Monday, November 8, 2010

Are Mutual Funds that Short a Good Idea?

Most investors don't understand the idea of a shorting an investment. The concept is relatively straightforward: an investor essentially bets that a stock will go down and if it does, profits from the fall. Going long does the opposite, wagering that a stock will move higher. This was formally the purview of the hedge fund, those high dollar investor clubs with equally high fees, that sought to use every market strategy available to gain ground for those investors.

As I said, this was formerly something of an investment style that was not available to mutual fund investors. But this is a different investment world and the mutual fund industry, in its own way, acknowledges that trend with a group of funds that offer a defensive footprint in the market. In other words, rather than simply assuming that all stocks will go higher, they believe their research and expertise can locate stocks that move in the opposite direction.

Studying an online MBA with an emphasis on finance can get you up to speed on mutual funds. If you don't have such a background, this information will help you understand shorting your investments.

The question is: is this a good investment for your portfolio and more specifically, how do you avoid the lure of their promise to do better than traditional funds or even ETFs? It's no easy feat launching a mutual fund and even though some appear new, they can take a year or more to hurdle regulatory requirements before the first share is offered.

In almost every instance, when it comes to investing in mutual funds, the basis for your decision rests on not only the tenure of the fund manager, but the length of the fund's performance. This backward looking approach doesn't always serve the investor well when it comes to picking a fund based on what it has done compared to where it is now, nor does this sort of comparison reveal the true nature of the fund's ability to best the overall marketplace, a field now numbering over 8,000 potential offerings.

When times are bad, as was the case twice during the last decade, good years can be wiped from the investors view, replaced with averages that make the fund appear lackluster.

New funds don't have that sort of problem. They're new, with no history and no track record. Just a charter and a manager. So new investors are forced to look at the fund family (which provides research and oversight) and the previous experience of the person(s) at the helm. This is no easy trick and requires a leap of faith. Not the soundest of advice; more like a word or two of caution.

According to Dan Culloton, associate director of fund analysis with Morningstar: "They're [long-short mutual funds] responding to the market fears and frustrations over the past 10 years. A lot of it is just pure-and-simple rearview mirror product management." One hundred and fifty new funds have decided that this is a market worth exploring.

Among the new offerings, seventeen are focused on emerging markets. This particular sector is teeming with potential and just as many problems. It is those problems, which can range from anything like political unrest to poor financial infrastructure are widely thought to be the main drivers in such an investment space. And the risks in some of those bets were indeed high. These new funds (some of which can be found here and do not constitute any recommendation to buy) have done quite well for themselves in the years following the downturn in the US stock market.

There is also opportunities to play both sides of the extremely volatile commodities markets. Many of us have watched with great interest the demand for some commodities and understand the risks involved. Yet we a lured by the potential returns this sector can offer, looking for some way to mediate those risks.

Enter the commodity mutual fund designed to play off of those investor fears, the world-wide demand for many commodities in short supply, and the ability to find profit where other investors may not yet be. And because they short securities as well, they bet some investors will not be there for long (the reasons vary from currency policy changes to the perception that something may be overbought and ripe for a bubble pop). You can find a list here.

But are these funds right for you? Yes and no. Yes if you are looking to fill a small corner of your portfolio, perhaps as little as 5-10%. There are great deal of more traditional investments that allow you to see where the fund has been and where it is headed. These still remains the best tools for making a decision on where to invest your money. And no, if you are easily swayed by the relatively high returns these funds have been providing investors over their short-life spans. That temptation can easily allow you to increase those percentages to too high a portion of your portfolio, eliminating the best diversity plans.

And since a vast majority of us will be using or retirement portfolios (401(k)s and IRAs) to do this sort of investing, special caution is worth considering.

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