DR.CHENJIAZI ZHONG

Investors who want the return opportunities of equities but are concerned about a fully valued market should consider strategies that are designed to asymmetrically capture up and down market movements, which can allow potentially for participation in market upside while mitigating losses during market declines. Specifically, long/short strategies deserve a larger role in investor portfolios going forward.

Mutual funds may offer several advantages to investors, including daily liquidity, portfolio transparency and fixed fee structures. Some investors, however, are skeptical about long/short mutual funds, perhaps believing that 40 Act guidelines restrict a portfolio’s flexibility and limit the advantages that come with adjusting market exposure.

Mutual fund guidelines restrict certain kinds of investment strategies, for example, strategies that employ significant leverage, invest heavily in illiquid securities or make extreme industry or single stock bets. However, for investors seeking a potentially lower-volatility approach to participating in equity returns, mutual funds are often less restrictive than generally perceived.

The key guideline related to long/short mutual funds concerns segregated assets. All financed, forward settle and derivative positions are required to be “covered” by the fund’s liquid assets. The important takeaway of this rule is that it limits mutual fund gross exposure to 200%, meaning that exposures can technically range from 200% long to 100% short. This provides broad flexibility, which gives mutual funds the ability to obtain exposures similar to private hedge funds.

Liquid long/short mutual funds can potentially play several roles within client portfolios. They can be a complement to long-only equity, designed to provide improved downside risk mitigation and lower volatility over the long term. They can serve as a liquid alternative, designed to offer lower correlation to the equity markets and improved portfolio diversification. Furthermore, certain long/short funds can be used as an active satellite strategy, providing alpha potential within a core/satellite strategy, providing alpha potential within a core/satellite framework.