Are new strategies from long-short
managers more sophisticated, or just riskier?

There are increasing ways to make plays on market risk now. You can buy funds that, like a funhouse mirror, will do the opposite of the Nasdaq. Twice. Or you can buy Google when its price is in the nosebleed area, then sell a call on it. You can buy pairs, holding Pepsi long and selling Coke short.
In a market moving up, down and sideways, spreading the risk doesn't sound like a bad idea.
Take John K. Bacci, a planner with Foundation Financial Advisors Inc. in Linthicum, Md., who doesn't look back on 1999 with fondness so much as vertigo. That year, his firm held positions in stocks like Yahoo! and Cisco Systems Inc., whose prices were climbing to dizzying heights and sometimes quintupling in value. He wanted to play it safe and shave positions. But clients, expecting 100% returns back in those days, couldn't believe he would sell.
"I had a client with a 2,000% rate of return on a Yahoo! position and the client almost closed their account because I sold little chunks of the position on the way up-and in hindsight we were not even close to the top," he recalls. "The client came in screaming bloody murder: 'What kind of idiot are you?'"
Out on a limb with what he considered overvalued names, he started thinking about downside protection more-selling calls against existing positions, buying puts and investing in long-short funds.
Long-short portfolios, with riskier strategies that allow portfolio managers to short sell a large percentage of fund positions, have come into vogue among retail mutual fund managers only in the past few years after long being the private preserve of the ultrasecretive hedge fund industry. In search of something that would offer him some downside protection and less correlation to the market, Bacci turned to portfolios offered by Diamond Hill Investments, Calamos Investments, Charles Schwab and Franklin Templeton Investments. He says that about 70% of his portfolios now include a long-short fund or some options trading.
Those funds haven't been such bad refuges for either bad or good weather. The Diamond Hill Long-Short Fund A (DIAMX) was up 12.81% for the five years ended Dec. 31, 2006. The Charles Schwab Hedged Equity Select fund (SWHEX), whose shares were first offered in September 2002, is up 13.17%, annualized, from inception to December 2006. The Calamos Market Neutral Income Fund (CVSIX) has gone up only 5.35% for the past five years, but that includes a 6.6% return for 2002, when the S&P 500 was a negative 22%.
Vivienne Hsu, vice president and senior portfolio manager with the Schwab Hedged Equity fund, says that long-short strategies are becoming more popular among retail investors who, just as they did after the bull run in the 1990s, maybe feel the good times can't last forever. "With the market very strong, but economic as well as market signals going mixed, many people do want to continue to participate on the upside with caution," she says.
Still, though long-short portfolios allow investors to make bets on names that are both rising and falling, such strategies also offer them two ways to lose money: The long positions can wilt and the short positions can unexpectedly sprout. The latter event is more fearsome, because, while a long holding can only dwindle to zero, a short holding can, in theory, lose an infinite amount of money forever, at least until the borrower eats crow and buys back the pricey shares to cover the lend from the broker or gets taken out of his misery by a broker.
For those and other reasons, many financial planners aren't yet convinced. "It's another one of those things that works in theory, but not in the real world," says Thomas E. Murphy, a financial advisor with TEMAA Financial LLC in Dallas. "It requires that the manager be able to predict both what goes up and what goes down with some accuracy, and we know that's a hard thing to do."
Murphy adds that the turnover in these funds makes them less tax-efficient, and even when they are successful, the additional expenses outweigh the additional return. He thinks clients would end up with the same return if they had bought an index or an ETF, where they would assume less risk.
Still, with new studies and numbers under their arms, the long-short cheerleaders are going on the offensive. According to an oft-quoted study by Analytic Investors, "Toward More Information-Efficient Portfolios," published in the Journal of Portfolio Management in 2004, the long-only constraint is actually one of the biggest ways to hamstring active managers, keeping them from truly underweighting the dogs in the portfolio and thus working their best information into the equation.
