In 1999, as most investors were piling on to the technology stock bandwagon, Michael Shinnick was contemplating how to get off. Shinnick, then a 30-year-old management consultant, had invested a substantial amount of his own money in the hot sector, and as stock prices climbed to stratospheric levels, he began to worry about a downturn. So he tried short-selling. That move helped him protect his gains when the market plunged the following year.

A few years later, Shinnick met with Ralph Shive, the chief investment officer at the Indiana firm 1st Source Corporation Investment Advisors. Shive was looking to incorporate short-selling into the portfolios of his clients to protect them, too. The two men considered forming a limited partnership to run a long/short strategy, but they were discouraged by the long lockup periods and high investment minimums.

They decided to launch a mutual fund instead, and in 2003 Shinnick left the consulting world to co-manage what would later become the Wasatch Long/Short fund. Now 44, he remains at the helm as lead manager while Shive co-manages.

If Shinnick’s path from personal investor to portfolio manager of a $1.3 billion fund deviated from the usual professional career, the same can be said of his fund’s returns. From its inception in August 2003 through the end of June 2013, the Wasatch fund has beaten the S&P 500, as well as the returns of most competitors in Morningstar’s long/short category, with a 6.8% annualized return. At the same time, it has suffered less volatility.

Shorting, in fact, has proved to be an effective tool for cushioning market downturns. In 2008, for example, it helped limit the fund’s loss to 21%, while the S&P 500 lost 37%. Yet, unlike its peers, the Wasatch fund also has a decent amount of pep in bull markets, says Morningstar analyst Mallory Horejs.
“While most long/short equity strategies trail in upward trending markets, Shinnick manages to capture more market upside than many of his peers, due largely to strong stock-picking skills and effective market exposure timing,” Horejs wrote in a July report.

According to Wasatch’s most recent fact sheet, the fund has captured 68% of the market’s upside and 51% of its downside since its inception.

Because managers who short do so in very different ways, they can produce dramatically different returns and volatility. The most controversial strategy of the breed, leveraged long/short funds, are the most volatile because they reinvest the proceeds from short sales in additional securities instead of holding the money in cash. This can amplify the returns, both up and down.

Another breed of funds that short securities, market neutral funds, aim to preserve capital by investing equal amounts in both long and short positions. The goal is that they will roughly balance each other out and the portfolio will deliver small, consistent gains. While the risk is low with these types of funds, the upside is fairly limited.

Wasatch Long/Short falls into a kind of in-between category called “directional long/short funds.” Instead of juicing up returns through leverage, these funds short-sell securities as a hedge against a stock market plunge. If the managers of these funds are very bullish, they can invest up to 100% of the assets in long equities, but also have the flexibility to take short positions in stocks they deem overvalued. They can eliminate the risks of leverage because they hold cash from the short sales in cash equivalents to cover the short-sale liability. Typically, their goal is to produce equity-like returns with lower volatility.

In Wasatch Long/Short, Shinnick and Shive look at the broad economic picture as well as valuations for individual sectors and stocks to tailor long/short exposure. They evaluate a stock based on their estimate of the company’s intrinsic value, or what a knowledgeable private buyer might pay for the company in a sale, as well as more traditional metrics such as the price-to-earnings ratio. They cap each long position at 6% and typically hold on to a security for at least two years. Meanwhile, they will not hold a short position at more than 3% of the portfolio, and those stay in for an average of only about six months. As of June 30, the portfolio held 53 long positions and 21 short positions.

The fund typically shorts between 20% and 30% of its assets, but that can vary widely depending on the managers’ view of the market. After the brutal slide in 2008, Shinnick reduced the short side to 10% because he saw abundant stock market bargains and felt the worst was over. But the fund’s highest short position, at 35%, came a few months later in February and March of 2009, when concerns about the financial health of banks led Shinnick to short stocks in that sector. Recently, the portfolio has been about 11% short. The position reflects the managers’ positive outlook for some corners of the market, and their less rosy outlook for bonds, which could slump if interest rates rise.

Despite that view, Shinnick cites a number of reasons investors should consider using a long/short fund. “Stocks tend to move in cycles, and some people believe we could be moving toward the next down cycle,” he says. “No one can predict where the market may be headed. But I do know it makes sense for a fund manager to have the flexibility to protect on the downside as conditions change.”

The uncertain outlook for fixed-income securities also means that increasing the bond side of a portfolio won’t necessarily provide the ballast it once did for portfolio managers. Amid rising interest rates, he says, using a long/short approach might be a better way to tame portfolio volatility.

“The goal of this fund is to produce mid- to high-single-digit total returns over the long term,” he says. “That’s also the goal of a lot of asset allocation funds. But in a rising rate environment, it is going to be difficult for the fixed-income side to pull its weight.”

While Shinnick views the broad market as “fairly valued,” he has observed a wide discrepancy in valuations among sectors. Some, he says, are still reasonably priced and have substantial upside potential. Others are overvalued and could be ripe for a downturn.

Sectors falling into the latter camp make up the fund’s short positions and include more defensive areas with high dividend yields such as utilities and telecommunications. A lot of people have already flocked to these stocks in their search for yield, and the companies don’t have much potential for growth.
In addition to rich valuations, Shinnick also looks for some catalyst that will likely lead to a stock’s further price deterioration. One of the fund’s newer short positions, J.C. Penney, recently announced that one of its biggest shareholders, Vornado Realty Trust, was selling positions. The department store has also issued a large amount of debt. “J.C. Penney represents the kind of short we look for,” says Shinnick. “It has a very leveraged balance sheet, negative cash flow and faces significant operating challenges to return of profitability.” Another company the fund is shorting, Verizon, is on much firmer financial footing, but Shinnick believes investors have overvalued it.

The long side of the portfolio features more cyclical companies in the financial services, energy and information technology sectors. Shinnick says many stocks in those groups are trading at attractive valuation levels, and the companies are rewarding shareholders by increasing dividends and buying back stock.

Often, he’ll decide to jump into a stock after investors have punished it for a disappointing earnings report or other reasons he considers temporary. He added Apple to the long side of the portfolio earlier this year after an underwhelming earnings release pushed its price down to attractive levels. Shinnick says the large amount of cash on the company’s balance sheet will help support the further expansion of the stock’s already attractive 3% dividend yield, and he believes that the extension and improvement of the current product line, as well as new innovations, will help fuel earnings growth. Some industry analysts have also speculated that Apple may use consumer information from its iTunes database to sell other items through a secure iPhone payment system.

Another fund holding, Denbury Resources, specializes in squeezing out more oil from mature land-based oil fields where production has been declining. While the company’s stock has retreated with the rest of the energy sector recently because of falling oil prices, Shinnick believes investors will eventually reward the company’s differentiated business model and growing cash flow.

Shinnick also holds iRobot Corp., a company that enjoys a large amount of sales, about 80%, from self-propelled floor-crawling vacuum cleaners, which are gaining an audience in overseas markets. The company also makes robotic devices that detect explosives, an area of business that depends highly on government contracts. Shinnick took a position in the fall of 2012, after concerns about cutbacks in defense spending sent the stock falling. He sees the cutbacks as a temporary problem and is confident that the company will continue to successfully grow the consumer side of its business in overseas markets.