Funds That Lead When Stocks Fall

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Producing modest results when times are good, long-short funds can excel during market downturns.

During the first six months of 2008, the Standard & Poor's 500-stock index lost 12%, and most equity mutual funds suffered double-digit declines. Long-short funds were among the few that avoided losses. These resilient choices have proven their ability to make money in up years and down.

To produce steady results, the funds divide their assets, holding some stocks in long positions and some in short. Long positions are the most common. Any time investors buy stocks and hold them, they are said to be going long. Long investors hope that stocks will rise. Short investors bet that stocks will drop. To go short, investors borrow stock from a broker and sell it.

Then they wait for the share price to drop. If that happens, they can repurchase the shares in the market at a low price. The investors can return the stock to the broker and book a profit.

Most investors hold long positions exclusively, so they can only do well in rising markets. Long-short funds produce modest results in good times, held back by short positions. The funds can excel in downturns, when the short positions thrive. “A good long-short fund can help diversify a portfolio and protect against losses,” says Marta Norton, an analyst for Morningstar, a Chicago fund tracker.

During the bull market of the late 1990s, few investors paid attention to the long-short funds, which quietly generated single-digit returns. Those modest results seemed insignificant in an era when the S&P 500 returned more than 20% annually for five years in a row.

Long-short funds began to stand out as markets became more difficult, however. In 2000, the funds returned 9.6%, more than 18 percentage points ahead of the S&P. The next year, the funds returned 5.4%, beating the S&P by 17 percentage points. By the end of 2007, the long-short funds had compiled an impressive record, staying in the black for 13 consecutive years. No stock fund category came close to matching that performance. Even many bond funds posted losing periods. In the 10 years ending in June 2008, the average long-short fund returned 3.5% annually, half a point ahead of the S&P.

With the strong showing, fund companies have been bringing out more long-short funds. The choices have climbed from 12 in 2000 to 54. Most new options are not worth considering. Many have high fees and poor returns, but a few have superior records.

A top performer is Aberdeen Equity Long-Short, which returned 7.7% annually for the past 10 years. The fund typically has about 60% of its assets in long positions and the rest going short. Aberdeen beat the S&P 500 by 10 percentage points during the first half of 2008. That strong showing isn't surprising for a fund that sells short. But Aberdeen also beat the S&P in 2007, a year when the market rose.

Another winning short seller is Schwab Hedged Equity. The fund aims to outdo the S&P a bit while taking less risk. To limit losses, the portfolio managers keep about 20% of assets in short positions and the rest in longs. That strategy has worked in downturns. During the past five years, the fund has returned 8.6%, about a percentage point ahead of the S&P.

James Market Neutral keeps about half its assets in shorts, hoping to find stocks that will decline even in bull markets. Most often the fund delivers single-digit returns, enabling shareholders to achieve modest growth.

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