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Will Market Rally Dampen Long/Short Funds' Luster?

During the recent bear market, long/short and market-neutral funds were pitched as alternative investments or absolute return havens that could provide positive returns with dampened volatility.

But with the S&P 500 Index returning more than 14.7% year-to-date through Sept. 30, will investors lose their appetite for these funds and revert to their old ways of chasing pure equity?

A more important question for fund executives is, will this particular asset class fall out of favor altogether for investors? Or will the absolute return strategy maintain lasting appeal through a potential new bull market run?

Long/short mutual funds invest in both long-only and short-only positions. Long positions are increased as the market rises and short positions are loaded up on when the market dives. In contrast, market-neutral funds invest in long and short positions in the same proportions so that some positions are winners no matter which direction the market moves.

"The stock market has done well, and people have been getting a bit greedy and chasing performance," said Don Cassidy, senior analyst at Lipper. Overall, market-neutral and long/short funds have not been the fund industry's super outperformers this year, he said. The average return on these funds, as a group was 2.17% year-to-date through Sept. 25, according to Lipper. In contrast, science and technology funds, as the top-performing category year-to-date, have returned a sweet 37.56%, according to preliminary data from Lipper.

Lipper loosely tracks such alternative investment mutual funds, but does not have a distinct category for them.

A look into a few of these funds shows that they are seeing red ink. The Centurion Market Neutral Fund, managed by Centurion Counsel, has lost 11.86% this year, while the AXA Rosenberg Long/Short Fund for institutional investors, managed by AXA Rosenberg Investment Management, has dropped 8.57%. The Caldwell & Orkin Market Opportunity Fund, managed by C&O Funds Advisor, has lost 4.21%. Still, at least until now, these funds have been popular. Long/short and market-neutral funds have raked in more than $600 million year-to-date through Aug. 31. Total assets in this fund category have increased from $1.13 billion at year-end 1999, to a new record high of more than $3 billion.

The now $703 million Calamos Market Neutral Fund, managed by Calamos Asset Management, fell victim to its own success. With assets swelling beyond capacity, the fund executed a hard close on March 14, declining new assets from both prospective and existing investors.

Must-Haves or Has-Beens?

As investors gain new confidence in accord with the rise in the stock market, a rise in corporate spending and other positive signs of market recovery, some return to pure equity funds is inevitable, say industry executives. But as an overall viable asset class, don't expect long/short or market-neutral funds to fade into oblivion.

"I don't think this [asset class] is a fad. It has picked up steam during the bear market," said Jeff Tjornehoj, an analyst at Lipper. Shorting stocks has been around forever, and even when markets are going up, some stocks are inevitably going down, he added. "They may not become the backbone of an investor's portfolio like a large-cap core fund is, but these will still provide an option for those seeking diversification," Tjornehoj added.

"You may see a shift toward funds with long-only strategies," said John Orrico, president of Water Island Capital and manager of the $240 million market-neutral Arbitrage Fund. But while retail investors may bolt from equity funds in favor of money funds or certificates of deposits, registered investment advisers understand the benefits of broad asset allocation have embraced the asset class, he noted. "RIAs are clamoring for market-neutral funds and are explaining to clients that they now have access to the same [sophisticated] investment strategies but in the mutual fund world," Orrico added.

"I really don't think that investors will get the market-neutral concept in the short term," said Patrick Adams, president of Choice Investment Management, advisor to the Choice Long/Short Fund, which debuted in early 2001, and the Choice Market-Neutral Fund, which launched this past April. "But when they hear about it and understand it, they say, Wow, why haven't I heard about this before?,'" Adams said. He noted that his market-neutral fund is not only marketed as a means for diversifying assets but also as an alternative to fixed-income funds.

Many investors haven't grasped the concept that absolute return funds aren't just an alternative to equity markets, said Steve Samson, CEO and co-founder of Alternative Investment Partners, advisor to the Alpha Strategies I Fund. "Alternative investments seek to minimize losses as the equity markets fall, but also minimize declines in the fixed-income market," he said. Declines in bond prices over the past few months have taken many investors by surprise, he added.

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