Short-selling funds come up big

While most investments are struggling, the bear market has actually been a boon to a handful of mutual funds – those that use trading strategies that capitalize on market declines.

Such funds are enjoying some of their best results ever, in many cases surpassing more conventional competitors.

A recent Standard & Poor's report focused on five funds that returned an average 28.6 percent year-to-date as of Aug. 2: the AXA Rosenberg US Value Long Short Equity Fund, the James Market Neutral Fund A, the Phoenix-Euclid Market Neutral B, the Potomac US Short Investor, and the Prudent Bear Fund. The average return does not reflect the effects of sales charges or taxes.

These funds' success has come in part from short selling. In a short sale, a fund borrows and then sells stock with the expectation it will fall. The fund then buys back the shares at a cheaper price and pockets the difference as profit.

The strategy is frequently used by traders – and has been responsible for some of the stock market's recent advance – but it's less common in funds.

"In the past, there was a specific restriction on a fund's ability to use income from shorting. That changed in 1997 with the amendments to the federal securities laws," says John Collins, spokesman at Investment Company Institute, the trade association for the mutual-fund industry. "That said, a fund can't start shorting suddenly unless it's somehow said in the prospectus that it's going to use those strategies."

On average, the S&P estimates that funds that employ short selling have returned 4.9 percent so far this year, compared with an average negative return of 11.6 percent for domestic funds.

The lure of a fund that performs well when the rest of the market is slumping can be hard to resist. But many experts caution against investing too much in funds that short stocks, noting that when the market turns up again, these funds could lose ground.

There's also the issue of cost. Investors will find sizable fees, or loads, when they enter or leave funds that use a shorting strategy.

"These funds are pretty expensive considering some of the other alternatives like bond funds. You really have to not only have tolerance for risk, but you really have to be in it for the long haul because the load, whether front-end or back-end, can really impact performance," says Jim Shirley, a research analyst at Lipper Inc. "If you're an investor who just wants to put this in his portfolio for a year or two, you're really going to pay for it."

Indeed, the fees for funds that short stocks tend to be higher than those of US equity funds. S&P estimates their average expense ratio at 2.2 percent – compared with an average of 1.33 percent for US equity funds.

There's also the potential for a bigger-than-expected tax bill. In addition to shorting strategies, many of these funds also buy and hold the stocks of companies they believe are undervalued. Because there tends to be more turnover in their portfolios, there are, therefore, more profits to tax.

For example, the Prudent Bear Fund, which had a positive year-to-date return of 64.4 percent as of Aug. 2, had an annual turnover rate of 386 percent, according to S&P. The Potomac US Short Investor, which had a positive return of 26.9 percent during the same period, had an annual turnover rate of 867 percent, also according to the S&P.

By contrast, the average US equity fund turns over about 88 percent a year.

Still, analysts say funds that use shorting strategies can be another way to diversify a portfolio – if the funds are used sparingly and monitored carefully.

"These are specialized categories that you might want to put a small portion of your money in if you believe the market is going down," says Rosanne Pane, a mutual-fund strategist at Standard & Poor's. "But I'd caution against using them too much. They may be too risky for many investors."