What is a long-short mutual fund?
A long-short fund is a mutual fund that holds investments long and in addition, it sells securities it does not own (short). The goal of a long-short fund is to find investments anticipated to go up, find investments anticipated to go down and invest in both in an attempt to increase returns. For example, if an investor puts $100 into a long-short mutual fund, the fund manager will generally take the whole $100 and invest long in assets he thinks will do well. Then the manager will use this equity as a margin to open a short position and sell assets he thinks will do poorly.
When he shorts these assets he will receive cash, say $30 for this example. He would then use this $30 to invest long into more assets, so in total he would have a $130 long portfolio and a $30 short portfolio, effectively using your $100 initial investment to make $160 worth of investments. This type of long-short fund in the example is called a 130/30 mutual fund.
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Traditionally, the majority of mutual funds are long-only, meaning if something was considered undervalued, it would be invested in, and if security was thought to be overvalued, the only thing investors are able to do is to avoid investing in it. Long-short funds allow the manager more flexibility to act on his analysis. However, investors should be aware of the risks associated with investing in this type of mutual fund.
If the fund manager made good investments, the combination of a long and short portfolio would leverage the fund’s return upwards. On the other hand, instead of just picking stocks that managers think will go up, they also have to predict which stocks are going down, which means the manager’s stock picking skill is very important. If mutual fund historical performance is any indication, it is extremely difficult to find a fund manager that consistently outperforms the market in long-only funds. Finding one that can predict stocks that go up and stocks that go down maybe even more challenging.
Long-short portfolios hold sizable stakes in both long and short positions. Some funds that fall into this category are market neutral – dividing their exposure equally between long and short positions in an attempt to earn a modest return that is not tied to the market’s fortunes. Other portfolios that are not market neutral will shift their exposure to long and short positions depending upon their macro outlook or the opportunities they uncover through bottom-up research.
An equity long-short investment approach is predominantly used by hedge funds, entailing taking long positions in shares that are estimated to hike in value and short positions to go down. You might be aware that going for the first option translates to purchasing it and going for the short position in shares means borrowing one from a broker, fund manager, or another investor. Hedge funds with equity long-short tactics merely carry out the same on a bigger scale.
At its most fundamental level, an equity long-short plan comprises purchasing an underrated share and selling an overpriced one. Preferably, the long position will go up in worth, and the values of the short position will dip, which will lead to significant returns from the hedge fund. Hence the purpose of any equity long-short tactic is to curtail exposure to the stock market generally and gain from the differences between the two.
Long-short mutual funds are market neutral, dividing their exposure equally between long and short positions in an attempt to earn a modest return that is not tied to the market’s swings. The strategy seeks capital growth and income.
Long-short strategies are best suited to investors who expect low returns from stocks in the coming years because these strategies do not rely solely on market returns. In this environment, the best funds might be those that seek to reduce stock market exposure without eliminating it.
The goal is to get most of the market’s returns when stocks go up while paring the losses when stocks tumble. The problem with these funds is that neutral investors might prefer them, while any investor who is either bullish or bearish has better options.