"People have been doing this in pensions for 50 years," James M. Bishop, director of advisor sales at Diamond Hill Funds, says of long-short funds and the resistance to them. "You do have unlimited risk, because a [short] stock can go up forever. That's where you have to have a lot of controls in place. Do I feel like the long-short has more risks? Ours has a lower standard deviation than the Russell 1000-lower beta. It looks more conservative than the overall market. The risks are there, but there are controls."
Diamond Hill's Long-Short fund cannot have any short above 4% at the end of the day in the portfolio, he says. Hsu, meanwhile, says Schwab also has rules to stop the loss on the short side.
"We allow it to go to 3% to 3.5% on the long side, and on the short side it's 2% to 2.5%, with a hard stop at 2.5%," Hsu explains. "So if I'm wrong on the short side, no matter what the outlook on the stock is, I start to trim it."
Further alienating financial planners, however, is the fact that many of these funds have no track record and are expensive. Morningstar Inc., which created the long-short category just last year, currently follows 51 long-short portfolios, and as of December 31, 2006, only 19 had been around for five years. "A lot haven't had the opportunity to show their stuff in a down market," says Todd Trubey, a Morningstar mutual fund analyst who follows long-short strategies.
Gateway Fund (GATEX) has the lowest expense tracked by Morningstar, at 0.95%, but at the high end, many gravitate around the 2% mark, Trubey says. Nine of them have a 5.75% front load.

Taster's Choice
One of the problems in figuring out what kind of long-short fund might be good for a portfolio (or even safe) is that there are so many different kinds with different strategies and risk levels. Trubey says that they roughly break out into two substyles: One is equity variable long-short strategies, which go mainly long on stocks and then either hedge these with shorts or short other stocks. The other is the market-neutral style, in which 50% of the assets are long and 50% short, a gambit in which there is supposed to be no market correlation.
Bacci believes the Diamond Hill fund is more aggressive and takes more bets on the market. The portfolio can make sector bets, for instance, voting long on energy and short against technology. For more conservative portfolios, he likes the Calamos fund (CVSIX), which goes long on convertible bonds and shorts preferred stocks.
Calamos Investments' chairman, CEO and co-CIO John Calamos, Sr. says the fund is unique because it is one of the only open-end mutual funds that he knows about that uses convertible arbitrage. "If you're long convertible bonds and you're short that same stock, your risk of divergence from longs and shorts is almost nonexistent," he says.
The fund, which has reached almost a billion dollars, had a five-year return of 5.35%, and as of Dec. 31, 2006, was up 8.29% since its inception on September 4, 1990. It has three levels of potential returns, he says: "One is you retain the coupon from the long-side portfolio, the interest income, and then by shorting the stock you create a credit that you earn interest income on. The third potential capital gains come from hedging as stock prices move up or down."
The strategy has very little sensitivity to the stock market, and Calamos sees it as an alternative to fixed income rather than equity. The Schwab fund is benchmarked to the S&P 500, and picks mid- to large-cap stocks of a billion or more in market cap based on Schwab equity ratings. It holds 150 names on the long side, and 60 or 70 on the short side. For every dollar invested, the company short sells 20 to 60 cents. Hsu says that the correlation to the market is about 0.5.   
"We do not make top-down calls and say I think energy is going to do this," Hsu says. "We will have underweights and overweights in the industry, but try to keep it close to the S&P because our value added is from stock picking and not rotating sectors."
However, Hsu concedes that with all the trading going on in these strategies, they can generate taxes. "There are more subtleties to managing long-short," she says. "On the short sides, all gains are accounted for as short-term gains no matter how long you hold them, so there are definitely considerations there. Our turnover ratio has been average or modest. Every year it has never been more than 100%."
Diamond Hill, which uses the Russell 1000 as its benchmark, has a fundamental stock-picking strategy, trying to find a limited number of names that will go up or down rather than shorting an index. The fund selects stocks that are $2.5 billion and greater in market cap, choosing longs that are trading at less than intrinsic value and shorting names selling for more. This approach, which includes a search for attractive expected rates of return, has allowed Diamond Hill to make bigger sector plays, and in the past two years that has meant large energy holdings-literal fuel that helped gas up the fund's recent return. Its three-year performance, when the load is waived, was 18.38%, says Bishop.

