Thinking Defense

CFP Diane Pearson, another long-short fan from Legend Financial Advisors in Pittsburgh, says these funds have been harmed by their sensitivity to low interest rates, since they hold cash in money markets for the shorting positions.

Another thing that critics don’t like is the funds’ higher expenses, which might not be so much about manager greed as the structure of the products, which require more trading and even money held for dividend payouts on the shorts.

In long-short funds, “there’s going to be more trading, obviously, just because there’s a significant amount of positions in the portfolio, more holdings, more costs, more research in general,” says Charney.

“Advisors who aren’t familiar with these funds can sometimes get hung up on the expenses,” says Verseput. “The expenses include the potential that the fund may need to pay a dividend on stocks that are held short through an ex-dividend date. Although this is an easily-avoided expense and does not go to the fund managers, the prospectus needs to account for the possibility of incurring this expense. Advisors often assume the managers are getting paid too much.”

Pearson says Legend Financial has been using long-short funds for almost 20 years, specifically the Caldwell & Orkin Market Opportunity fund, which has shorting capabilities. The fund lost only 4.66% in 2008 while the S&P sank 38%. “We have always used this hedging type strategy in what we call our lower volatility portfolio,” she says. “Long-short funds have fit this strategy very well over the years and in particular in 2008. Probably even better in 2000 and 2001. Because many of our portfolios actually made money during that downturn.” But she wishes the shorting positions had worked better afterward. In 2009, the Caldwell fund was down 5% when the S&P rose 26%, and in 2010 it was down 1.01% when the S&P was up 15%.

“It hasn’t necessarily done what we would like for it to have done since 2008 … understanding that for the shorting strategy they still have to have exposure to the money markets. Just for the asset class as a whole, not necessarily for [Caldwell & Orkin], they could have done a little bit better and had a little bit more exposure to the equity market in this environment. But that’s trying to tell somebody they should know exactly what’s going on in the market at all times.”

Martin is a real bear. He’s totally out of stocks. He’s started looking to long-short bond mutual funds.

“I’m in a bond strategy,” he says. “I don’t want my clients to suffer from bond funds that only pay 1.5% and I don’t like to see people get stuck with a 30-year duration to get a bigger coupon. So one compromise is these long-short bond funds, so sometimes they are able to pull off 3% and 4% yields and keep the duration very low and keep their credit quality at reasonable levels like ‘BB,’  you know one notch below investment grade. So the amount of below-investment-grade bonds might be only one-third of the portfolio. So they have a good mixture of credit quality, low duration and high yield and somewhat low risk. But there is no guarantee they won’t make a mistake.”