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Long/Short Funds Come Up Short

Are you drawn to hedge funds' exclusivity and potential, but can't afford the minimums? Then long/short funds may be an option for you. But be warned: Just as hedge funds have shown poor performance, so have long/short funds. Today, my Buckingham Asset Management colleague Brad Jenkins takes a look at their performance.

Long/short funds use leverage, derivatives and/or short positions in trying to beat its benchmark. This strategy should sound familiar, as hedge funds have been doing it for years. The difference is that while hedge funds are only limited by their prospectus, mutual funds are limited by law. (In fact, mutual funds were banned from short selling until 1997.)

While long/short funds may tout their abilities to increase returns, the data shows otherwise. For the year through the end of October, they are up 2.2 percent, compared to 7.8 percent for the S&P 500 Index. For the past five years, long/short funds have an annualized return of only 0.8 percent per year, versus 1.7 percent for the S&P 500.

There are several reasons for such underperformance. First and foremost, long/short funds employ an active investment strategy. We know that actively picking stocks and timing the market is a loser's game. And their hurdles are even greater since the fund manager not only has to consistently pick the stocks that will outperform the rest of the market, but also the ones that will underperform the market. Simple outperformance of his picks isn't enough, as he has to overcome the incremental costs of shorting stocks (which includes the fees paid to borrow stock as well as trading costs). On top of this, he has to be right on timing both of these selections twice: when to buy and sell the long positions, and when to sell short and cover that position. Good luck!

There are two issues for believers in active management to overcome. The first is that the evidence is that long-only active management has failed to outperform with great persistence because the market has proved to be highly efficient. So why would we think they would now succeed by adding the ability to go short, when they would also have the incremental burden of extra costs?

The second is that there is plenty of evidence on the failure of hedge funds to outperform risk-adjusted benchmarks. In fact, the evidence on hedge funds is much worse than it is on mutual funds. If hedge funds have failed, why should you believe that mutual funds will succeed?

One of the reasons you're getting such dismal returns is that in addition to the incremental transactions costs, the fund expenses associated with long/short equity funds are extremely high. The average expense ratio for a long/short fund is 2 percent. That's 20 times the expense ratio of the SPDR S&P 500 ETF (SPY) (0.1 percent) or about 33 times the Vanguard S&P 500 ETF (VOO) (0.06 percent).

The evidence shows us what long/short funds have in common with hedge funds: They are great vehicles for transferring assets from the wallets of investors to those of the purveyors.

More on MoneyWatch:
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Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via or through the Buckingham Asset Management podcast page on iTunes.

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