Long-Short Funds Can Steady Your Portfolio

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.

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.

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Staff Writer, Kiplinger's Personal Finance