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The Short Answer

Is There Room for a Long-Short Fund in Your Portfolio?

If so, it's for the long haul.

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In the current market meltdown, a fund that can profit from falling stock prices looks like the place to be. Investors appear to agree: While most categories have lost assets over the past year, the net assets in the long-short category--which is home to funds using exotic strategies, such as short selling, to stay out-of-step with the broad market--have grown by nearly 20% and now stand at $25 billion. (Short selling means that the fund borrows a stock, sells it, and hopes to buy it back at a lower price.) And while long-short funds, on average, have lost 4% for the year so far, that sure beats the S&P 500 and the typical large-blend fund, both of which have dropped 13% since the start of 2008.

The growth in assets and the category's relative outperformance begs the question: Should a long-short fund get a slice of your portfolio? And if so, which long-short fund should you choose? We'll tackle those questions in this article, and we'll also walk you through the three general types of long-short funds and explain how you can use them in a portfolio. As we go, we'll also give you some pointers of what fundamental characteristics you should look for in one of these funds.

Do You Even Need One?
So do long-short funds deserve a slot in your portfolio? Well, not always. Those who view the category as temporary shelter from the current market storm may still find themselves hung out to dry. Timing market downturns is extremely difficult, so getting in and out at the right times can be costly. As part of a long-term investment strategy, however, the category makes more sense. Research has shown that adding hedge-fund-like investments to stock-and-bond portfolios has historically led to better risk-adjusted returns over the long haul. Even so, however, proceed with a skeptical eye. Long-short funds may be worthwhile diversifiers for a small slice of one's portfolio, but so are other asset classes such as real estate and commodities. It would be a mistake to load up on such so-called "noncorrelated assets" while short-shrifting plain-vanilla stocks and bonds. And while a handful of long-short funds are worth considering, there are plenty more with inexperienced management, convoluted strategies, and painful price tags. Thus, deciding on adding a long-short fund to your portfolio should go hand in hand with a search for a long-short fund with strong fundamentals.

Meet Larry, Moe, and Curly
Say you've decided to move forward and add a long-short fund to your portfolio. Where should you start? First, it's important to remember that Morningstar's long-short category is something of a catchall, with some funds structured as diversifiers, aiming to offer limited volatility (and limited returns), and others considered return enhancers, gunning for strong returns regardless of the market environment. The funds' strategies tend to fall into one of three groups: market neutral, absolute return, and equity variable. (The 130/30 types--which use 30% of their assets to short sell stocks, then use the proceeds from those shorts and their remaining assets to invest 130% of their assets in other stocks--are considered core holdings and aren't constituents of the long-short space.) Even among these subgroups, there's a lot of variation. For instance, both market-neutral and absolute-return funds generally try to offer a low-risk, low-return profile; however, they go about it in very different ways.

Market Neutral
Like their name suggests, market-neutral funds aim for zero exposure to the broad market. That means that when the stocks tank--or rally, for that matter--these funds should remain largely unaffected. Typically speaking, a market-neutral fund buys the stocks that the manager thinks have bright prospects and then uses an equal amount of assets to short-sell the stocks that the manager thinks have poor prospects. When the broad market moves, their long and short positions should offset one another. Why? Because whatever influence the broad market has on the long positions is, in theory, exactly the opposite influence it has on the short positions. Over the long haul, the gains or losses by their stock picks should drive whatever returns they garner.

Often, these funds will bill themselves as money-market or short-term bond replacements. It's true that their returns can often look in line with those investments. But don't forget that owning and short-selling stocks gives them a riskier profile than the ultraconservative bond funds. So while investors can use these funds in moderation to limit the volatility of their overall portfolios over the long haul, we wouldn't recommend them as fixed-income replacements, and we'd strongly object to investing for short-term goals here, as you might with an ultrashort-bond fund.

Carefully consider manager skill and expenses before settling on a fund of this variety. Short-selling is no easy task; even talented managers with plenty of experience running conventional stock portfolios struggle to do it well. In fact, from what we've seen, many market-neutral funds haven't always remained neutral to the market. Phoenix Market Neutral (EMNAX) dropped 4% at the end of last summer, for example, when the market abruptly tanked.

Moreover, because these funds tend to generate moderate returns, it makes sense to look for funds with moderate expenses: The higher the expenses, the larger share they will capture of the overall total return.

Given the poor showing we've seen by many market-neutral funds--not to mention lackluster underlying fundamentals--we've yet to be convinced by many of this variety.  Calamos Market Neutral Income (CVSIX), however, is one we've liked for a while. It has both the experience and the reasonable expenses that we like to see.

Absolute Return
Unlike the market-neutral variety, the "absolute return" moniker doesn't reveal much about the aim of these funds. "Absolute return" suggests positive returns regardless of what the rest of the market is doing, but that's too high a hurdle for this group. Instead, these funds generally aim for a low-volatility, low-return profile, often using options or short-selling to get the job done. Some also take a fund-of-funds approach. By combining various uncorrelated strategies, such a global macro strategy designed to profit from global political and economic factors and a convertible arbitrage strategy, which entails buying a convertible and shorting the underlying stock, they attempt to eke out a gain over a full market cycle without causing too many fits and starts along the way.

This group is another one that investors can theoretically use to smooth portfolio volatility over the long haul. Again, bear in mind that these funds take on far more risk than the typical bond fund, so, like market-neutral funds, investors generally shouldn't consider them fixed-income replacements or use them for short-term investment goals.

These funds haven't found great success so far, and, considering the high level of skill that their strategies require, we recommend placing a premium on manager skill here as well. With a low-return profile, low expenses are another key to long-term success. Overall, we've yet to find many convincing funds of this variety, but we are keeping an eye on  Absolute Strategies (ASFIX), which uses the fund-of-funds approach that we described above. The fund's steep expense hurdle makes it hard for us to give it a wholehearted endorsement, however.

Equity Variable
Think opportunistic. Unlike the low-volatility, low-return market-neutral and absolute-return funds, the funds that fall in this subcategory often boast flexible mandates and can short stocks or load up on their favorites as they see fit. Some of this variety fall under the "return enhancer" classification, meaning that investors should consider them a way to boost overall portfolio return. Of course, by shooting for higher returns, the risks also increase. (There's no such thing as a free lunch, remember.) Indeed, the market has raked some funds in this grouping across the coals lately. Templeton Global Long-Short (TLSAX), for example, has lost nearly 15% for the year so far, and ICON Long/Short (IOLIX) is down 17%.

Our favorite equity-variable funds have experienced management teams that have proven ability to weather various markets without costing investors their shirts. And, while expenses aren't as paramount here as they are in the lower-returning long-short funds, they still matter: Our research has shown that funds with ultrahigh price tags are less likely to produce compelling long-term returns. With that in mind, we think  Hussman Strategic Growth (HSGFX) and  Diamond Hill Long-Short (DIAMX) are two funds worth considering. 

Marta Norton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.