Long-Short Funds Ride Out Market Storm

The long and short of the recent market tempest is that investors would have been better off in a long-short fund.

The hurricane hitting stocks over the past month has leveled nearly every category of mutual fund save bond and bear funds, which welcome such stormy skies. International, precious metal and natural resource funds have been particularly slammed after their rapid run-ups, with some falling by as much as 20%, according to fund tracker Morningstar. Meanwhile, growth funds of all sizes are down by close to double-digit percentages.

Long-short funds, which invest shareholder dollars exactly as their name implies, have been one of the only fund classes to weather the storm. The average long-short fund, says Morningstar, is down just 1.7% over the past month and, more importantly, is up 2.1% year to date, even as the Nasdaq and the S&P 500 have been dancing with the red line for the year.

"There are inflation concerns, problems in the housing sector, a Fed in transition, budget deficits and a weak dollar," says Mike Arone, co-portfolio manager of the $20 million (SDCQX - Cramer's Take - Stockpickr)SSgA Directional Core Equity fund. "Add all that up, and it becomes quite clear that now is the time to play defense, and long-short funds are a good way to do it."

Arone's fund, which is up 0.4% year to date, maintains a long bias, so it's affected by the market's tumble, but not as much as a long-only fund. For every $100 worth of stocks he buys, Arone sells short $30, giving the fund equity exposure of 70% to large-cap U.S. stocks. In order to maximize his overall return, Arone buys companies with strong free cash flow, sound balance sheets and strong earnings growth, and he shorts shares of companies with what he calls the "mirror image."

Barry James, portfolio manager for the $73 million (JAMNX - Cramer's Take - Stockpickr)James Market Neutral fund, matches his long and short percentages, making his fund less susceptible to the market's violent mood swings, and he also holds some cash.