In 1995, long-short funds began an impressive streak. For 13 consecutive years, the group made money, according to Morningstar. No stock category came close to matching that record. Even such safe bond categories as intermediate government and intermediate municipal posted some losing periods.During the late 1990s, the long-short funds attracted little notice. At a time when the S&P 500 was returning more than 20% annually, few investors cared about a vehicle that quietly delivered single-digit results. But in the difficult markets of this decade, the long-short funds began to stand out. In 2000, the funds returned 9.57%, 18 percentage points ahead of the S&P 500. The next year, the long-short portfolios returned 5.37%, outdoing the S&P by 17 points. During the decade ending this June, the funds returned 3.51% annually, about half a percentage point ahead of the S&P. As investors came to appreciate vehicles that could stay in the black, fund companies introduced new choices. The number of long-short funds has climbed from 12 in 2000 to 54 now. To be sure, most of the new selections are not worth considering. Many charge high fees and deliver meager returns. But a handful rank as superior. These can serve as diversifiers, rising when stocks are heading down. As their name suggests, long-short funds hold conventional stock portfolios -- known as long positions -- and also sell some stocks short, betting that prices will drop. In bull markets, the short positions drag down returns, but in downturns the funds surge ahead of the markets.
One of the top performers is Aberdeen Equity Long-Short ( MLSAX), which returned 7.70% annually over the past decade. With stocks falling during the first half of this year, the fund was ahead of the S&P by 10 percentage points. That showing isn't surprising for a fund that sells short. But Aberdeen also beat the S&P in 2007, a year when the market rose. The fund has achieved its record by taking long positions in stocks that seem poised to surpass Wall Street's forecasts for earnings growth. Aberdeen goes short stocks that are likely to produce earnings disappointments. In 2007, the fund took full advantage of its ability to go long and short. Portfolio manager Christopher Baggini scored by shorting banks and other financial stocks -- and he achieved gains by going long on a few financial names, including IntercontinentalExchange ( ICE), which handles red-hot commodity futures. "We made money with financials that were not connected to the mortgage problems," says Baggini. Another winning short seller is Schwab Hedged Equity ( SWHIX). The fund aims to outdo the S&P 500 a bit while taking less risk. To limit losses in downturns, the portfolio managers typically keep about 20% of assets in short positions. That strategy has worked. During the past five years, the fund has returned 8.55% annually, about a percentage point ahead of the S&P. The fund managers use Schwab's proprietary ranking system, which evaluates 3,000 stocks based on 19 factors, including valuations and free cash flow. The top 5% of stocks earn an A and are considered likely to outperform. The bottom 5% receive an F and are judged to likely underperform.
Schwab says that its A-rated picks have outdone the S&P 500 since the scoring system began in 2002. The system favors companies with stable sales growth and rising share prices. Stock buybacks are considered a positive sign, indicating that managements believe their shares are undervalued. "We buy stocks with higher ratings and short stocks with weaker scores," says Vivienne Hsu, a SWHIX portfolio manager. Investors seeking to diversify their bond holdings should consider Gateway ( GATEX). During the past five years, the fund returned 6.56% annually, outdoing intermediate-term bond funds by more than 2 percentage points. In the five-year period, intermediate-term bond funds recorded eight negative quarters. Every time bonds sank, Gateway stayed in the black. Gateway recorded about the same risk levels as intermediate-term funds did as indicated by standard deviation, a measure of how much investments bounce up and down. Gateway holds down risk by following a complicated strategy. The fund starts by buying a stock portfolio that roughly tracks the S&P 500. Gateway then sells call options on the S&P 500. The calls give buyers the right to collect cash if the index rises above a certain level. The call sales provide the main source of returns for Gateway. While the option sales produce varying amounts of income, the annual average is around 20% of the value of the fund's stock portfolio. Gateway takes the cash from the option sales and uses some of it to buy put options. Like short sales, the puts gain in value when the market drops. The puts insure that the fund will suffer only limited losses in downturns. Gateway's stock portfolio by itself can produce only limited gains. If the market appreciates, the value of Gateway's stock portfolio will climb. But most of the profits must go to pay buyers of the calls who earn payments in rising markets. After paying the call buyers, the fund usually has enough money left over to provide shareholders with the kind of single-digit returns that long-short investors appreciate.