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The vast majority of mutual funds have been invested long-only – managers buy stocks based on those they think will rise in value. Selling short, or betting a stock will fall, has been the purview of a handful of short-only funds or hedge funds.

But long/short investment strategies, which allow a fund manager to sell short as well as buy long, are increasingly being made available to retail investors through mutual funds.

Mutual funds have always been allowed to short stocks, as long as this is made clear in their prospectus and registration. It is surprising it has taken until now for the idea to catch on, given the prevalence of short-selling, especially in the US. And long/short strategies are the most popular type of hedge fund, accounting for 40 per cent of hedge fund assets.

A number of long/short mutual funds have launched in the past six months, with Goldman Sachs, Mellon, ING, JPMorgan and Deutsche Bank joining the party. Some alternative asset managers, such as ThomasLloyd, are launching such funds for retail investors. Some are no different from long/short hedge funds but without the 20 per cent performance fees.

These new funds have various names, which can make them hard to pin down. Many are 130/30 or 120/20 funds – 30 per cent or 20 per cent short. Typically the fund is leveraged so that, say, of any $100 invested in a 130/30 fund, it borrows another $30 then invests $30 in short positions.

The funds are not quite the same as market-neutral funds, which aim to use short positions to more or less cancel out the risk of long positions. The 130/30 or 120/20 funds aim to outperform the market and are typically benchmarked to Standard & Poor’s 500 index. Long/short funds, such as the ThomasLloyd one, have more flexibility – and risk – in that they might be wholly long if the manager thinks that is the position to take.

The 130/30 funds are an extension of a product that has been offered to institutional investors. The strategy tends to perform better than pure long investing but does not have the risk of a fund entirely invested in short positions.

For institutional investors or individuals investing through a separate account, there is a disadvantage: they must also choose a prime broker to undertake the short selling part. But this does not apply to retail investors putting money into a fund because the fund chooses the prime broker.

Morgan Stanley has estimated that about $50bn is managed in the US alone in this strategy, mostly in institutional money. That is up from next to nothing three years ago. Most of the 130/30 funds that have been set up are quantitatively managed. The stock selections are made by computer programs rather than fund managers. This is partly because existing quantitative strategies are easily scalable and applied to new funds.

A program might rank 4,000 stocks in order of their desirability. The stocks at the bottom are ones that should be sold short. A long-only mutual fund would be unable to make full use of the list because it cannot sell short but a long/short fund can act on the spectrum of investment information that the programme provides.

“A short position is nothing more than an underweight position,” says Andrew Alford, the portfolio manager of Goldman’s 130/30 fund, called Flex.

But the cap on how much of the portfolio can be sold short might be of comfort
to those investors worried about the unlimited downside of short-selling. Unlike a long investment, where the losses are capped by the fact that the share price can only fall to zero, a short investment can theoretically suffer an unlimited fall because the share price could keep rising.

It seems likely that these funds will catch on with retail investors although explanations will be needed. The publicity surrounding hedge funds has made alternative investing more mainstream. Short-selling is probably one of the more straightforward strategies followed by hedge funds. There is also a history of retail investors following institutional investing trends, with use being made of long/short strategies.

Morningstar, the fund tracker, last year set up a category to cover long/short funds although it is still working out which funds to include. The total of assets under management in the category has risen sharply to more than $16bn.

Long/short mutual funds do not yet have enough of a record to make any consistent performance claim. Market-neutral funds, which have been around longer, have tended to underperform long-only equity funds. Last year they returned less than 5 per cent.

But the goal of market-neutral funds tends to be to beat cash returns rather than the market. The newer long/short funds have more ambitious return targets. The ones that Morningstar has tracked – it does not yet have a complete universe – have returned just above 8 per cent in the past year – better than market-neutral but below the total return of 15 per cent for the Standard Poor’s index in 2006.

Goldman recently added an international long/short fund to its US equities fund. And depending on how its US equities fund goes, ThomasLloyd says it plans to launch a long/short emerging markets fund later this year.

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