What Are Long-Short Mutual Funds and How Do They Work?

Investors looking beyond traditional mutual funds may come across long-short mutual funds. These funds aim to generate returns by taking both long positions (betting on stocks to rise) and short positions (profiting from declines). This approach helps manage risk and provides returns in different market conditions.

Understanding how these funds operate is essential before investing, as they differ significantly from standard mutual funds.

Long and Short Positions

Long-short mutual funds use two strategies: going long and selling short. A long position involves buying a stock with the expectation that its price will rise, profiting by selling at a higher price. This is the standard approach in most mutual funds.

Short positions involve borrowing shares and selling them, anticipating a price decline. If the stock drops, the investor repurchases it at a lower price, returns the borrowed shares, and keeps the difference. However, if the stock rises, losses can be significant since there is no limit to how high a stock can go.

To manage risk, long-short funds often hedge their positions. A fund might go long on a strong-performing company while shorting a weaker competitor in the same industry. This strategy reduces exposure to broad market swings and focuses on relative performance. Some funds also use derivatives like options or futures to adjust risk exposure.

Portfolio Composition

The structure of a long-short mutual fund varies based on strategy, risk tolerance, and market outlook. Some funds aim for a market-neutral stance, balancing long and short positions to limit exposure to market movements. Others take a directional approach, adjusting based on economic conditions or sector trends. The proportion of long versus short positions is measured by net exposure, indicating whether the fund is positioned aggressively or defensively.

Sector allocation plays a key role. Some funds focus on specific industries, such as technology or healthcare, while others diversify across multiple sectors. Fund managers use fundamental and quantitative analysis, evaluating financial statements, earnings reports, and valuation metrics to select stocks.

Liquidity is another consideration. Since short positions require borrowing shares, funds must ensure they can access sufficient liquidity without incurring excessive costs. Stocks with low trading volumes or high borrowing fees may be avoided. Additionally, funds often hold cash or cash equivalents to meet redemption requests and margin requirements.

Fee Structures

Long-short mutual funds generally have higher expenses than traditional mutual funds due to their complex strategies. These funds charge management fees and, in some cases, performance-based fees. Management fees, expressed as an expense ratio, typically range from 1% to 2% annually, covering research, trading, and compliance costs. This is higher than the average expense ratio for standard equity mutual funds, which is usually below 1%.

Some long-short funds impose performance fees, similar to hedge funds. These fees are structured as a percentage of profits exceeding a benchmark. For example, a fund may charge a 20% fee on returns above the S&P 500’s performance. While this incentivizes managers to generate strong results, it also increases costs for investors. Some funds use a high-water mark provision, ensuring performance fees apply only to new gains rather than recovered losses.

Frequent trading within these funds leads to additional costs. High portfolio turnover increases transaction expenses, including brokerage commissions and bid-ask spreads. Securities lending fees, incurred when borrowing shares for short selling, further add to overall costs.

Tax Treatment

Taxation of long-short mutual funds is more complex than that of traditional mutual funds due to short selling and frequent trading. One key factor is the treatment of capital gains. Unlike standard mutual funds, which primarily generate long-term capital gains taxed at lower rates (0%, 15%, or 20%, depending on income), long-short funds often realize more short-term capital gains, which are taxed at ordinary income rates ranging from 10% to 37% as of 2024. This occurs because short positions and actively traded long positions are typically held for less than a year.

The use of derivatives, such as options and futures, further complicates tax implications. Many derivative contracts fall under Section 1256 of the Internal Revenue Code, which mandates a 60/40 tax treatment—60% of gains are taxed at long-term capital gains rates, while 40% are taxed as short-term, regardless of holding period. This can provide a slight tax advantage compared to fully short-term gains. However, certain strategies involving swaps or structured notes may generate ordinary income rather than capital gains, leading to higher tax burdens for investors.

Redemption Policies

Redemption policies for long-short mutual funds can differ from those of traditional mutual funds. While most mutual funds offer daily liquidity, allowing investors to buy or sell shares at the net asset value (NAV) at the close of each trading day, some long-short funds impose restrictions to prevent excessive turnover and liquidity issues.

Certain funds implement redemption fees or minimum holding periods to discourage short-term trading. For example, a fund might charge a 1% fee on shares redeemed within 30 or 60 days of purchase to offset transaction costs. Additionally, funds that rely heavily on short selling or derivatives may require additional time to settle trades, leading to longer processing times for redemptions. Investors should review a fund’s prospectus to understand any limitations or fees associated with withdrawals.

Role of Fund Managers

The success of a long-short mutual fund depends on the expertise of its fund managers. Unlike traditional funds that primarily rely on long-term market appreciation, these funds require active management to identify mispriced securities, manage risk, and adjust portfolio exposure. Managers must continuously evaluate both long and short positions to ensure the portfolio remains balanced.

Risk management is a core responsibility, as short selling introduces additional complexities, including margin requirements and the potential for significant losses. Skilled managers use techniques such as stop-loss orders, position sizing, and sector diversification to mitigate downside risk. Some funds also employ quantitative models, using algorithms to identify trading opportunities based on historical data and market trends. Investors should assess a fund manager’s track record, investment philosophy, and risk management approach before committing capital.