Stock Funds for New Investors
By Saghir Aslam
Irvine, CA

(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the ummah will benefit from this effort through greater financial empowerment, enabling the community to live in security and dignity and fulfill their religious and moral obligations towards charitable activities)

Investors are caught between the fear of another stock market crash and the possibly low yields on safe havens like Treasurys.

“Long-short” mutual funds, which bet for and against stocks at the same time, offer ways to seek profits, protection or some of both. Many don’t try to beat the stock market. They try to lock in most of the market’s gains while paring losses when it falls. But with their high fees and complexity, the funds aren’t for everyone.

Long-short funds still are rare in the mutual fund world; there are handfuls under 100, compared with more than 2,500 long-short stock hedge funds. But the numbers are growing. A basic long-short strategy involves buying, say, $ 200 worth of stocks (going long) and “selling short” $ 100 worth. Short sellers bet against stocks by selling shares they don’t yet own. The idea is to buy them back in the future at a lower price and pocket the difference.

In this example, the long-short strategy does two things for investors. First, it gives fuller exposure to the manager’s talent and even more important experience.

“If you really believe in a manager’s stock- selection ability, long-short gives you a way to profit from what he likes and what he doesn’t like, you need to do your homework and research. See who is managing it for you. What kind of experience, track record he/she has. This is very important for you to get the full benefit.”

Second, if the market plunges, investors would expect the $ 200 in “long” stocks $ 100 in short stocks to make money. Thus the fund is said to be 50% “net long”, which is generally better than being 100% long during a crash.

There are many different kinds of long-short funds. The earlier example uses a middle-of-the-road approach. On the conservative end of the spectrum, a “market neutral” fund uses positions designed to negate market movements entirely. Investors make money only if the manager buys and shorts the right stocks.

Market-neutral funds aren’t designed to generate big gains. They aim for low “correlation”, or for moving independently of the broad market rather than in lock step with it- a benefit during market routs, when all manner of assets can trade similarly.

Closer to the risky end of the spectrum, a 130/130 fund would buy $ 100 worth of stocks, short $ 30, and use the proceeds from the short sales to buy another $ 30 worth of stocks. That leaves it 100% net long, like a regular stock fund, but investors hope to profit from a fund manager’s ability to pick both winners and losers rather than just winners. The goal is more to amplify returns than to reduce risk. Manager’s ability to be correct on both sides of the market long and short.

There are plenty more strategies than these that extend to different asset classes or use different tools, like options, to achieve their targets. There are many different ways to buy and sell options. Some of them more riskier than the others.

The biggest drawback? Fees. The average expense for the long-short category as a whole is more than 2% of assets per year, compared with an average of 1.3% for US stock funds.

Long-short strategies are best suited to investors who expect low returns from stocks in coming years, because these strategies don’t rely solely on market returns for profits. However, the benefit is that in case of market crash you will be partially protected.

In such an environment, the best funds might be those that seek to reduce stock-market exposure without eliminating it. The goal is to get most of the market’s returns when stocks go up, while paring the losses when stocks tumble.

On the other hand, most people will want to steer clear of long-short funds that seek to jack up returns rather than reduce risk. Investors can get similar stock market exposure at a lower cost via a traditional mutual fund.

The Fidelity 130/30 Large Cap fund, for example, has a yearly expense of 1.97% of assets. Over the past three years the fund has returned 10% a year. The Fidelity Spartan 500 fund, which tracks the S & P 500, costs just 0.10% a year, and has returned 19.9% a year over the past three years.

“The last thing you probably need is to pay high fees for something that moves just like the rest of your portfolio.”

Likewise, an investor who buys a long-short fund simply for crash protection is making a mistake. Therein lies the problem with these funds: While ambivalent investors might find comfort in them, bears and bulls can probably do better else-where.

(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr. Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, or does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr. Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr. Aslam does not have anything for sale.)

 

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