The long and short of long-short funds
By Gary M. Stern • Bankrate.com

You've heard a lot about hedge funds in recent years. These highly prestigious investments claim membership among the most elite investors -- those worth $2.5 million or more with a minimum $100,000 to invest. Some of these wealthy investors have lost a lot of money in hedge funds, most recently due to the subprime mortgage meltdown, though the hedge funds which bet against that market are doing quite well.

Want a piece of this rather unnerving action but don't quite have the wherewithal? There's a democratized version in long-short mutual funds. You don't need to be rich to get into them, because initial investments range from $5,000 to $10,000 (though you might get in with $2,000 through a discount brokerage firm). Maybe the best part is that you can get out at any time, whereas with hedge funds, you generally can't make an exit until the end of a month or quarter.

Over the past three years, long-short mutual funds have gained in popularity. Cash flows to long-short funds reached $16.5 billion in 2006, a 58 percent jump from the previous year, Boston-based Financial Research Corp. reported.

What are long-short funds?
Long-short funds combine investments in stocks that portfolio managers think will rise -- the long position -- with investments that are expected to decline -- the short position. Most traditional mutual funds take only long positions, with portfolio managers simply buying stocks they think will appreciate.

Here's how shorting stocks works: When a fund manager conducts a short sale, he borrows shares from a brokerage firm and sells them to a buyer. Eventually he must cover his short position by buying the shares and returning them to the lender. His goal is to sell at a high price and then buy at a reduced price at payback time. "If you short a stock at $50 and it goes down to $30, you cover your short by purchasing it back and you've made profit on the difference," says Todd Trubey, a fund analyst at Morningstar.

Because of the shorting strategy, long-shorts carry inherent risks that traditional funds do not, Trubey notes. "The risk of shorting a security is unlimited. If you buy something at $20 long, you can only lose $20," he says. Conversely, if you short a stock at $20, it can keep going up and up, though Trubey says most fund managers cover their positions by getting out before the stock rises too much.