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The Long and Short of Long-Short Funds

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At the Morningstar Investor Conference in 2006, one breakout session panelist noted the 40 long-short funds in existence, predicting the number would increase tenfold in the next two years.

A little over a year later, Morningstar analyst and director of personal finance Christine Benz added them to her list of trendy funds to avoid.

“It’s a stretch to call long-short funds a gimmick, but most of the new long-short funds are simply not a good value proposition,” she wrote at the time. “When you consider that the average long-short fund launched over the past year has an expense ratio of more than 2%, it’s hard to see how anyone would be better off in a long-short offering than in a plain-vanilla bond fund. The case for long-short funds is even weaker for investors’ taxable assets, because the strategies tend to be tax-inefficient.”

Long-short funds hold positions in both long and short investments. Some are market neutral, meaning they have an equal weight on both sides, and some tilt one way or the other depending on perceived market opportunities.

As the financial crisis worsened, so too did the prospect of long-short funds achieving their promised returns. Chalk it up to another investment product that failed its hype when the bubble burst. Like so many other products, they severely disappointed investors when it all went bad, threatening the very idea of employing hedging strategies in mutual funds as a whole.

Yet make the argument to Mike Buckius and he’ll take it head on.

“Well, I agree,” says Buckius, portfolio manager of Gateway Fund (GATEX). “There have certainly been a lot of long-short products that have come out over the last few years, and they’ve performed all over the mark.”

But, as he’s quick to note, while Gateway technically resides in the long-short category, it’s different in that he and his co-managers aren’t stock pickers. They’re not trying to pick good ideas and short bad ideas and earn return along way.

“We’re using broader options markets and market volatility to generate cash flow and reduce risk,” he explains. “We’re akin to a long-short fund in terms of goals, which are steady return and reliable performance with reduced levels of risk, but we’re coming at it from a wholly different direction than most long-short funds.”

And it’s working. Despite Benz’s previous analysis of the space overall, Gateway is a Morningstar Analysts’ pick in the long-short category, partly because of its long track record. Over 20 years, Gateway has delivered average annual returns of 7.5%. Sure, the S&P 500 has returned 9.5% annually over the same period, but Buckius and his co-managers have done it with 40% less risk. And over the past 10 years, the fund outperformed the S&P 500 Index. Analysts rate it as the most tax-efficient fund among the lowest cost funds in its category.

Investors have taken notice: With $5.3 billion in assets currently, the fund has quadrupled in size over the past decade.

A fund of that size isn’t one that typically rates as “overlooked,” but it’s largely flown under the radar. Is it a deliberate strategy?

“It’s not deliberate,” he says. “We’ve spent decades trying to be experts at this particular niche in the market. As markets have gotten more developed and as investors have gotten more information, they’re able to look at different choices on the risk spectrum, and we’ve been getting a lot more notice. They’re looking for something that’s addressing a particular need in a portfolio that stocks, bonds and cash might not deliver.”

Buckius has been with Gateway Investment Advisers since 1999, one member of a three person management team. Before joining the Cincinnati-based firm, he worked in investment banking in New York and Baltimore on the options trading desk (hence the strategy). He’s got his CFA and an MBA from Loyola University. Even though he’s been with his current firm for 12 years, he’s still considered “the new guy,” an indication of the strong tenure and track record Gateway enjoys.

When asked what sets them apart, Buckius gets very specific.

“What we do is straightforward and consistently applied. We buy a portfolio of stocks that tracks the S&P 500 index. Rather than speculating on the market, we use that portfolio to build a risk management strategy that actively dials down the risk of that stock portfolio. To do that we use S&P 500 index options to generate cash flow and reduce volatility. We also use a portion of that cash flow to buy downside protection in the form of index put options. The combination of those three gives us an attractive risk profile and balances risk and return at a sensible level.”

Buckius repeats the “win by not losing” mantra, something high in demand from clients worried first and foremost about protecting the assets they have.

“The stock market is where growth is over the long term; unfortunately, it tends to be a pretty big roller coaster ride to get where you need to be with equity investing,” he says. “We focus on trying to get the benefits of investing in equities that grow in place of protection, but doing so with a lot less risk. We think solid, positive returns when markets are good are important, but we think it’s just as important to avoid those large losses that, unfortunately, seem to be happening with increased frequency.”

A standard question asked of all overlooked managers is where they’re finding alpha and good deals—the areas that really excite them. To this, Buckius throws a curve.

“We focus on a lot of different areas, but individual stocks or even the direction of the market isn’t one of them,” he says. “The bread and butter of our focus are on volatility. Market volatility is the sentiment that gets priced into the market. So it incorporates the big macro picture, what’s going on with the Fed, what’s going on in Europe, what’s going on with individual company earnings and also how people feel about that going forward. It’s certainly a sentiment type of an indicator, but it translates into the options market in a very real, very measurable and quantifiable way.”

To put it in lay terms, volatility is good, something of which they look for and take advantage. It’s a story that works well given the current economic and political environment. And, speaking of the latter, Buckius (like any good manager) is keeping a sharp eye.

“This is an interesting period in the market,” he says with obvious understatement. “There’s certainly a lot of fear out there; justifiably so. Are we entering a recession? What’s left for the Fed to try? Then there’s the big question mark of what’s going on in Europe. The VIX index (which is really the fear index) was well above 30 for a significant period. The flip side of that is that it seems that there’s cause for optimism, rightly or wrongly. It seems as though there’s a lot that central banks around the world are going to do in terms of some coordinated action to address the markets, liquidity, credit increases. As I said, we’re at an interesting inflection point. We’re very comfortable being a little more conservative, a little bit more hedged, which fits with our strategy overall. There’s always going to be something to worry about.”