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Long-short mutual funds, designed to deliver returns uncorrelated with equity, so far have been living up to their expectations during the period of stock market turmoil that began last summer.

In the 12 months ending in February, the average stock fund has dropped almost 6%. By contrast, the average long-short fund dropped just one-half-of-one percent, according to Morningstar Inc., Chicago. Some long-short funds however did significantly better. The Janus Adviser Long/Short Fund gained 12.8%. Meanwhile the Nakoma Absolute Return Fund and Diamond Hill Long/Short Fund were up 9.14% and 5.5%, respectively.

Long-short funds were solid during the heat of the subprime mortgage and stock meltdown. From August 2007 through January 2008, the average long-short fund declined half as much as the S&P 500, which dropped 6%, according to Morningstar.

Long-short mutual funds typically deliver absolute returns independent of the performance of the overall stock market by shorting overvalued stocks and taking long positions in undervalued stocks. In theory, adding a market neutral fund, such as a long-short fund, as a portfolio diversifier may deliver attractive results. Market neutral funds, including long-short funds, strive to exhibit low or no correlations to the stock market.

There are more than 50 open-end long-short funds. Morningstar Analyst Marta Norton says that during the market downturn, an investor could have achieved portfolio diversification with long-short funds because of their low equity correlation. But, stock-picking ability is a significant variable in the success of a long-short or market neutral fund, she warns. Taking long and short positions magnifies a portfolio manager's decisions and can increase risk.

"There's some evidence these funds can deliver," she says. In 2007, the category's median standard deviation of returns was about 3% lower than that of the 6.5% standard deviation of the S&P 500.

The big problem: Not all long-short funds are alike. Some funds sport low correlations to the S&P 500, and have delivered consistent returns over the past three-year and five-year periods. Other funds, at times, may be highly leveraged and make big bets-either by sector or by making long or short sales. As a result, these funds can register equity-like gains or losses.  

For example, Norton says that the aggressively managed Caldwell & Orkin Market Opportunity Fund, with a 33% return in 2007, was the best performer in its class. By contrast, the Forward Long/Short Credit Fund-the category's worst performer-lost 17%.

"You have to be very careful if you want to use these funds for diversification," she says. "They don't have much of a track record. With so much uncertainty, the characteristics that are important at more conventional mutual funds, such as manager experience, sensible strategies and low expenses, are even more critical here."

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