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Alternatives Weekly

Three Traits of a Successful Long-Short Equity Manager

Distinguish Between the Pros and the No's.

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The alternatives category provides an exciting new approach to the old asset-allocation conundrum. Many investors seek the long-term return potential of the stock market, but bail out when volatility creeps up a few notches, only to miss out on any sort of recovery. The difficulty for advisors is how best to dampen volatility in their clients' portfolios, so that it's palatable during turbulent times, while still insuring that their clients will have adequate funds for retirement. A long-short equity fund may be just the solution. Since these funds can short securities, managers can hedge the portfolio and boost returns in a down market. But buyers beware; not every long-short fund is good. In fact, the average long-short mutual fund manager has lost money over the last one and three years (ended Sept. 30), while the S&P 500 is up. Several long-short managers have handily beaten the market, however, on both a total-return and risk-adjusted return basis. Here are a few traits that separate the good from the bad.

Proven Short-Seller
Conveniently, the first characteristic of the most skilled long-short managers can be found right in the category's name: short(ing). Despite the number of funds that short (there are more than 70 long-short equity funds), there are few that are good at it. Although screening on a manager's short performance is difficult (funds are not required to segregate long and short performance), one way to determine a manager's shorting acumen is see how much alpha (or outperformance above the fund's exposure to the market, or beta) a fund provided during a market's rough patch, which is when a shorting strategy should pay off. Of the 27 funds around in 2008, only 10 exhibited alpha.

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

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