These funds offer an alternative for investors looking to reduce volatility without giving up the benefits of stocks. They're also good diversifiers because they don't move in tandem with either stocks or bonds. By Katy Marquardt, Staff Writer March 26, 2007 As many of you know from painful experience, stock funds can suffer big losses quickly. That was certainly the case on February 27, when stock markets around the world tanked. And sometimes, as the 2000-02 bear market demonstrated, stock funds lose money over agonizingly long periods. Historically, the best way for investors to stay afloat as stocks sank was to keep some of money in bonds or bond funds. But now comes a relatively new category -- so-called long-short funds -- that offers a tempting alternative. These funds purport to offer stock-like returns with low, bond-like volatility and behave differently from either asset class. Long-short funds use a sophisticated strategy ripped straight from the playbooks of hedge funds: short-selling. Most funds "go long" on stocks by betting that their share prices will rise. "Shorting" is a way to make money from the decline of a stock. To do this, a manager borrows a stock and sells it with the intent of buying it back later at a lower price -- and profiting from the difference. By design, long-short funds behave differently from almost anything in your portfolio. Shorting enables funds to appreciate when the market slumps, or at least decline less than other stock funds. Meanwhile, these funds also own stocks the old-fashioned way, which lets them participate in market rallies. The combination of both "longs" and "shorts" has a stabilizing effect on returns, making the funds far less volatile than the overall stock market. Perhaps most importantly, the performance of long-short funds doesn't correlate with stocks or bonds. Such unique behavior allows them to serve as diversifiers, which means they should reduce overall portfolio risk. There are some caveats. For starters, annual fees are costly compared with those of traditional stock funds. One reason is the extra cost of running both a long and a short portfolio. These funds must also pay dividends on the stocks they've borrowed to establish short positions. Long-short managers are quick to point out that their fees are much less than the cost of traditional hedge funds: 2% of assets per year, plus a 20% cut of profits. Still, a 2% to 3% expense ratio for long-short mutual funds is hard to swallow. Most long-short funds are so green that they haven't yet been put to the test of a bear market. However, their performance during shorter market pullbacks offers some insight into how they might perform during a long slide. Many long-short funds use computers to choose which stocks to short and which to buy. The Schwab Hedged Equity fund (symbol SWHIX) starts with the top 3,000 domestic stocks by market capitalization. Each stock gets a grade of A through F, based on a number of value, risk and momentum factors. The fund's three managers then decide with of the A- and B-rated stocks to buy, and which D- and F-rated stocks to sell short. The portfolio's short position ranges from 20% to 60% of assets. "That means that for every $1 we invest, we additionally sell short somewhere from 20 to 60 cents," says manager Vivienne Hsu. The fund is currently shorting 35% of assets, with the shorts spread among all sectors. The fund aims to beat Standard & Poor's 500-stock index, but to do so with significantly less volatility. So far, it has been successful. The fund's oldest share class, Select, returned an annualized 13% since its 2002 inception through February 28, 2007, the same as the SP (the retail class, with a cheaper $2,500 minimum initial investment, launched in 2005). But Hedged Equity achieved the same gain with about 40% less volatility. "The return is similar, but the path we took there was different," says Hsu. Don't expect show-stopping results during strong up markets. That's precisely by design. These funds truly show their mettle when the market craters. For example, when the SP lost 3.3% on February 27, Hedged Equity lost only 1.8%. The fund charges 1.98% in annual fees. As the market rises and falls, so do opportunities to go long and sell short. That's the view of the managers of ICON Long-Short, another computer-driven fund with the ability to short stocks. Although ICON (IOLIX) can put as much as 50% of the portfolio in short sales, the fund hasn't shorted more than 25% since its 2002 inception. That's because opportunities to short have been scarce since the bull market began in 2003, says J.C. Waller, one of three co-managers. "The way we think of it is that we afford ourselves the ability to short when the right market conditions exist," he says. Currently, the fund is shorting just under 4% of its assets -- all in real estate investment trusts. Says Waller: "REITs have had a tremendous run but are now starting to show persistent signs of weakness. That's where we're seeing the most overpricing." Because the fund is heavily biased on the long side, its performance is largely driven by stock selection. ICON's screens flag undervalued sectors and industries that show good relative strength compared with the overall market. The idea is to scoop up bargain-priced stocks that are beginning to show signs of improvement. Over the past three years, the fund, which carries a 1.45% expense ratio, has returned an annualized 10%, an average of one percentage point per year more than the SP. Michael Orkin has been in the long-short business longer than most fund managers. Since 1992, he has steered the Atlanta-based fund Caldwell & Orkin Market Opportunity (COAGX) to an 11% annualized return, with volatility half that of the SP. Orkin uses quantitative models to help him assess the big economic picture and decide how much of the fund to dedicate to short-selling (he can go up to 60%.) Quant screens also lead Orkin to buy or short particular companies or sectors of the market. On the flip side, Orkin uses bottom-up analysis to buy or short a stock based on that company's prospects. This includes identifying catalysts that could spark growth, such as management changes and new products. Caldwell & Orkin's long-term performance illustrates the long-short strategy's strengths and weaknesses. From 1995 to 1999, the fund churned out annualized returns of 24%, with astonishingly low volatility. It also gained 28% during the 2000-02 bear market, when the SP plunged 47%. But as the market rallied, the fund logged small losses in 2003, 2004 and 2005. It gained 7% in 2006, again trailing the SP. Orkin admits that the rising market over the past few years has made it difficult for short sellers. Large buyouts engineered by private equity groups have been particularly troublesome. Even the rumor of a takeover bid is enough to cause a spike in the shares of a potential target, which hurts short-sellers. "When a stock gets beaten up, often private equity will come in and grab the stuff we like to short," says Orkin. Lately, the fund has been on a tear, thanks to shorts in the subprime mortgage sector. So far this year through March 23, Caldwell & Orkin has climbed 7.2%, 5.5 percentage points ahead of the SP. Orkin is currently shorting 37% of the portfolio, with his biggest shorts in companies that supply building materials to home builders. The fund, which has a minimum investment of $25,000, charges 1.60% in annual fees.