Long/Short Mutual Funds -- More Style than Substance

(MoneyWatch)  As a general rule, if someone recommends an investment product or strategy to you largely on the basis of its sophistication, your best move is to run in the opposite direction. That would seem to be an appropriate reaction to anyone attempting to convince you of the merits of a "sophisticated" long/short mutual fund.

For a number of years, long/short fund have occupied a small niche in the mutual fund industry. As recently as 2004, there were but 34 of them, with just over $8 billion in assets. But as investors became infatuated with the seemingly remarkable performance of hedge funds in the second half of this decade, and then sought safety from the recently turbulent markets, long/short funds became increasingly popular. Indeed, these funds are seen as one of the industry's next areas of growth, with some optimistic reports estimating their assets will reach the trillion dollar level over the next few years, which would represent quite a bit of growth from today's asset total of $32 billion.

What makes these funds unique is that they allow the fund manager to "short" stocks -- which is essentially a bet that a stock's price will decline over time. Some funds in this category short-sell stocks in an effort to follow a "market neutral" strategy. In bull markets, the fund's long positions would benefit, and in bear markets, the fund's neutral positions would pay off. If done successfully, the strategy would provide a relatively smooth, if modest, return over time.

Other funds in this category follow a 130/30 strategy, in which the manager uses 30 percent of the fund's assets to short stocks he believes are overvalued, and uses the proceeds of those sales to invest 130 percent of the fund's assets in stocks he believes are undervalued.

(Of course, the logic behind either approach is based on the assumption that the fund manager can identify not only what stocks are undervalued, but also those that are overvalued and ripe for a fall. The fact that history has demonstrated that managers have failed to win the "long only" bet might make one question the assumption that these managers can now win two simultaneous bets, but I digress.)

Whatever their strategy, the funds in this category typically have one thing in common: staggeringly high expense ratios. According to Morningstar data, the average long/short fund carries a 2.16 percent expense ratio -- more than half-again as high as the expense ratio of the average equity fund.

Unfortunately, the track record of the funds in this group indicates that they have been unworthy of those lofty fees. Over the past five years, the average long/short fund has earned an annual return of 2.38 percent. A balanced index fund, following a more traditional method of hedging one's stock risk by allocating 60 percent to the total stock market and 40 percent to the total bond market, earned an annual return of 3.45 percent in that same period.

Even worse, that 2.38 percent return does not include the records of the dozens of long/short funds that have disappeared in the past five years. Including them would knock about one percent off of that annual return, bringing it to 1.4 percent -- or just 40 percent of the balanced index fund's return.

And we're not done yet. The investors in those funds have fared even worse, earning an annual return of just 0.13 percent, according to Morningstar.

In a certain sense, then, these funds have succeeded in bringing hedge funds to the masses. Like hedge funds, they charge outsized fees in return for subpar performance.

Like most of the mutual fund industry's innovations, long/short funds have, thus far, proven to be more style than substance. The idea of giving a manager the flexibility to go long and short as he finds mispriced stocks in the market sounds wonderful, but like most investment strategies, what sounds good on paper is exceedingly difficult to execute in the real world -- and nearly impossible if you're handicapped by an expense ratio north of two percent.

If you're comfortable forgoing a bit of sophistication in your portfolio, the record thus far is clear that you're likely to be far better off passing over these complicated funds in favor of more traditional, simpler, and less expensive alternatives.