Hedge Your Bets With This Long-Short Fund

Alternative asset classes, such as commodities, can reduce volatility in a portfolio because they produce returns with a low correlation to stocks.

Strategies also exist for combining long and short positions in stocks that can play a similar role in a portfolio.

Typically they are only available through hedge funds. But I spoke recently with portfolio manager Mark Fedenia and senior analyst Greg Schroeder, two of the decision makers for a very interesting little mutual fund called the (NARFX)Nakoma Absolute Return Fund (NARFX).

The basic idea is that combining long and short positions can produce steady returns, regardless of whether the market is rising or falling. In pursuing this they have a lot of flexibility as to how much they can be short and long.

Although they unambiguously describe themselves as bottom-up (stock pickers) they do incorporate some top-down (big picture) themes as well.

A successful example that illustrates this is their decision to be short Cabela's (CAB). From the bottom-up perspective, they felt the outfitter's expansion plans were too ambitious, competition from Bass Pro Shops would be formidable and that the company was relying too much on its branded credit card for revenue and earnings. From the top down, they felt that higher gas prices and the slowing economy would hurt a lot of consumer-discretionary names.

One point Fedenia and Schroeder stressed is that there will be some short positions, such as the one in Cabela's, that work out well and others, such as the net short position in energy, that don't. What should matter is the result of the overall portfolio, whatever the short position.

There is an intricate blending that goes on in the fund to create the results, which thus far have been exactly as advertised: slow steady returns with much less volatility than the market.

Sticking with the short Cabela's/short energy idea, there is a built-in partial hedge between the two. The managers feel that higher gas prices benefits the CAB short position, but obviously higher gas prices the short position on energy. If the trend in oil prices reverses, that would probably be good for their energy short and bad for their CAB short.

This type of hedge exists throughout the fund.

Philosophically, they realize that noone can be right 100% of the time. The goal, therefore, is to be right more often than they are wrong -- a point I have tried to stress in my writing since long before I ever heard of Nakoma.

The managers also use stop orders on their positions. I have written several times that stop orders are not the ideal tool for risk management. Specifically, putting an 8% stop under every position seems like a bad idea, and the team at Nakoma gets this. They said their policy on stop orders is not mechanical. What that means is that if it makes sense to put a 5% stop under one stock (or above for a short position) and a 20% stop under another stock, they have that flexibility.