Long-Short Mutual Fund Investing

Looking for an investment that will survive--or even thrive--in a risky stock market environment? Consider the growing number of long-short offerings: mutual funds that couple investments in securities with upside potential and short selling, or betting that a stock will tumble.

Still a relatively small portion of the mutual fund market, long-short mutual funds are growing in popularity, reports Dan McNeela, associate director of funds analysis at Morningstar Inc., who attributes the bump to the success of the hedge fund industry. "The short component hedges the fund's exposure to a broad stock market decline, so the fund's performance is linked to the manager's strategy and execution of that strategy rather than how the market as a whole performs," he says.

But investors can enter a long-short fund with a mini-mal investment and can cash out at anytime, while hedge funds usually require a six-figure minimum investment, charge hefty management fees and impose severe liquid-ity restrictions. "[Long-shorts] have become a good diversification tool," says McNeela, who notes that the prolifera-tion of long-shorts spurred Morningstar to roll out a separate category for tracking the funds.

But remember, long-short funds are only as good as the strategy underlying them and the fund manager's execution of that strategy. "Long-short investors need to understand the strategy and look for proven fund managers," says McNeela. "[And] pay close attention to expenses because fees can be high relative to those of [traditional] mutual funds."

This article was originally published in the August 2006 print edition of Entrepreneur with the headline: Safe Bet?.