One of the excuses you’ll hear from traditional “active” managers is that they’re not given enough latitude to beat the market.
This meme spawned an entire mutual fund category, “Long/Short Equity.” Long/short mutual funds typically buy stocks they think will go up, and short stocks they think are overpriced and poised to fall or perform worse than the companies they own. The hope with this strategy is that you can get market-like returns by picking the best stocks, but with far less risk by avoiding the obviously mispriced companies. The investment industry loves these strategies because they are able to justify much higher management fees for the perceived sophistication of a long and short “hedged” approach.
I looked at the Long/Short Equity category average in Morningstar since 2000 — a stretch that includes two of the five worst bear markets in 90 years for stocks, as well as two bull markets. If ever there was a period that should benefit astute active management, this would be it. Long/short managers as a group returned +62.3% ($1 grew to $1.62) through 2016, with a loss of 17% in 2008. How does this result stack up?
What’s the lesson here? Instead of trying to pick the best stocks while avoiding the overpriced ones, you’re far better off diversifying broadly across the global stock asset classes, adding an appropriate amount of short-term bonds to customize your overall level of volatility and risk, and rebalancing periodically to restore your allocation to its target. It might not have the allure of long/short active management, but you’ll be far better off in the long run.
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Past performance is not a guarantee of future results. Mutual fund returns include the reinvestment of dividends but do not include advisory fees. This content is provided for informational purposes only and should not be considered a recommendation or endorsement of any particular security, strategy, or service.