130-30 Mania
With the stage already crowded, a raffish upstart has jumped into the action: a new generation of long-short strategies known as 130-30 funds. Inspired in part by the Analytic Investors study, these portfolios seek 130% exposure to a market: The first 100% is invested long, while 30% of the holdings are sold short, so that the cash generated by the short sale can be reinvested in the long-term bets and show the portfolio manager's confidence in them. Depending on how much risk the manager wants to take, the funds can pare down to a 120/20 strategy, or, even ratchet up to 150/50. This type of portfolio has developed something of a cult recently, not only among alternatives investors but also among quant managers and indexers who say that it could be the future of investing.
"I think this is the next evolution in investment management," says Ric Thomas, a senior portfolio manager and head of the U.S. enhanced equity group at State Street Global Advisors in Boston, which has been running a quantitative institutional 130-30 strategy in the U.S. since July 2005. "No one had ever thought of being long-only as a constraint. And it's a very inefficient constraint."
The argument for this type of investing is that the managers have the same amount of exposure to the market, only now, with shorting, it is possible to truly underweight the names those managers don't like. Before, they argue, underweighting unattractive stocks in the index was nearly impossible, because the cap weights of the smaller companies in the index were already too little next to the big fish weighing down most of the index.
Schwab has not yet pursued this strategy, though Hsu says she has looked at it. "It's a good strategy," she says. "If we do something like that it allows me to amplify the power of the stock selection model more. But it is much more risky because investors leverage up, so with upside potential you also get more risk."
Goldman Sachs Asset Management launched two 135-35 strategies for U.S. retail investors in the second half of 2006 called the Flex Funds, which include strategies benchmarked to the MSCI EAFE and S&P 500. These funds also target beta 1 correlation to their respective indices, says Andrew Alford, a managing director and senior portfolio manager in the Global Quantitative Equity unit.
"The primary risk in the portfolio is still market risk," he says. "The portfolios have full market exposure, which means market volatility is going to be felt by an investor in the funds. We are taking active bets around the benchmark, and in the event those bets are wrong, you'll see returns lag the benchmark. In contrast, if the bets are right, you'll see the portfolios outperform."
Even so, some think that the overall risk of shorting is still there, since the bets can still be wrong in two ways, but Alford thinks diversification is part of the answer to that.
"Any actively managed portfolio is making positive and negative bets relative to its benchmark, so an actively managed portfolio is always overweight and underweight some stocks," he says. "If you have a portfolio with 50 names, chances are that most, if not all, those 50 names are overweight relative to the benchmark. The other names that are in the benchmark, but are not in the portfolio, are underweights. You're betting against them. Moreover, in a long-only portfolio, you're spreading those bets over many names, so no single name is likely to have a dramatic effect on performance, either positive or negative. As a result, most of the relative performance for a long-only portfolio comes from the overweights."
It's hard to forecast how the strategy will actually do in practice. However, State Street's Thomas says that the company's institutional 130-30 strategy has outperformed the S&P by 375 basis points (annualized) since its inception in July 2005.

Will It Down A Bear?
For most people, the most important question is: Will their long-short fund save the day in a bear market? Bacci says some of them have disappointed him. In 2002, he said Diamond Hill "fell flat on its face," with a negative 10.5% return, and he also thinks the fund has more of a moderate market correlation. Diamond Hill's Bishop, however, says that the style of the fund was changing at the time, and that it did not start shorting until June of that year. By contrast, it was up 22.91% in 2003, he says.
Says Morningstar's Trubey, "To my mind, these funds haven't really captured investors' imagination as of yet, and I think it's one of these things where people don't want them until they need them, and that's in a bear market." He adds, however, "I don't think it's the cost driving people away. Over their lifetimes, most of them don't have a particularly attractive set of returns."
As with all types of investing, however, the best thing is to trust the portfolio manager and believe in the model. It could be a nice cushion to fall back on during those moments of vertigo.