Separate the Wheat from the Chaff in Long-Short Land

The past year was nothing if not volatile. The S&P 500 Index gained 5.5% last year, but thanks to the subprime mortgage debacle and the crippling credit crisis, its annual standard deviation of returns was near 10%, making 2007 bumpier than any of the calendar years since 2003. Given the ups and downs, it's not too surprising that funds offering protection from the fits and starts have attracted more attention. In particular, long-short funds, or funds that can buy stocks or bet against them by selling them short, have intrigued investors. Many of them employ strategies formerly used only by hedge funds and aim to provide a smoother ride than the broad market.

There's some evidence these funds can deliver. In 2007, the category's median standard deviation of returns was about 3 percentage points lower than that of the S&P 500, at roughly 6.5%. But that isn't reason enough for investors in search of a safe haven to pile blindly into the category. Many of these funds rely on complicated strategies and hold exotic securities. Given the embedded risks of their approaches, a year is simply too short a time period to gauge their worth. And because the typical long-short fund is only three years old, most have yet to prove their long-term merit. Plus, even over their short lifespans, long-short funds have earned a wide range of returns.  Caldwell & Orkin Market Opportunity (COAGX) topped the category with a 33% return in 2007, while Forward Long/Short Credit , the category's worst performer, lost 17%. Thus, those drawn to a fund for its bold promises and newfangled strategy could very well suffer painful losses when something goes wrong.

All things considered, we recommend extremely careful analysis before investing in a long-short fund. With so much uncertainty, the characteristics that are important at more conventional mutual funds, such as manager experience, sensible strategies, and low expenses, are even more critical here. Below, we highlight a couple long-short funds that look good from all the traditional angles, as well as two that don't.

The Cheap and the Proven
 Hussman Strategic Growth (HSGFX)
This fund looks good on all fronts. Its manager, John Hussman, has been at the helm since the fund's mid-2000 inception. Hussman looks for stocks selling at attractive valuations, but he also uses options (securities that grant the buyer the right to buy or sell stocks at specific prices) to adjust broad market exposure based on macro signals. Broad market calls are tough to get right consistently, but Hussman has earned a respectable record over his tenure by outperforming during hard times (consider the fund's gains in 2001 and 2002) and keeping pace when the market takes off. (It gained 21% in 2003's growth-hungry market.) We like that the fund's 1.11% expense ratio clocks in well below the no-load, long-short category median, as Morningstar research has shown expenses are the most powerful predictor of future long-term returns. We're also pleased Hussman is invested alongside shareholders: He has more than $1 million invested in the fund. That investment gives him added incentive to act in shareholders' best interests.

 Calamos Market Neutral Income (CVSIX)
In a category dominated by fledgling offerings, this fund is another one of the few that's proven its merit over a longer time horizon. Lead manager John Calamos has been running the fund since its 1990 inception. Along with other members of the investment team, Calamos invests in convertibles (hybrid securities with stock and bond characteristics) and options. The team's efforts have kept the fund from responding to the broad market's ups and downs--its since-inception beta, which measures its volatility relative to an index (in this case the S&P 500), stands at 0.18--and have also earned an excellent risk/reward profile. The fund's 7.5% return over the 10 years ending Dec. 31, 2007, is behind that of the S&P 500, but its 4% standard deviation returns, a measure of return volatility, is nearly 11 percentage points lower than that of the index. A 1.15% reasonable expense ratio (the typical front-load, long-short fund charges 1.67%) rounds out the fund's appeal, as it makes it easier for the fund to continue its peer-beating ways.

Siren's Songs
 Laudus Rosenberg Value Long/Short 
We're not overly confident in this fund's long-term prospects. Introduced in late 1997, it takes a market-neutral approach by buying roughly 600 stocks ranked as attractively valued and financially healthy by its quantitative model, and selling short another 400 that don't stack up as well. Those efforts have kept the fund from responding to every fit and start of the broad market, but they haven't helped it keep pace with the three-month Treasury Bill (a common benchmark for funds practicing a market-neutral approach). The fund has lagged the T-bill in 52% of the 109 rolling 12-month periods since its inception. Part of the trouble is the breadth of strategy. In strong markets, it's tough to find 400 stocks that are poised to fall, and in bad markets, it's hard to find nearly 600 stocks poised to climb. Of greater concern, however, is the fund's high expenses. The fund charges a hefty 1.99%, which makes its modest performance goals that much harder to achieve. Taking that into account, this fund may very well be doomed to mediocrity.

 Alpha Hedged Strategies 
This fund has a certain appeal. Managers Lee Shultheis, Michael Portnoy, and Mark Tonucci sort through hedge fund managers practicing a variety of approaches and enlist the ones they feel are the best as subadvisors for the fund. Given the complicated strategies and the lack of transparency in the hedge-fund world, having people who know the terrain pick managers for you can simplify things. Moreover, combining many strategies under one roof helps the fund do well in different market environments. Over its lifetime (it was introduced in 2002), the fund has earned steady returns with limited volatility each year. So what's the problem? The fund charges a painfully high 3.99% expense ratio, which takes an enormous bite out of returns. Over the long haul, it's tough to see how the fund will have an edge over other options that come at more attractive prices.