What is a long-short mutual fund?
A traditional mutual fund is an open-ended investment vehicle that owns a basket of stocks or bonds that the adviser believes may be undervalued and will appreciate in value. Long-short mutual funds deviate from traditional long-only mutual funds by also shorting a basket of stocks that the adviser believes is overvalued and may go down in value. What exactly is shorting? The adviser borrows shares from another investor in hopes of selling it back to them at a later date, and at a lower price, thereby profiting from that security going down in value. The theoretical idea is that the adviser can isolate both undervalued and overvalued securities and profit from them in any market environment, not just markets that go up in value. In reality, shorting is investing with a headwind. Why? Stocks typically go up in the long run. Even if the adviser is correct about a stock that is overvalued and the stock starts to go down in value, it becomes a smaller and smaller position and subsequently has less effect on the overall mutual fund’s return. Here is an example:
|Stock Name||Value||% of $1M Portfolio|
|Big Bust Inc.||$50,000||0.50%|
|Big Bust Inc.||$10,000||0.10%|
|Big Bust Inc.||$100,000||1.00%|
As can be seen, betting on a security going down in value can be a double-edged sword. As our fictitious company Big Bust Inc. goes up in value, so does its position as a percentage of the portfolio. In addition, there is no limit as how much money you can lose shorting a stock; theoretically, it can go to infinity, whereas a stock you own long can only go to zero if they go out of business.
At R. W. Rogé & Company, we spend countless hours researching the advisers of mutual funds. We’ve found that many managers of long-short mutual funds have never shorted a security before. Many of these funds also charge fees that are typically double their long-only counterparts. This doesn’t bode well for the industry group. Only a few funds are really worthy of consideration, and we do our best to find these for you.