Insightful Investing

The Wasatch Long/Short Fund (FMLSX) is one of our favorite Long/Short Equity Mutual Funds. Before we get into the details why we like that fund, let’s talk about these funds in general.

Long/Short Equity strategies are actually lower risk than traditional long-only equity investing. Long/Short Equity funds have the ability to sell stocks “short” in addition to taking traditional long equity positions within their portfolios. While there are three types of Long/Short Equity funds, we only consider directional Long/Short funds, like the Wasatch Long/Short Fund (FMLSX), for inclusion in our investment portfolios.

In general, these funds are focused on risk-adjusted returns, seeking the capital appreciation and equity-like returns, but with less risk. While they may invest up to 100% of the fund’s assets in long equities, they also have the ability to vary short position exposure even to the extent of taking more short positions than long positions depending on the manager’s evaluation of the stock market environment.

The amount of securities sold short typically increases as the market rises in valuation and decreases as valuations fall. As such, the fund typically increases its downside protection via short sales as the risk of a market decline increases. The fund seeks to avoid being hurt by its short sales in rising markets by picking securities for short sales that are believed to be overvalued regardless of market direction.

Using these strategies, the goal of directional Long/Short funds is to achieve both capital appreciation and capital preservation. Successful fund managers expect to significantly outperform equities in down markets and to slightly lag equities in up markets, resulting in better performance and less volatility than equities over the long term.

Like most equity mutual Funds, the Wasatch Long/Short Fund’s objective is capital appreciation. The difference between FMLSX and long-only equity funds is that the fund manager’s goal is to deliver equity-like returns with less volatility and risk. The Wasatch Long/Short Fund functions like a regular equity fund, but has the ability to sell short securities in order to potentially limit downside risk. The managers have flexibility in the magnitude of their short positions, but the Fund has typically been 20% to 30% short. At any time this fund may have either a net long exposure or a net short exposure to the equity markets. It also has the flexibility to invest in companies of all sizes, but has primarily invested in mid and large cap companies (both long and short).

Key criteria for selecting Long positions — a value approach

• Low valuation relative to sector/industry
• Company positioned to benefit from a global theme/framework
• Targeting securities that are at least 25% below intrinsic value

Key criteria for selecting Short positions — fundamental and technical analysis

• High valuation relative to sector/industry
• Clear thesis for why valuation will come down or earnings will be hurt
• Technical signs of distribution/breakdown

For those interested in a directional long/short fund, the Wasatch Long/Short Fund (FMLSX) is worth considering as one of the most seasoned in this fund category. Michael Shinnick and Ralph Shive have run the Fund since its inception and have consistently delivered equity-beating results with lower volatility.

Volatility was all over the map in February, reaching its highest level in 3 months, and its lowest level in almost a year. For most investors, Once again, ETFs were where the action was on both sides of the ledger. We mentioned earlier that Silver had an incredible this month from a steep pullback in January so it should not surprise you that leading ETF on our hit list was iShares Silver Trust (SLV) which flew up 20.9% in February. This ETF was followed not to closely by PowerShares DB Precious Metals (DBP) which gained 9.0%, thanks to its 25% allocation to Silver. Next in line was iShares MSCI Canada Index (EWC) which picked up 7.6% thanks to a strong allocation to Energy and Materials. Keeping with the Commodities theme, Energy Select Sector SPDR (XLE) returned 7.4% for the month.

For the most part, the down side this month belonged to Emerging Equities with iShares MSCI Singapore Index (EWS) dropping 5.0% and
SPDR S&P Emerging Markets Small Cap (EWX) losing 3.1% in February. Short Term Government Bonds lost a little ground this month with iShares Barclays 3-7 Year Treasury Bond (IEI) landing on the bottom of that list with a slight fall of only 0.4%

Smaller was better for stocks in the USA this month with iShares Russell 2000 Growth Index (IWO) gaining 5.9%, iShares Russell 2000 Index (IWM) returning 5.5%, and iShares Russell Microcap Index (IWC) picking up 5.4%. Bonds, on the other hand, performed better overseas with SPDR DB Intl Govt Infl-Protected Bond (WIP) earning 2.4% and SPDR Barclays Capital Intl Corp Bond (IBND) gaining 1.5% in February.

Interestingly, actively managed Mutual Funds for the most part, did not fair any better than their Index based ETF counterparts, but we will point out a few of our Funds that did. After looking at the numbers for ETFs, its not surprising that Rydex Long/Short Commodities Strategy (RYLFX) topped our list of funds with a respectable gain of 7.0% in February. Parnassus Small-Cap (PARSX) and Wells Fargo Advantage Growth (SGROX) gained 5.9%, while Heartland Value Plus (HRVIX) picked up 5.6% and Royce Micro-Cap (RYOTX) earned 5.4% in February. Top gainers with an International flavor were Oakmark International (OAKIX) which was up 3.6% and Artio Global High Income (BJBHX) which returned 1.4%.

As might be expected, the downside was less eventful for our Mutual Funds than for our ETFs. For example, the biggest fall by any of our Funds was the 1.3% drop by Wasatch Emerging Markets Small Cap (WAEMX), which was less than half of what its corresponding Index ETF lost in February.

Our March 2011 Mutual Fund Portfolios, ETF Investment Portfolios, and Best Fidelity Funds have been updated through February 2011. The Mutual Funds in our Mutual Fund Portfolios are chosen from our 50 Best Mutual Funds. The ETF’s in our ETF Investment Portfolios are chosen from our List of 100 Best Exchange Traded Funds. The investment performance history of our mutual fund portfolios and ETF investment portfolios are tracked on our investment portfolio performance page.

February started out like it was going to be a better month than January until political unrest in the Middle East struck once again, this time in Libya. In a matter of 3 days, the price of oil went from $90 a barrel to over $100 a barrel. This disrupted the recent trends in the financial markets, with Stocks reversing a 6 month rise and Long Treasuries rebounding from a 6 month fall. That being said, it was still a good month for Equities as Small Cap Stocks gained 5.5%, Mid Cap Stocks picked up 4.6%, International Stocks added 3.7%, and Large Cap Stocks returned 3.4%. Money continued to flow out of Emerging Equities, which actually lost almost 1.0% in February.

High Yield led the way for Bonds, picking up 1.3% in February, while TIPS gained 0.9% and International Bonds gained 0.8%. Short Term Bonds actually lost less than 0.1%. Kind of a quiet month for Fixed Income securities.

The real action this month was in Commodities. Oil continued to be the leader in volatility, starting the month in something of a downward spiral, but actually finishing the month significantly ahead. While everyone was watching the flight to quality that pushed up both Long Treasuries and Gold, Silver quietly rebounded 21% after last month’s 9% plunge.

It will be interesting to see how financial markets react in March to the recent uptick in volatility, thanks to the Libyan crisis, that looks like it could put a throttle on recent signs of improvement in the US economy.