Beginner's Guide to Long/Short Equity Mutual Funds

Long/short strategies bet for and against stocks at the same time, offering additional ways to seek profits, protection of capital, or both. Long-short strategies are best for those investors who expect low returns from their investments in future years, primarily because the strategies don’t rely purely on the market for their returns. The ultimate goal of long/short strategies is to get most of the market returns when stocks go up and limit the losses when stocks go down.

Long/short equity mutual funds take that concept and apply it to mutual funds, thus giving exposure to the strategy with the additional benefit of diversification. Each fund is different in its own way in the percentage of its net long or net short position. For example, the most popular type of long-short fund is the 130-30 fund meaning 130% of the exposure is long, while 30% of exposure is short. How this works is given a $100 investment, $30 would be sold short with those proceeds being used towards the long position, giving additional leverage and exposure to the long position, ultimately ending up with $130 invested in long positions and $30 in short.

Be sure to also see the 10 Mutual Funds for Hard-to-Reach Places.

In long/short equity mutual funds, fund managers hold what they deem to be attractive investments while simultaneously shorting overvalued stocks. When done properly, investors get the upside of stocks while limiting the volatility in the market. In other words, investors get less upside than they would have gotten going 100% long in the market, but at the same time they are exposed to less potential losses.

Traditionally the majority of mutual funds are long-only, so long/short equity mutual funds give the manager more flexibility to act on their analysis. As a result, a manager’s stock picking skill is very important with these types of mutual funds.

There are many different types as well, including “market neutral” funds where positions are designed to negate market movements entirely, and are on the safer side, to riskier funds such as a “middle of the road” approach where a fund is more weighted on the long or short side. They can also be differentiated in other ways including market geography (emerging markets, Asia, Europe, etc), investment philosophy, and sector.

As with any type of investment, there are risks involved as well. The biggest drawback is the high fees associated with the funds, because active management is required by the fund manager. According to Morningstar, average fees for long/short equity mutual funds exceed 2% of assets per year, compared to 1.3% for plain vanilla mutual funds. Moreover, in relation to the active management required, again there is a lot more emphasis placed on the manager’s skill of choosing the right stocks to buy and sell short. If the manager is wrong, then that will eat into the investor’s returns. There can also be correlation risk, where the offsetting investment is not perfectly correlated, giving more market exposure than intended (mostly in relation to the market neutral strategies, thus not making it 100% market neutral).

Be sure to see the Cheapest Mutual Funds for Every Investment Objective.

There are many benefits to using mutual funds to gain exposure to the long/short equity strategy, including ease of use, diversification, and low costs. Historically, hedge funds were the only method in which investors could take part in a long/short equity strategy. Now, there are more and more mutual funds adopting this strategy.

Furthermore, compared to hedge funds, long/short equity mutual funds do not require a minimum investment, thus appealing to a broader set of investors, and are much more liquid with daily pricing. The ability to liquidate a position at any given time should give any investor comfort, and long/short strategies give the possibility of excess returns when compared to index funds.

Because a long/short equity mutual fund is both long and short, and by its very nature is limiting the risk in the market, the losses on one side can help offset the capital gains taxes on the other side. As with any investment vehicle, however, if there are capital gains, taxes will have to be made on them. Be sure to contact your personal accountant for tax advice.

Learn more about How Mutual Funds Are Taxed.

Just as with mutual funds, there are many different kinds of Long/Short Equity Mutual Funds. Here are some of the largest according to Morningstar, along with their AUM and expense figures:

AllianceBernstein Select US Long/Short Portfolio (ASLAX)

• Total Assets: $1.81B
• MER: 2.25%-

Diamond Hill Long-Short Fund (DIAMX)

• Total Assets: $3.82B
• MER: 1.43%

Gateway Fund (GATEX)

• Assets: $8.18B
• MER: 0.94%

MainStay Marketfield Fund (MFADX)

• Assets: $16.04B
• MER: 1.78%

Robeco Boston Partners Long/Short Research Fund (BPIRX)

• Assets: $5.6B
• MER: 1.48%

Neuberger Berman Long Short Fund (NLSAX)

• Assets: $3.23B
• MER: 1.96%

Long/short equity mutual funds come with higher costs, and arguably higher risk compared to other types of mutual funds. However, when taking into account historical returns and investors’ own risk parameters, a long/short equity mutual fund can fit into an investor’s portfolio just as with any other type of investment. It is ultimately up to the individual to decide if they want to cap their returns while limiting their losses. If so, a long/short equity mutual fund offers the diversification benefits, ease of use, and liquidity to give investors comfort. Lastly, as with any investment, be sure to do your due diligence beforehand.

If you’ve enjoyed this article, sign up for the free MutualFunds.com newsletter; we’ll send you similar content weekly.