Mutual funds that both buy stocks long and sell stocks short have been attracting inflows. Indeed, the Morningstar long/short equity fund category has seen total assets rise from $19 billion in December 2011 to more than $26 billion in December 2012. Josh Charney, an alternative investments analyst at Morningstar, sees this trend continuing.

“Part of the appeal is that long/short funds are easier to understand than other alternative strategies because it is equity based,” he says, adding that investors also like the protection these funds can offer by shorting and losing less in a market decline.

The funds in the long/short space are more differentiated than most equity strategy categories. “These funds pursue different strategies, have different net exposures and betas, and are very different from one another,” Charney says. “By contrast, large-cap value managers all have similar criteria for stock selection. But long/short managers are all over the map.”

This diversity is reflected in the approaches of Morningstar’s top-rated funds. The MainStay Marketfield fund (MFLDX) uses a global asset allocation strategy, based largely on the macroeconomic viewpoint of manager Michael Aronstein, whose stewardship has delivered a 11.77 percent return over the past year (through April 25) and 7.40 percent over the past three years, easily besting the category average of 6.09% and 3.91 percent, respectively. The fund’s expense ratio is 1.53 percent.

Morningstar rates this fund five stars based on historical risk-adjusted returns, and awards the fund a “bronze” medal based on a subjective evaluation of the fund by the analyst.

Another solid fund in the long/short category, the Robeco Boston Partners Long/Short Research fund (BPRRX), takes a bottoms up approach to buying and selling stocks based on valuation targets.

The fund, which was launched in 2010 after Robeco closed its original long/short fund to new investors, has returned 9.8 percent over the past year. The fund’s expense ratio is 1.79 percent.

Charney has a positive view on the fund based on its short-term track record, as well as on the firm’s historical results and its strong investment process.

“Robeco’s fund is another compelling opportunity,” he says. “Robeco has a strong but volatile value-add from the short side, adding two percent annually for the last 10 years.” Morningstar awarded the fund a bronze medal.

Style Drift

Analyzing returns from the short side is critical in examining these funds, since shorting is one of the prime differentiating practices of these funds. In addition to Robeco’s funds, MainStay Marketfield has also added value on the short side. But not all funds attempt to deliver absolute returns from the short side. Some managers use put options, which will typically don’t make money but hedge the long exposure.

Financial advisors who use long/short funds should also consider the varying exposures of these offerings. While the funds typically have risk targets they attempt to achieve, both their gross exposure (which measures the absolute percentage of equity invested in stocks) and net exposure (which subtracts short exposure from long exposure to arrive at the amount of unhedged long exposure) can change, which means there is some element of market timing at these funds.

For advisors familiar with the risks of ‘style drift,’ this approach can be anathema. But coming to terms with this risk is a critical part of becoming comfortable with these funds. “I am not looking for dogmatic managers who are very bullish or bearish, but rather those that navigate the field as situations change,” Charney says.

He notes that Morningstar generally doesn’t like market timing approaches, but adds that making thematic and uncorrelated bets across international markets has worked for MainStay Marketfield, and that both Robeco and MainStay Marketfield have experience and long track records with their respective styles.

And for some advisors, this type of flexibility creates opportunity. “Marketfield has delivered remarkable performance, with limited downside in 2008, and nearly full upside capture in the 2010-2012 period,” says Joseph Schwarz, a managing member at Schwarz Dygos Wheeler Investment Advisors LLC, a Minneapolis-based wealth management firm.

Schwarz currently allocates five percent of his clients’ portfolios—and ten percent of their equity allocations—to the MainStay Marketfield fund. “Although I worry if the performance is repeatable, and not just the result of a late 2007 launch, I am encouraged by the positive results of the quarter-over-quarter performance comparisons to the S&P 500,” says Schwarz.

Other Options

In addition to the Robeco and MainStay Marketfield offerings, Morningstar is also positive on some of the funds that use options to limit risk, including The Collar fund (COLLX), which is long equity and buys puts while selling calls, and the Gateway fund (GATEX), which uses the same option strategy and is tax efficient, Charney says.

The former is rated bronze and the latter is rated silver, and both carry an expense ratio of 0.94 percent.

Morningstar is also positive on the Wasatch Long/Short Investor fund (FMLSX), which has two portfolio managers—one with a tactical and macro approach, and the other focused on bottoms up stock picking. It charges 1.27 percent.

ETFs

There are also exchange-traded funds that follow a long/short equity strategy. The ProShares Large Cap Core Plus (CSM), which is rated five stars by Morningstar, returned16.67 percent in 2012 and has delivered 11.70 percent year to date. Both figures are in the top one percent for funds in this category. The fund’s expense ratio is 0.45 percent.

The AlphaClone Alternative Alpha ETF (ALFA) constructs portfolios based on the publicly filed holdings reports of top hedge funds, and is up 10.55 percent year to date, ranking in the 15th percentile in the category. The expense ratio is 0.95 percent.

Overall, Charney believes these funds do have a role to play in investors’ portfolios. “This category will offer investors a more muted risk profile,” he says. “If you are scared of equity exposure or want to hire extremely active managers, these funds can be appealing.”

For advisors looking to add equity exposure while minimizing market risk, or hoping to add active management that is truly active, these funds are worth a look.