Searching for the Fund That's Always a Winner
Long-short funds promise a bear market refuge and steady returns. But there's a better, simpler way to get that.
(MONEY Magazine) – It's the holy grail of investing: a fund that makes money year in and year out, no matter how the market performs.
For years, hedge funds--along with a few retail mutual funds--have carried on the quest with what's called a long-short strategy. That basically means buying stocks that the fund manager expects will go up (going long), while at the same time betting that other stocks, or the market as a whole, will go down (going short). The 2000 crash, the seesaw nature of the current bull market and the cool factor of hedge funds have piqued interest in long-short funds. Spying an opportunity, Janus and American Century are getting into the game. And fund trackers Morningstar and Lipper have recently carved out new long-short fund categories--moves that are likely to attract new cash to these funds, prompting fund companies to turn out still more of them.
Two Sets of Bets
In theory, the funds are a great idea. By shorting--that means borrowing shares of a stock from a broker, then selling them to another investor in the hopes of buying back at a lower price--the manager lessens the chance that you'll get killed in a bear market when most stocks are falling. A long-short fund may even go up then. True, in a raging bull market the funds should lag, but raging bulls are hard to spot these days.
There are several ways to play the long-short strategy, but most of the funds employ one of three variations. The first holds mainly long positions but varies the proportion of shorts based on how the managers see the market's prospects. Others balance their long and short positions to effectively give you zero exposure to risk in the overall market. And a few funds buy stock in companies that are being acquired, and short the purchasing companies. All of these funds, however, tend to move very differently from the overall market. In effect, they're a way to use stocks to diversify away some of the risk that comes with owning stocks. Sounds pretty neat, right?
The fact is, most of these funds haven't lived up to their hype. That's because long-short managers face two giant challenges. One is stock picking. "You have to get both your long and short bets right," says Dan McNeela, associate director of fund analysis at Morningstar, "and few managers are really good at both." The other problem: hefty expenses. The typical long-short fund costs 2.4% of assets a year, nearly twice the expense for the average stock fund. And the constant readjustments of their portfolios cut further into returns. "When you add the transaction costs and short-term taxable gains," says Ross Levin, a financial adviser in Edina, Minn., "the typical long-short fund manager has a 5% hurdle to overcome before delivering any returns to investors." And as the graphic below shows, over the past five years those high expenses have become a drag on the average long-short fund's performance, despite their solid record in the bear market of 2001-02.
An Easier Way
The flaws plaguing long-short funds raise a fundamental question: Why try to outmaneuver the market with a single fund? There's a far less expensive, more effective way to protect against market downturns and achieve steady returns--and that's to build a diversified fund portfolio of U.S. and overseas stocks and bonds. As Rick Ferri, a financial adviser in Troy, Mich. puts it, "Some 90% of the game is doing asset allocation." It works, and you can do it simply and cheaply.
Take a basic three-fund asset mix using index funds--say, 50% in Vanguard Total Stock Market, 25% in Vanguard Total International Stock and 25% in Vanguard Total Bond Market. The overall expense ratio for this portfolio is roughly 0.2%, less than a tenth the cost of the average long-short fund. With this allocation, your portfolio would have outpaced the S&P 500 each year for the past five years and held your losses in 2002 to half that of the index's. You would have earned an average annual return of 6.3% vs. 4.5% for the long-short category. That record may not constitute the holy grail, but given that it includes a nasty bear market, it'll do just fine.
TO SURVIVE A BEAR ATTACK, DIVERSIFY
In a down market long-short funds do much better than the S&P, but so does a balanced portfolio holding bonds and foreign stocks.
But over the long run long-short funds' high costs are a drag on their returns. You'll earn more from a balanced investment mix.
NOTES: Balanced portfolio is 50% U.S. stocks, 25% international stocks, 25% U.S. bonds. Returns as of March 15. Three- and five-year returns are annualized. SOURCE: Morningstar.