Long-short funds bring hedging strategies to mutual fund investors.

Throughout their histories, hedge funds and mutual funds have often been thought of as polar opposites. But with the rise of long-short mutual funds, the line between the two industries is starting to get a bit blurrier.

The idea behind long-short funds is fairly simple: The funds can have both long positions (bets in favor of stocks) and short positions (bets against stocks). This mixed strategy serves two main purposes. First, it gives managers the ability to profit in both directions. In other words, they can make money by predicting not only which companies and indexes will succeed but also which ones will fail. In that sense, shorting can be somewhat risky and speculative.

But in its second use, hedging serves the exact opposite purpose. Notably, managers often use shorting to hedge their bets, meaning that they will structure their strategy so that when their long positions fail, their short positions will pick up the slack. This helps managers limit risk in adverse market climates.

Until fairly recently, the added margin of safety that shorting can offer was a hallmark of hedge funds. By default, that meant that retail investors who couldn’t afford to buy hedge funds had little access to long-short strategies. But that’s beginning to change. Currently, Morningstar’s database lists 79 long-short funds, up from 61 at the end of 2006.

The timing of this increase is no coincidence. After taking a savage beating during the downturn, investors are increasingly clamoring for downside protection, and long-short managers have stepped in to fill the void.

In the process, something interesting has happened: The walls have started cracking. On the one hand, many mutual fund investors want their managers to move in the direction of hedge funds. At the same time, hedge fund managers are beginning to ponder trying their hands at running mutual funds.

While this can hardly be considered a substantial convergence of the two styles of investing, it still represents more give-and-take than investors have been used to. In this climate, hedge fund manager Rob Kaimowitz earlier this year converted one of his three hedge funds into a mutual fund, which is now called Bull Path Long Short. Recently, U.S. News spoke with Kaimowitz about his fund, which is up 9.5 percent year to date (including its preconversion performance), and about the gradual erosion of the long-standing separation between hedge funds and mutual funds.

Why did you decide to give mutual fund management a try?

I discovered purely by accident that the way that I run my hedge funds is identical to the way that the SEC requires a long-short mutual fund to run. So I figured that if I could convert one of my funds over and capture my track record and capture our performance record, I’d be a top-ranked fund, so it makes a lot of sense to bring this to a new market.

Broadly speaking, why has the mutual fund industry been so interested lately in strategies that had typically been reserved for hedge funds?

I think the biggest thing is because the market was down about [55] percent from peak to trough. Long-only mutual funds were down, in a lot of cases, a lot more than that, while hedge funds outperformed by 40, 45 percentage points. People all of a sudden realized that they can’t be long only, so there’s a big push to bring some risk management to all investors.

How do you manage risk in your mutual fund?

The way we do it is through shorting strategies, by limiting your net exposure while still having market exposure. So if you can create alpha, which means making money beyond what the market is going to give you, and limit your net exposure, you can in effect have the best of both worlds.

What type of exposure should average retail investors have to long-short funds?

They should be 20 to 30 percent of your equity bucket, so if you have 60 or 70 percent of your overall portfolio in equities in one way or another, 20 to 30 percent of that should be in a long-short fund where you limit your market exposure. Otherwise, you’re driving down the highway at 100 miles an hour not wearing a seat belt. Long-short funds offer seat belts and air bags.

In that case, why do you think mutual funds have, at least until recently, been slow to adopt long-short models?

Because they never had to before. They never had to manage risk before. Long-only did really well [until the downturn]. And there was no benefit to shorting if you had tons of money flowing to you without having to have any risk management. So there’d been no demand and no need for it.

What are some of the obstacles to this transition?

A lot of long-only [mutual fund] managers cannot run a long-short strategy because of internal compliance issues. So, for example for Fidelity, which owns pretty much every stock on the planet, it might be difficult for them to run a true long-short fund because it’s probably difficult for them to justify being short in the same name they’re long in elsewhere. So it’s going to be difficult for big complexes to launch a true long-short strategy.

In the hedge fund industry, managers have a lot more freedom to pursue alternative investing styles. Do you see any factors that would give them more incentives to do what you did and move into the mutual fund space?

There’s [substantially] much money in equity mutual funds than there is in hedge funds. And No. 2, if there’s a demand, you want to get the best. So if there’s going to be demand for new long-short products in the mutual fund world, then it’s going to create supply.

So the talent will start moving?

For the past 15 years, if you were a talented analyst or portfolio manager, you didn’t want to go into the mutual fund business; you wanted to go into the hedge fund business. Now, as all the talent has been clearly skewed toward the hedge fund business, the mutual fund business showed its weaknesses by being down so much in ’07 and ’08, and all of a sudden hedge fund guys like me are smelling an opportunity to bring a better product to where people need it.

How will this change the dynamics of the hedge fund industry?

I think [until now] it’s been a type of investment that’s only for endowments and pensions and very wealthy individuals. But I think now retail investors are likely to discover the benefits of long-short investing the way they discovered the benefits of mutual funds in general in the early ’90s when you had the explosion of mutual funds. And so I think you’re going to have a similar learning curve.