The Long and Short of It

07/01/2005 12:00 am EST


Sheldon Jacobs

Author, Investing Without Wall Street, Five Essentials for Financial Freedom

No-load mutual expert Sheldon Jacobs has decided, for the first time, to consider market neutral funds. These vehicles are also known as long/short funds due to their ability to both buy long positions as well as sell short. Here, he highlights his favorite.

"Absolute bargains are tough to find today. There are simply no easy choices across the financial markets for achieving big returns by buying at current prices. Price to earnings ratios of growth stocks of various sizes tend to be above 20, which isn’t exceptionally attractive. By the same token, bonds are not cheap. Long-term Treasuries now yield only a percentage point or so above inflation over the past 12 months. Real estate is frothy. Only money funds, benefiting from the Fed’s increases in short-term rates, seem like a no-brainer investment. But of course, their yields won’t make you rich. Simply put, the market is not paying investors to take risk now. The better course is to invest conservatively, hoping for total returns in the high single digits over the next 12 months.

"There are many types of conservative investments that we hold in our model portfolios. One kind that we haven’t included before is the long-short fund, which is sometimes called a market-neutral fund. Long-short funds, which buy securities long while simultaneously selling other securities short, have the potential to minimize or even completely offset market fluctuations. Over the long run, these fund strategies tend to be inferior to long-only strategies, for four reasons. First, they rely on superior stock picking. Second, most stocks rise during long bull markets, so continually devoting assets to short positions is likely to dampen returns over the long run. Third, during irrational markets, traditional methods of evaluating investments do not apply. During the late 1990s, for example, some long-short funds suffered terribly. Fourth, long-short funds have substantially higher costs than regular funds.

"Mutual fund companies are not blind to investing trends. As a result, a number of hedged funds have been launched since 2000, when the bear market began. There are now some three dozen hedge-like mutual funds, usually features terms such as long-short or market-neutral in their names. We exclude most from our coverage due to loads, ridiculous expenses, or sub-par performance. However, a few have expenses that are only moderately ‘too high’ and, of these, we are most comfortable with Schwab Hedged Equity Select (SWHEX) and Schwab Hedged Equity Investor (SWHIX). Note, the two funds are equivalent except for purchase requirements. Buy the Select shares if you have a large portfolio and can make the $50,000 minimum. Otherwise, buy the Investor shares, which have a low minimum but a higher, although still reasonable, expense ratio.

"Hedged Equity attempts to beat the S&P 500 with less risk than the index. Currently, the fund is 50% short, up from 25% short a few years back (earlier this year, the fund’s policy was changed to allow more shorting). Since its inception, the fund has beaten the market during down months and flat periods, but it gained more (30.3%) than one might have expected during the cyclical upturn the market experienced between March 2003 and February 2004. Through the first four months of 2005, the fund has just about broken even, while the S&P 500 produced a loss of about 5%. The fund is one of several in-house Schwab offers that use the firm’s Equity Ranking System, which gives grades from A to F to 3,000 of the largest US stocks based on expectations for relative performance over the next 12 months. The fund’s managers than buy stocks with grades of A or B and sell short stocks with grades of D or F. Though risk control is an objective of the fund, the managers are attempting to make money from their short positions as well as their buys."

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