Some people would have you believe that in order to get investing profits in a bull or bear market, you have to invest in hedge funds. But these vehicles, which are prized for delivering "absolute returns," are not for everyone. Some hedge funds only accept millionaires and six- or seven-figure minimum investments are common. Hedge funds are largely unregulated, their fees are high, and liquidity is low. For the average investor, there has to be a better way.
Dan McNeela a senior analyst at mutual fund tracker Morningstar, says, "A few mutual funds provide [hedge fund] strategies to investors." Investing in these hedge-fund-like mutual funds can be done for as little as $1,000, and you can cash out whenever you like.
"Long-short" funds buy, or go long on, stocks they think will appreciate while simultaneously selling, or going short on, stocks they think are overpriced. (If you sell short on a stock at, say, $25 per share and then close your position once the stock drops to $15, you'd have a $10-per-share profit.) Such an approach is considered less risky than investing in most stock funds because short positions may deliver gains in a bear market.
"Although Iong-short funds are generally less volatile than traditional stock funds, they still can be risky. A manager's Iong picks might be losers, while the short positions may go up in value," says McNeela. "Therefore, you'll see large variations among long-short funds." In 2003, for example, Choice Long-Short Fund lost 16.6%, while ICON Long-Short Fund gained 17.7%.
So-called "market-neutral'" funds also go long and short. "While long-short funds tend to tilt toward the long side," says McNeela, "market-neutral funds keep a 50-50 balance. Half of the money is long, while the other half is short."
Even with such a split, there's always a chance that a market-neutral fund will be long on stocks that aren't performing and short on stocks that are. For example, if tech topples while healthcare skyrockets, such a market-neutral fund could have a disastrous year.
Some market-neutral funds, therefore, aim for sector-by-sector neutrality. If it buys long on Pfizer, for example, it might sell short on Merck The goal is to reduce the effects of industry and broad-market swings by consistently generating positive returns via savvy stock-picking. "In practice, market-neutral funds have largely lived up to their billing by diversifying investors' portfolios," says McNeela, "They've often lagged behind...