What is a long/short mutual fund?
When you own shares of a stock, in the vernacular of Wall Street you are “long” that stock. If you sell stock that you do not own – stated otherwise, you owe stock to someone – you are “short” that stock. On Wall Street, as a regular course of business, people are allowed to sell securities they do not yet own.
A long/short mutual fund is an investment company holding both long and short positions. Generally, these funds will be long (own) those things its managers like and short (owe) those things its managers don’t like.
Mechanically, when you sell a security you receive cash. That cash can be invested. A common long/short structure is abbreviated 130/30. For every $100 received from fund investors like you, another $30 is raised through the short sale of supposedly bad things, providing $130 to invest in supposedly good things. The net value is still only $100, since $30 worth of sold securities is still owed – at least on day one.
In theory, the securities bought will go up by more than the sold ones, providing even better returns than a portfolio with only 100% invested in the “good stuff”. In a best-case scenario, the bought stocks go up and the sold ones go down, allowing the manager to buy the sold ones back at a lower price and thus make profits on both sides of the trades.
Why you should avoid long/short funds
Poor performance of managed money
One of the selling points of long/short funds is the opportunity to magnify the benefits of excellent portfolio management. If a manager can do great things with all of your money, imagine what he or she could do for you with even more. Additionally, if you can profit from winners, why not profit from losers found with the very same system. The problem is reality: most professional money managers are beaten by the markets.
As discussed here, indices beat active mutual fund managers most of the time. Since an index is by definition average, active stock managers historically do a terrible job choosing winners and losers. Inferential evidence suggests you are better off owning stocks these managers want to sell and selling short the ones they want to buy.
Indeed, while $10,000 invested in an S&P 500 index fund would have grown to $22,344 during the decade ending 2017, the same amount earning the average return of all long/short mutual funds tracked by Morningstar would have grown to only $13,078. Versus the annualized rate of 8.37% earned by the index fund over this period, long/short funds earned a paltry 2.72%.
Greater uncertainty
With most funds, your exposure is limited to the amount of money you’ve invested. If you place $10,000 into a large-cap stock fund you will own at most $10,000 worth of large-cap stocks.
If you put $10,000 into a long/short fund, the net value at first will be $10,000 but your actual exposure could be far greater. Using the 130/30 model, you might own $13,000 worth of long positions and owe $3,000 worth of short positions. You would have $16,000 of exposure.
Stocks usually move in the same direction, so the $3,000 of short positions should offset about $3,000 of the long positions. But there are no guarantees. It is possible for the short stocks to go up, increasing what you owe while the long stocks go down. If the up and down movements were each 5%, this long/short fund would be down 8%.
The hope and intention of the fund design is the opposite. But the hope and intention of managed money in general is to beat the market. This does not happen much.
What you should do instead
Take long/short funds out of your consideration. If you already own shares, liquidate them. If you like the particular exposure such as large-cap value or small-cap growth, invest in a low-cost, no-load index mutual fund with that specific exposure. If the long/short fund was to be your primary investment vehicle, click here for better direction.
* Data sources:
The Vanguard Group, Inc., Morningstar, Inc.