By JACK HOUGH
Investors are caught between the fear of another stock market crash and the punishingly low yields on safe havens like Treasurys.
"Long-short" mutual funds, which bet for and against stocks at the same time, offer ways to seek profits, protection or some of both. Many don't try to beat the stock market -- they try to lock in most of the market's gains while paring losses when it falls. But with their high fees and complexity, the funds aren't for everyone.
Long-short funds still are rare in the mutual fund world; there are only 75, according to fund tracker Morningstar, compared with more than 2,500 long-short stock hedge funds. But the numbers are growing: 35 such mutual funds launched in 2010 and 2011 alone, according to Morningstar.
A basic long-short strategy involves buying, say, $100 worth of stocks ("going long") and "selling short" $50 worth. Short sellers bet against stocks by selling shares they don't yet own. The idea is to buy them back in the future at a lower price and pocket the difference.
In this example, the long-short strategy does two things for investors. First, it gives fuller exposure to the manager's talent, or lack thereof.
"If you really believe in a manager's stock-selection ability, long-short gives you a way to profit from what he likes and what he doesn't like," says Fran Kinniry, a member of Vanguard's Investment Strategy Group.
Second, if the market plunges, investors would expect the $100 in "long" stocks to lose money but the $50 in short stocks to make money. Thus, the fund is said to be 50% "net long," which is generally better than being 100% long during a crash.
There are many different kinds of long-short funds. The earlier example uses a middle-of-the-road approach. On the conservative end of the spectrum, a "market neutral" fund uses positions designed to negate market movements entirely. Investors make money only if the manager buys and shorts the right stocks.
Market-neutral funds aren't designed to generate big gains, per se. They aim for low "correlation," or for moving independently of the broad market rather than in lock step with it--a benefit during market routs, when all manner of assets can trade similarly.
Closer to the risky end of the spectrum, a 130/30 fund would buy $100 worth of stocks, short $30, and use the proceeds from the short sales to buy another $30 worth of stocks. That leaves it 100% net long, like a regular stock fund, but investors hope to profit from a fund manager's ability to pick both winners and losers rather than just winners. The goal is more to amplify returns than to reduce risk.
There are plenty more strategies than these that extend to different asset classes or use different tools, like options, to achieve their targets.
The biggest drawback? Fees. The average expense for the long-short category as a whole is more than 2% of assets per year, according to Morningstar, compared with an average of 1.3% for U.S. stock funds.
Long-short strategies are best suited to investors who expect low returns from stocks in coming years, because these strategies don't rely solely on market returns for profits, says Christopher Brightman, head of investment management at Research Affiliates.
In such an environment, the best funds might be those that seek to reduce stock-market exposure without eliminating it. The goal is to get most of the market's returns when stocks go up, while paring the losses when stocks tumble.
Morningstar gives high marks to two such funds. Wasatch Long/Short targets net long exposure of 30% to 90%. It has returned 13.9% a year after expenses over the past three years, versus 8.4% for comparable funds and 19.9% for the Standard & Poor's 500-stock index. But during that period it showed only three-quarters of the S&P's volatility.
Morningstar also likes the Marketfield fund, which seeks to limit stock exposure to 75%. It returned 17.7% a year after fees over the past three years.
The Wasatch fund charges 1.63%, while the Marketfield charges 2.54%.
On the other hand, most investors will want to steer clear of long-short funds that seek to jack up returns rather than reduce risk. That is because they can get similar stock market exposure at a lower cost via a traditional mutual fund.
The Fidelity 130/30 Large Cap fund, for example, has a yearly expense of 1.97% of assets. Over the past three years the fund has returned 10% a year. The Fidelity Spartan 500 fund, which tracks the S&P 500, costs just 0.10% a year, and has returned 19.9% a year over the past three years.
"The last thing you probably need is to pay high fees for something that moves just like the rest of your portfolio," says Matthew Glaser, chief of investment strategies for Turner Investments, which offers long-short funds.
Likewise, an investor who buys a long-short fund simply for crash protection is making a mistake, says Vanguard's Mr. Kinniry. For that, "you want short-term Treasurys."
Therein lies the problem with these funds: While ambivalent investors might find comfort in them, bears and bulls can probably do better elsewhere.—Jack Hough is a columnist at SmartMoney.com. Email: email@example.com