Long-Shorts That Dodged The Blows

How three funds succeeded in a summer when most hedge-like strategies failed

At first glance, long-short mutual funds seem like a good idea. They mimic various hedge fund strategies, aiming to rise when stocks fall—or at the very least, to lose much less ground.

The reality has been a little different, though. From July 1 through Sept. 14, the 53 funds tracked by Morningstar (MORN ) fell an average of 1.4%, vs. a 0.86% decline for the Standard & Poor's 500-stock index. Even as the market has recovered a bit, some long-short funds are still getting clobbered. Among them: Geronimo Multi-Strategy Fund, down 9.75% since July 1.

What happened? In part, the funds were hit by the same forces that rocked hedge funds. Facing requests for redemptions, many hedge fund managers sold high-quality stocks that had fallen in price. To reduce their leverage, they also bought back stocks they'd sold short. With lots of funds in the same bind, that pushed up the prices of lower-quality issues. The effect: losses on both their long and short positions.

This is not the first time these funds have come up short. Over the past three years, in months when the S&P 500 has fallen by more than 1.5%, the group has barely managed to beat the market.

But even as the category has disappointed, a few funds have proven themselves. They have generally performed well in periods such as July and August, when other investments have not—a feat that has helped them shine over longer periods.


Portfolio manager Michael Orkin had shorted the stocks of homebuilders and subprime lenders when they were still Wall Street's darlings, cutting into returns. That wasn't the first time Orkin got the trend right but the timing wrong. In 1999 the fund finished 25 percentage points behind the S&P 500 because he had bet against Internet stocks while the bubble was still inflating. "We've done well when bubbles pop, although we tend to anticipate them too soon," says Orkin, who has managed the fund—one of the oldest in the category—since 1992.

Up 20.1% this year, Caldwell & Orkin was one of the few long-short funds to turn a profit both in February, when subprime concerns first arose, and during the market slides in July and August. Largely because the fund was profitable in the 2000-02 bear market, it has kept pace with the S&P over the past 10 years. The fund "can work for investors who are willing to stick with it over a long time," says Rick Lake, co-chairman of Lake Partners in Greenwich, Conn., a firm that invests in long-short funds, including Caldwell & Orkin.

Recently, Orkin has had short positions in homebuilders Beazer Homes (BZH ) and D.R. Horton (DHI ) and subprime lender Fremont General (FMT ). He's also bearish on the stocks of restaurant chains, retailers, and boat builders, which will suffer if debt-burdened consumers curtail spending. What does he like? Internet-related stocks, such as Omniture (OMTR ), a software provider that helps companies manage Internet advertising. Net companies "have learned how to build a successful business model," he says.


Like Caldwell & Orkin, this fund challenges conventional wisdom. That was the case with energy stocks, a sector that's favored now but wasn't when co-manager Ric Dillon started buying four years ago. Thanks to the fund's out-of-sync bets, it has earned an average annual 10.13% since its launch on June 30, 2000, vs. 1.98% for the S&P.

Dillon's not ready to give up on energy stocks such as Apache (APA ), Devon Energy (DVN ), and ConocoPhillips (COP ). "It will take up to a decade or more before producers add enough supply to meet the growing demand." The fund also holds Freeport McMoran Copper & Gold (FCX ) and banking giant Wells Fargo (WFC ), which Dillon argues has fallen too far on subprime concerns.

His short positions? Companies that depend on free-spending consumers. They include General Motors (GM ), Ford (F ), and Harley-Davidson (HOG ).


The $4 billion Gateway Fund (GATEX ) is up a market-beating 6.69% so far this year and 6.66% over the past 10 years. But stock-picking hasn't played a big role. Gateway buys a broad basket of stocks that roughly resemble the S&P 500 with a dividend yield of 2.6%, vs. 1.9% for the index. The fund generates additional income by selling call options on the portfolio.

While Gateway tends to rise and fall with stocks, its gains and losses are typically about a third as great. That's because in selling call options, the fund forfeits a portion of its upside returns. It also spends a small amount on put options that gain in value if the market takes a quick, deep dive. That's the short side of the portfolio.

Now, with volatility almost twice what it was in June, the fund's income from selling calls has spiked. When volatility rises, options buyers pay higher premiums to sellers, such as Gateway, because stocks are more likely to move sharply higher, as well as lower. "It's a good time for us," says co-manager Paul Stewart.

By Anne Tergesen

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