provide a steady return no matter what the markets do, but small investors don’t meet account minimums.
But the fund industry has stepped in, offering range of long and short products that attempt to prosper in all market conditions. Some try to be market neutral all the time, while others shift their emphasis between long and short as managers bet on market trends.
“With the market more volatile now than the over the last two years, a long-short fund should be a small portion of anyone’s portfolio,” says Kristin Hull, CEO at Nia Impact Capital in Oakland, California.
[See: 7 ETFs for Income Investors to Play It Safe.]
“Long-short funds enable an investor to have flexible exposure to the markets,” says S. Michael Sury, a former long-short strategist for Goldman Sachs and other firms, now a lecturer at the University of Texas at Austin. “When the market has run up very quickly, shows signs of excessive valuation, or exhibits volatility, long-short funds can enable investors to reduce or hedge their exposure to market risks.”
A Morningstar report in December said that long-short funds had indeed beaten the market during the stock crash of 2008, losing 15.4 percent while the Standard & Poor’s 500 index lost 37 percent. But the short positions are a drag when stocks climb, with those funds gaining just 3.4 percent a year in the three years ended in December while the S&P 500 gained 11.4 percent a year.
“Long” means betting stocks will rise and is accomplished by buying stocks or derivatives like options and futures contracts that rise alongside the markets. “Short” means betting that stocks will fall. Short selling, for instance, is selling borrowed shares at today’s price in hopes of repaying with shares bought more cheaply later. Options and futures are contracts that allow the owner to buy or sell a block of shares at a given price sometime in the future. If the price falls, the contract owner can sell at the higher price specified in the contract, avoiding the loss or profiting on the price difference.
But experts warn that the long-short strategy is not for everyone, and they note a number of issues to consider in addition to the fund’s track record, management team and investment strategy.
“If one were to invest in a long-short fund, there are many considerations to take into account,” says Daniel Lugasi, portfolio manager at VL Capital Management in New York City. “First, and foremost, it is crucial to examine the firm’s performance track record. A five-year track record for a strategy is the bare minimum that should be accepted. A longer track record, particularly one that stretches back prior to the Great Recession is best, as this was the ultimate stress-test for most long-short funds.”
Lugasi is not a long-short fan, however, noting that short positions can have very large losses if the stocks continue going up instead of falling. That constantly enlarges the gap between the sell price and the cost of buying replacement shares. Losses on long positions are limited to what was spent on the shares.
Among other issues to consider:
Costs. Protection against loss can be costly, as short strategies involve expenses for contracts that work like insurance policies, as well as higher expenses for active management. Some long-short funds use leverage, which can amplify gains but also increase losses if things go wrong.
[See: 10 Tips for Keeping a Cool Head in a Market Meltdown.]
“Many long-short funds charge higher fees simply because they are “long-short funds,” Sury says. “Be wary of long-short funds that charge very high fees, or have high 12b-1 marketing fees built in.”
Higher minimums. While long-short funds are designed for investors who don’t qualify for hedge funds, many require larger deposits to open than one faces with ordinary mutual funds or exchange-traded funds. Also be sure there are no onerous restrictions on withdrawing your money.
Transparency. The whole idea is to rely on fund managers to do things you cannot or would not do on your own. But experts caution against investing in anything that is too complex and obscure to understand.
“Understanding exactly what industries and types of companies are being held and being shorted is essential, as well as understanding and trusting the overall strategy for the long term,” Hull says.
Benchmarking. As with all investments, it’s important to think about how you will measure the fund’s performance. Is it tracking the broad market, or just a narrow sector? Also, does the fund take a long-term or a short-term perspective.
“Long-short funds can also vary with respect to their investment horizon,” Sury says. “Some funds have long-term outlooks, while others take on more risk by seizing trading opportunities. It is important for investors to match the strategy to their own risk tolerance.”
How much management? Does the fund use strict long and short allocations, or do the managers have leeway for significant changes as they see fit?
“If an investor is selecting an actively managed fund for its prowess in picking stocks, they should ensure that they are doing so on both the long side and short side,” Sury says. Investors, he says, are wise to get a clear explanation of the fund’s “delta,” which is the percentage of the portfolio devoted to long positions.
Be realistic. Long-short funds are not all designed to beat the market — the short component will dampen returns when stocks go up. Rather, they are meant to add a degree of safety, and you pay a price for that.
If costs and other features bother you, remember that there are alternatives. First is the option of just owning ordinary stocks or funds and waiting out any downturns. Over time, the broad markets have always rebounded from downturns and gone on to set new records.
[See: 7 of the Best Stocks to Buy for 2018.]
Another option is to shift some money from stocks to cash, which will hold its value in a money market or bank account as stocks decline.
More from U.S. News
11 Steps to Make a Million With Your 401k
6 Reasons to Love Apple Inc. (AAPL) Stock in 2018
7 Stocks Primed for an Amazon.com, Inc. (AMZN) Buyout
How Investors Can Cope With Market Swings originally appeared on usnews.com
