Long-short funds may be a nice addition to a healthy long-term investment strategy, according to Marta Norton of Morningstar. "Research has shown that adding hedge-fund-like investments to stock-and-bond portfolios has historically led to better risk-adjusted returns over the long haul," she says. But other kinds of assets, like real estate or commodities, work just as well for diversifying a portfolio, she warns. She outlines three major types of long-short funds:
Market neutral - These funds aim for zero broad market exposure, so their long and short positions are offset when the market moves a lot in one direction. They're riskier than the money-market or short-term bond funds they're sometimes compared to, so they don't make for good income replacement funds, according to Norton.
Absolute return - These funds use options or short selling to create a low-volatility, low-return profile. Norton says they work well in theory to smooth long-term volatility, but warns they also carry a lot of risk.
Equity variable - "Think opportunistic," Norton says. "The funds that fall in this subcategory often boast flexible mandates and can short stocks or load up on their favorites as they see fit."