Four Long-Short Funds that Defied the Recent Downturn

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.

The Market's Pop Quiz
Recently, the market has provided something of a pop quiz for funds in this category. While the roughly 2% dip in the U.S. stock market over the past four-plus weeks isn't even close to a big drop, there were a couple of days that provided long-short funds with a stress test. On Feb. 27, 2007, stocks fell broadly across regions, sectors, and market-cap ranges; the S&P 500 Index fell 3.47% that day. On March 13, another fairly sharp fall took the S&P 500 down 2.04%. All told, from Feb. 26 through March 28, the S&P 500 lost 2.18%.

Overall, long-short funds did largely what they were supposed to do. The typical long-short category member lost 1.00% on Feb. 27, less than half that on March 13, and only 10 basis points (0.10%) for the month-plus period. Still, some funds did much better than that, and others flunked their stress tests. Below are those at the head--and the back--of the class.

A
Two market-neutral-style funds were the most impressive overall during the swoon.  Highbridge Statistical Market Neutral  and  Laudus Rosenberg Value Long/Short Equity  posted gains on both of the sharp down days and for the overall period. Indeed, while the S&P 500 fell 2%, the Highbridge fund gained 1.3% and the Laudus fund gained 2.5%. We've had some doubts about the Laudus Rosenberg offering, because its value bent has caused losses in some years, and overall it hasn't had large-enough returns to entice. But the Highbridge fund, which has an impressive hedge-fund pedigree, is promising. It uses statistical arbitrage and very rapid-fire trading to build gains in tiny, quick increments. Investors seeking a market-neutral fund should check out the Highbridge offering.

A-
 Hussman Strategic Growth (HSGFX) is one of the long-short funds we view most favorably overall. It had a snappy 1.15% gain on Feb. 27 and gained a nice 1.86% over the month-plus period. It did lose a tiny amount on March 13, though, which was a slight nick to its short-term record. This was a case of a fund finally getting its due. Manager John Hussman uses technical and valuation analysis to assess the stock market's attractiveness and uses options to adjust the portfolio's sensitivity to the market. He was bearish during much of 2005 and 2006 and had only modest gains, but he did well in the recent downturn and very well in the crushing 2000-2002 downturn.

B+
 Caldwell & Orkin Market Opportunity (COAGX) did okay on Feb. 27, losing just 0.98%. But it gained 1.37% on March 13 and had a category-topping 4.77% for the short-term period. In a very real way, the fund is making up for lost time. Its year-to-date gain of 8.16% through March 28 (which is tops in the long-short category) largely stems from its long-standing bet that credit-sensitive firms would falter. In particular, manager Michael Orkin has shorted mortgage lenders. In recent months, subprime mortgage lenders began imploding and the fund is thriving, but that same stance held the fund back in 2005 and 2006. Investors in the fund have had to wait for quite a while for this reward, and most investors aren't that patient.

D
Direxion PSI Macro Trends  has had a short, tough life. It debuted on Jan. 8, 2007, and has lost 5% through March 28. That's twice as heavy a loss as anything else in the long-short category. And from Feb. 26 through March 28, it lost 5.3%--more than twice the loss of the S&P 500. Regulatory filings indicate that this vehicle uses a complicated process: It uses economic analyses to determine the "phase of the business cycle for each major global market segment." It also measures relative strength of currencies, and then it uses technical and quantitative analysis to identify attractive segments. Finally, the fund attempts to predict--using all of the above--where the market is going. Because the fund doesn't bill itself as emphasizing downside protection, we won't say it's failed--but clearly it hasn't succeeded. We'd steer well clear of this offering at this point.

F
All three Geronimo funds, which claim to have "absolute return" strategies, landed in the bottom quartile of the long-short group for the period of Feb. 26 through March 28. That means that each of them lost 3% or more--at least half as much again as the S&P 500. The most striking disappointment was Geronimo Sector Opportunity , which lost 8.57% on Feb. 27--more than double the losses in the broad markets. Even though it's over a short time frame, it's a big red flag when a fund that proposes to provide absolute returns in most market conditions with low volatility goes this far off the rails. We don't recommend any of the Geronimo funds.

The Bigger Lesson
It's important to remember that although some funds aced and some funds failed what we're calling a pop quiz, it's not a final exam. Investors shouldn't invest in funds based on one solid month, and neither should they completely write off a promising fund based on a bad month. Relatively few of the long-short funds that now exist were around in the 2000-2002 bear market, which is the type of period that will really separate the best funds in the category from the rest.