Long/Short Fund

Long/Short Funds

A long/short fund is an investment vehicle—structured as a mutual fund, hedge fund, or ETF—that holds both long positions (buying securities expected to rise) and short positions (selling borrowed securities expected to fall). By profiting from both undervalued and overvalued securities, these funds aim to exploit market inefficiencies and manage risk more actively than long-only funds.

Key takeaways

• Long/short funds take long positions in securities expected to rise and short positions in those expected to fall.
• They often use leverage, derivatives, and active stock selection, which can increase costs and complexity.
• These funds can offer higher return potential and downside protection but typically carry higher fees, higher volatility, and sometimes lower liquidity.
• A common approach is the 130/30 strategy, where a fund is 130% long and 30% short, maintaining net exposure of 100%.

How long/short funds work

• Strategy: Managers research and rank investments, going long where they see upside and short where they see downside. Short-sale proceeds are often reinvested to increase exposure to favored long positions.
• Instruments: Holdings can include equities, options, futures, and other derivatives used for hedging or leverage.
• Management: Active management and frequent trading drive higher expense ratios compared with passive funds. Industry data show long/short funds generally have materially higher average expense ratios than broad equity funds.
• Liquidity and access: Mutual-fund and ETF formats offer greater liquidity and lower minimums than many hedge funds, but long/short products still may be less liquid and more expensive than standard mutual funds or index ETFs.
• Regulation: Public long/short funds face limits on leverage and risk-taking that hedge funds may not, providing some investor protection.

The 130/30 strategy explained

The 130/30 approach expands a traditional 100% long portfolio by shorting the weakest 30% of the investment universe and using the proceeds to increase exposure to the top 30% by an extra 30 percentage points. Example process:
1. Rank stocks by expected return.
2. Invest 100% in top-ranked stocks.
3. Short bottom-ranked stocks up to 30% of portfolio value.
4. Reinvest short-sale proceeds to achieve 130% gross long exposure and 30% short exposure, keeping net exposure at 100%.

This can magnify gains from the best ideas while attempting to neutralize market direction risk, but it increases short-related risks and costs.

Examples (illustrative)

• AQR Long-Short Equity Fund (QLEIX): A globally diversified long/short equity fund that allocates both long and short positions across sectors. It is an example of a high-activity long/short mutual fund with relatively higher expense ratios reflecting intensive management.
• Invesco S&P 500 Downside Hedged ETF (PHDG): An actively managed ETF that blends S&P 500 equity exposure with a volatility hedge (via VIX futures) and cash to reduce downside risk. It shows how some long/short strategies emphasize volatility management and can have lower expense ratios than active mutual funds.

Related strategies

• Market-neutral funds: Aim to minimize market exposure by pairing long and short positions in matched stocks to capture relative performance.
• Pairs trading: Go long one security and short a related security to profit from price divergence while hedging market risk.
• Options and derivatives: Often used alongside or instead of short positions to hedge downside while limiting potential losses.

Why shorting is riskier

Long positions have a limited downside (the investment can fall to zero). Short positions carry theoretically unlimited loss potential because a stock’s price can rise indefinitely. Shorting also incurs borrowing costs and potential margin requirements, adding to risk.

Bottom line

Long/short funds offer flexible, actively managed strategies that can enhance returns and provide downside protection relative to long-only investing. However, they bring higher costs, complexity, and unique risks—especially those related to short selling and leverage. Investors should weigh potential benefits against fees, liquidity, and the manager’s skill before allocating to a long/short strategy.