The market downturn last year has led mutual funds to begin testing new strategies to produce gains with lower risk. Many managers are trying to replicate the methods used by long/short hedge fund managers. By finding negatively correlated positions, fund managers are able to offset losses with gains from other assets in the portfolio.

“130/30” Funds

“130/30” funds short securities valued at 30% of the value of the assets in the fund, and can use the proceeds to purchase long positions in other securities, allowing the fund to invest 130% of the fund’s value in a long position. For instance, if the fund manager believes Visa is a superior stock to Mastercard and has a $1,000,000 fund, he could short Mastercard for $300,000 and use that $300,000 plus the $1,000,000 he has in the fund to buy $1,300,000 in Visa stock. Now the fund manager has a net $1,000,000 long position because he is holding $1,300,000 in a long position and $300,000 in a short position.

If the assumption about Visa outperforming Mastercard is correct, and the market is up, The gain on the extra $300,000 in the long position is higher than the loss on $300,000 short position. If the market is down, the gain on the $300,000 short position will be higher than the extra $300,000 in the long position and offset some of the loss on the whole long position.

Market Neutral Long Short Funds

A long/short fund can be similar to market neutral funds if the size of the investments in the long position equal the short position investments. For example, if a long/short fund manager believes that Coca Cola is a better stock than Pepsi Cola and puts $1,000,000 into a long position on Coke and sells another $1,000,000 in a short position on Pepsi, he has taken a market neutral position because he has net zero position.

Downside to Long/Short Strategies

The purpose of a long/short fund is to create stable returns, but there is a downside. In the Visa/Mastercard example above, the long/short fund doesn’t make nearly the amount of gains as a long position during an aggressive bull market. Also, the profitability of a long/short fund is predicated on picking one investment to outperform the other. Like market neutral funds, there is the unique risk in long/short positions called “beta mismatch”. If the beta of the long position is larger than the short position, a market downturn should cause the long position to lose more, as market moves affect the long position more. Furthermore, if the beta of the short position is larger, a market upswing should increase the short position’s loss more than the long position’s gain.

Paired Trades

While long/short funds can be used to decrease market risk, fund managers can reduce other types of risks by making “paired trades”. Using the Coke/Pepsi example from above, the fund was protected whether the market moved up or down. Also, the fund was protected even if the soda industry moved up and down. By using this “paired trade” model, fund managers can hedge against market swings in particular sectors, industries, regions, and currencies.

Read Part 1 Mutual Funds Emulate Hedge Fund Strategies

Read Part 2 Market Neutral Funds