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Fund Spy

Four Long-Short Funds that Defied the Recent Downturn

The market gave this group a pop quiz. Some passed; some flunked.

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Many investors understandably associate long-short mutual funds with hedge funds, which they believe to have supercharged returns. It's true that some hedge funds combine long portfolios and short portfolios and that some hedge funds have knockout returns. But investors would be better off understanding the differences between the varying risk/reward profiles of long-short funds and their long-only peers. The key point is that, due to their structure, almost all long-short funds have lower potential long-term rewards than long-only funds, but long-short funds also should have lower potential risk.

Mutual funds that fall into Morningstar's long-short category tend to fall into one of three groups. Some of the funds use most of their assets to buy a "long" stock portfolio--which makes money if those stocks rise--and hedge their bets with a short stake in a broad index, thereby lowering losses should equities drop off. Other slightly more bold funds devote most of their assets to long stakes but sell short--or bet against--a varying number of firms that seem to have poor prospects. Still others are market-neutral funds, which devote half their asset base to favored firms and half their assets to unloved firms. It's really only the small bold group that's gunning to top the market when it's rising, and even then it's a tough trick to pull off.

Often market-neutral funds--as well as funds that cobble together a variety of eclectic strategies--bill themselves as "absolute return" funds. That label suggests (but cannot guarantee, of course) that such funds will have positive gains year-in and year-out, no matter the market's direction. Frankly, we don't think that many funds will be able to deliver on the implicit claim.

Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.