Mutual Funds: You Can Sit on Two Stools

Long-short funds play on rising and falling stocks

There were more bears in last quarter's top-performing mutual-fund list than in the Moscow Circus. Profunds Ultrabear, Prudent Bear, Rydex Ursa--all these are "short" funds that soar when the stock market swoons. The problem with these funds, however, is you have to get out when the bulls start to stampede. That's why a better alternative may be the "long-short" funds that also are high on the recent mutual-fund hit parade. Such funds as AXA Rosenberg Value Market Neutral and Boston Partners Long Short Equity profited handsomely. Since they bet on some stocks rising in addition to falling, their results are impressive in a down market.

These hedged funds are not too different from hedge funds, the exclusive province of investors with at least $1 million in assets or annual income of $200,000. Unlike regular hedge funds, which can boost returns through buying on margin, these funds can only leverage their assets by 30%. So their upside potential is not as great as conventional hedge funds, but the downside is more protected. They also don't have hedge funds' many drawbacks, which include high fees, little regulatory oversight, and illiquidity.

Since hedging practices vary, the funds are not all alike. For instance, Phoenix-Euclid Market Neutral Fund buys stock of companies that have low price-to-earnings ratios and high revenue growth and sells short the high p-e, low-growth stocks in the same industry. So, portfolio manager Carlton Neel holds New York Times (NYT ), which he thinks is undervalued, and has a short sale on Dow Jones (DJ ), which he considers overpriced. This kind of pairing puts investment research to good use. If Neel is right on both companies, he will make money as Times rises and Dow Jones falls. Such pairing across many industries also neutralizes broad market moves. AXA Rosenberg Value Market Neutral has a similar strategy. Both are up sharply in 2001 (table).

Calamos Market Neutral takes a different approach. It buys the convertible bonds of a company and shorts the underlying stock. The fund owns Lucent Technologies (LU ) convertible bonds, yielding 8%, and has a short position in the stock. In a bear market, the short position makes money. The convertible bond declines in value, but not as much as the common stock. An added kicker to the investment is the income from the bond. In the past 11 years, the Calamos fund lost money only once--in 1994, a brutal year for the bond market.

DOUBLE PLAY. Other long-short funds are not market neutral but take bets on the long and short sides. That's riskier but can also lead to higher returns. Manager Edmund Kellogg of Boston Partners Long Short, a value-oriented fund, is bullish on energy stocks and bearish on housing. "Historically, housing stocks trade between 0.5 to 1.5 times book value," he says. "They recently got up to 1.7 times, though there's weakness in the housing market." His fund is up 20.7% this year because he favors cheap stocks. Invesco Advantage and Gemini Global New Economy, which are long-short funds but lean toward pricier growth stocks, are down 24.9% and 27.6%, respectively.

Such sophisticated strategies are costly. Boston Partners' fund, for instance, has a 2.75% expense ratio--much higher than the 1.41% average for U.S. equity funds. One reason is the extra cost of running two portfolios, one long, the other short. Another is that these funds must pay dividends on the stocks they've borrowed to establish short positions. That can add as much as 0.4 percentage points to the expense ratio, experts say. Yet the extra costs are not unreasonable considering that traditional hedge funds charge 1% of assets plus a 20% cut of investment profits. In a bear market, paying for protection may be well worth it.

By Lewis Braham

    Before it's here, it's on the Bloomberg Terminal.