What Is a Long/Short Fund?
Let me explain what a long/short fund is. It's a type of mutual fund, hedge fund, or exchange-traded fund (ETF) that holds both long and short positions in investments, usually within a specific market segment. You take long positions in stocks you expect to rise in value and short positions in those you think will fall. These funds draw on techniques like leverage, derivatives, and short selling, which originated with hedge funds and later spread to mutual funds and ETFs. As the name implies, most hedge funds operate this way, and according to the Financial Industry Regulatory Authority (FINRA), there are 176 mutual funds and ETFs in this category. They're also known as enhanced or 130/30 funds.
Key Takeaways
Here's what you need to grasp about long/short funds. They use a strategy where you go long on underpriced stocks and short overpriced shares. This approach expands beyond traditional long-only investing by profiting from both undervalued and overvalued securities. Hedge funds commonly use long/short equity, often with a 130/30 setup where 130% of assets are in long positions and 30% in shorts. Due to the intensive active management, analysis, and trading involved, these funds come with higher expense ratios.
Understanding Long/Short Funds
Long/short funds work to increase returns by focusing on specific markets and using both long and short positions. Because they demand active management, expertise, and detailed analysis, you'll see higher expense ratios—averaging 1.98% for those in the FINRA database as of 2024, compared to 0.42% for all equity mutual funds in 2023.
These mutual funds and ETFs mirror hedge fund strategies but differ in key ways. They provide a similar balance of risk and potential returns against benchmarks, but they offer better liquidity than hedge funds, no lock-in periods, and somewhat lower fees. That said, they still have higher expense ratios and lower liquidity than typical public funds. Many require larger minimum investments and are part of the 9% of mutual funds that charge front- or back-end loads.
Historically, mutual funds and ETFs with long/short strategies faced restrictions on leverage and risk, stemming from the Great Depression era to protect everyday investors from complex instruments. Even with some rules relaxed, oversight remains tight to prevent excessive risks.
If you're looking for targeted index exposure with active management, long/short funds can fit, provided you understand the risks. They let you hedge against market shifts and trends that skilled managers can navigate.
The 130-30 Strategy
The most typical long/short approach is the 130-30 strategy, where you're long 130% and short 30% of assets under management, netting to 100%. For instance, a manager might rank S&P 500 stocks by expected returns from highest to lowest.
The team uses vast data and quantitative rules to rank them, based on criteria like total returns, risk-adjusted performance, or relative strength over periods such as six months or a year.
Then, you invest 100% in the top-ranked stocks and short the bottom ones up to 30% of the portfolio's value. Proceeds from shorts get reinvested into the top stocks, boosting exposure to their potential gains.
Examples of Long/Short Funds
To show how these funds operate differently, consider two examples.
First, the AQR Long-Short Equity Fund (QLEIX) stands out as a strong performer in the long-short equity space. It invests globally across sectors, with specific percentages in long and short holdings per industry. As of the end of Q1 2024, it posted annualized returns of 23.04% over three years, 13.32% over five, and 10.6% over ten, with an expense ratio of 4.35%.
In contrast, the Invesco S&P 500 Downside Hedged ETF (PHDG) is an actively managed ETF aiming for positive returns in any market direction. It hedges downside risks differently, allocating across the S&P 500 Dynamic VEQTOR Index components, including S&P 500 equities, a volatility hedge via the S&P 500 VIX Short-Term Futures Index, and cash. It tracks equity markets while hedging volatility, adjusting based on S&P 500 equity and volatility levels. Its expense ratio was 0.39% in April 2024, with three-, five-, and ten-year returns of 4.41%, 7.05%, and 4.69%.
What Is the Difference Between Long and Short Investing?
Long investing means buying securities to sell later at a higher price. Short investing involves borrowing stock from a broker, selling it, then buying it back cheaper to return it, profiting from a price drop.
What Are Other Investments Like Long/Short Funds?
Options and derivatives are often used to hedge equity downside risks, but long/short funds incorporate this directly. Market-neutral funds seek profits from stock price differences while minimizing market exposure, using matched long and short positions to hedge broader risks. Pairs trading involves going long on one stock and short on a related one to exploit temporary price gaps.
Why Is Going Short Riskier Than Going Long?
Short selling carries more risk because a security's price can rise indefinitely, leading to unlimited losses, whereas long positions limit downside to 100% of the investment.
The Bottom Line
Long/short funds go beyond just buying undervalued stocks—they also short sell to profit from declining prices. This boosts potential returns but increases risk, fees, and reduces liquidity compared to standard mutual funds.
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