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A long-short fund is a mutual fund, hedge fund, or exchange-traded fund (ETF) that takes both long and short investment positions.
A long-short fund is a mutual fund, hedge fund, or exchange-traded fund (ETF) that takes both long and short investment positions. Simply put, these funds take long positions in stocks they expect will increase in value and short positions in stocks they believe will decrease in value. These funds often employ investment techniques pioneered by hedge fundsleverage, derivatives, short positions, etc.and later adopted by mutual funds and ETFs. As the name suggests, most hedge funds fall into this category, and 176 mutual funds and ETFs listed by the Financial Industry Regulatory Authority (FINRA) are also in this category. [1] Long-short funds are also known as enhanced or 130/30 funds.
Long-short funds aim to enhance returns by investing in specific markets and taking both long and short positions. These funds typically have higher expense ratios due to the need for active management, expertise and analysis. As of 2024, the average expense ratio for long-short funds listed in FINRA's database is 1.98%, while the expense ratio for all equity mutual funds in 2023 is 0.42%. [2]
Like their long-short hedge fund counterparts, these mutual funds and ETFs use similar strategies, but there are significant differences. They offer similar portfolios, balancing higher risk with greater return potential, against standard benchmarks. Most long-short funds offer higher liquidity than long-short hedge funds, have no lock-up periods, and have relatively low fees. However, their expense ratios are still higher than other public funds and their liquidity is relatively low. Additionally, many funds require higher minimum investment starting points and are among the 9% of mutual funds that impose front-end and back-end fees (commissions). [2]
Historically, mutual funds and ETFs, especially those with long-short strategies, have had certain limitations on leverage and risk tolerance. Dating back to the Great Recession, these restrictions were designed to protect ordinary investors who might not fully understand the complexities of these financial instruments. Although some rules have been relaxed in recent years, regulations remain strict to protect public investors from undue risks. [4]
Long-short funds can be a good investment option for investors looking for target index exposure and some active managementprovided you understand the risks involved. Long-short funds also provide hedging capabilities against market changes and other trends, allowing better managers to make adjustments.
The most common long-short strategy is a 130% long and 30% short position on the asset under management (130 - 30 = 100%). [5] For example, a fund manager might rank S&P 500 stocks based on expected returns, from best to worst.
Fund management teams take large amounts of data and use quantitative rules to rank stocks. Selection criteria may include total return, risk-adjusted performance or relative strength over a specific period - six months, a year or other time periods.
The manager can then invest 100% in the highest-ranked stocks and short-sell the lowest-ranked stocks, up to 30% of the portfolio value. Proceeds from short sales will be reinvested in the highest-ranked stocks, gaining greater exposure to rising prices. [5]
Let's look at two examples to illustrate how two funds in this category allocate their assets in very different ways.
The AQR Long-Short Equity Fund is one of the better-performing long-short equity funds for long-term investors. The fund invests in companies across a variety of industries around the world, as shown below. You can see what percentage of the fund's holdings are long and short in each industry.
As of the first quarter of 2024, the fund's annualized total returns over the past three, five and ten years were 23.04%, 13.32% and 10.[6]% respectively. Its annual expense ratio is 4.35%6.
The Invesco S&P 500 Downside Hedged ETF (PHDG) is an actively managed ETF designed to achieve positive returns in both bull and bear markets, regardless of trends in stocks and bonds. This ETF contrasts with QLEIX, showing how long-short funds take very different approaches to hedging downside risk.
While QLEIX typically takes short positions in the same industries in which it establishes long positions, PHDG allocates its assets among the components of the S&P 500 Dynamic VEQTOR Index. The latter consists of stocks representing the S&P 500 Index, volatility hedges representing the S&P 500 VIX Short-Term Futures Index, and cash. Below is a chart of its holdings.
Invesco said its funds track the performance of the broader equity market while providing a hedge against implied volatility. The fund adjusts its exposure based on stocks and volatility in the S&P 500 Index. As of April 2024, the fund's expense ratio is 0.39% -- relatively low for an actively managed fund, although it shares the characteristics of an index fund, which typically has lower fees. Meanwhile, its three-, five- and 10-year returns were 4.41%, 7.05% and 4.69% respectively.
Long investing is the purchase of securities with the expectation of selling them at a higher price in the future. Short investing, on the other hand, involves borrowing shares from a broker, selling them, and then buying them back at a lower price to return to the broker, with the goal of profiting from the decline in the value of the security. [7]
Most broadly, options and other derivatives trades are often used to hedge downside risk in stocks. However, long-short funds incorporate this into performance optimization. Market-neutral funds attempt to profit from price differences between stocks while minimizing exposure to the overall market. They take long and short positions among carefully matched stocks to hedge broader market risks. There is also pairs trading, which is a strategy of establishing a long position in one stock while simultaneously establishing a short position in a closely related stock. The goal is to profit from temporary inconsistencies in their prices. [8]
Short selling is considered more risky, mainly because there is no limit to how much a stock can rise in price. When you open a long position, the worst-case loss is limited to 100%. There is no limit to short selling. [5]
Long-short funds don't just invest in stocks that are considered undervalued. These funds stand out because they are also involved in short-selling trades, profiting from price depreciation. The additional trading activity increases the likelihood of higher returns, but at a cost: Long-short funds are generally riskier than regular mutual funds, have higher fees and are less liquid.
[1] D. Aryeh, T. Alessi, M. Gerber, and C. Kohler. "Equity Long/Short: Because Life Is Too Short To Be Just Long." Hedge Fund Journal.
[2] Investment Company Institute. "2023 Fact Book."
[3] Financial Industry Regulatory Authority. "Fund Analyzer."
[4] B. McCann. "Tactical Portfolios: Strategies and Tactics for Investing in Hedge Funds and Liquid Alternatives," Pages 3-6. John Wiley & Sons, 2014.
[5] J. Parnes. "Short Selling for the Long Term: How a Combination of Short and Long Positions Leads to Investing Success," Pages 82-83. John Wiley & Sons, 2020.
[6] AQR. "RiverPark Long/Short Opportunity Fund."
[7] Gregory-Allen, R.B. et al. "Short Selling by Portfolio Managers: Performance and Risk Effects Across Investment Styles." In Greg N. Gregoriou, ed., "Handbook of Short Selling." Pages 437-451. Academic Press, 2012.
[8] CMC Markets. "[Pairs Trading: An Advanced Strategy for Hedging](https://www.cmcmarkets.com/en/trading-guides/p
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