By SARAH MORGAN
The past week's market turmoil provided a big test for a slew of mutual funds designed to gain when stocks stumble. Unfortunately, some of them flunked.
Investors made gun shy by the last crash have flocked to this group of funds in recent years, and this is when they would expect such a move to pay off. Not necessarily so: So-called long-short funds and market-neutral funds, which both invest in some stocks while selling short others, both lost money in the past month through Thursday, down an average of 7.58% and 1.85%, respectively. That's better than the average stock fund, which lost almost 11.73%, but short of the implied promise to flourish when markets founder. The only funds that truly cleaned up this month were short-only funds, which only bet on stocks to fall. The average in this category was up 16.62%, according to data from fund-tracker Lipper.
Plenty of investors may be surprised by the results. Since the 2008 downturn, investors have jumped into these funds as a way to avoid any huge losses from another crash, sort of like portfolio insurance. Through July, short-bias funds, which only bet against stocks, have attracted $4.07 billion in assets, following inflows of $9.3 billion in 2010, according to Lipper. Long-short funds, which invest in some stocks and sell short others, have gathered $1.65 billion this year, already equaling last year's total. And market-neutral funds, which try to be neutral, have taken in $2.15 billion, after inflows of $6.9 billion last year. Meanwhile, the ranks of alternative funds have been swelling: According to fund tracker Morningstar, 56 new funds have been launched since 2009, bringing the total to 102.
Not everyone believes these types of funds belong in your portfolio. Because some of these funds' strategies rely on market-timing, managers can be caught on the wrong side of a bet and incur big losses (see long-short funds). They also tend to be more volatile than plain-Jane stock funds, say experts. "Our analysis has shown you're better off in a well-diversified long fund over the long term," says Mickey Cargile, a managing partner with WNB Client Services. These funds also don't come cheap: The typical expense ratio for these funds is between 1.5% and 2%, compared to 1.08% for the average large-cap stock fund and 0.17% for Vanguard's S&P 500 index fund.
Because of these risks, financial advisers and investing pros recommend putting no more than 15% of your stock portfolio into these strategies. Investors with strong views on the direction of the market could allocate to these funds tactically, when they expect stocks to slide, but some advisers also recommend keeping a permanent position as protection from a correction or crash.
Bear-market or short-bias funds: As the name implies, these funds are purely short, and they've been cleaning up. Not surprisingly, they've done less well over the long term, when stocks were performing well. The average short fund has lost 26.89% in the past year, while the S&P is up 6.45%. For investors who think we're in for a long market downturn, one good option with relatively low expenses is the $2.5 billion Pimco StocksPLUS Total Return Short fund (PSSAX), says Jeff Tjornehoj, a senior analyst for Lipper. Run by bond guru Bill Gross, the fund was up 11.41% this week. Steve Jones, a spokesman for the fund, says that competitors use more leverage and so might post better returns in a short, steep market slide, but that this fund's returns should be more predictable over time.
Market-neutral funds: These funds aim to be, well, neutral, with equal bets against and for stocks. The idea is to generate consistent returns in good times and bad by picking the right stocks to bet on and against. The category is slightly positive for the past year, with a 1.7% gain, compared to the average stock fund's 11.2% gain. Morningstar recommends the Highbridge Statistical Market-Neutral fund (HSKAX) for its strong performance in the last downturn (it gained 9.79% in 2008), and it was a standout again this week, losing just 0.26%. Expenses, however, are almost 2%, which is far above average, according to Morningstar. A company spokesperson wasn't available for comment.
Long-short funds: Rather than trying to balance long bets and short ones, these funds generally allow their managers a little more tactical freedom. They can be mostly long when they expect stocks to rise and mostly short when they turn more bearish. Over the past year, long-short funds have also fallen behind, gaining 4.68% compared to the average stock fund's 11.2% gain, according to Lipper. Tjornehoj recommends the Wasatch Long Short fund (FMLSX), which was down a slightly-better-than-average 1.46% this week and up 9.12% for the past year, according to Morningstar data. "Think of it as a defensive equity fund," says Gene Podsiadlo, Wasatch Advisors' director of mutual funds. "You're still going to get equity exposure on the upside but hopefully some downside protection as well."