Estimated reading time: 3 minutes, 35 seconds

Even though markets have been calm recently, the large equity selloff in the second half of 2015 and in the early portion of 2016 illustrates how quickly investor sentiment can sour.

Investors, of course, have much to fret over, with lingering concerns over slowing economic growth in China, oil price volatility, and expectations that U.S. corporate earnings will decline. At the same time, investors have been carefully watching the Federal Reserve, with shifting expectations for monetary policy playing a big role in driving market performance.

Many financial advisors have sought to manage risk with long-short strategies, which can have a low correlation to equities. Yet, care must be taken when selecting long-short strategies as a wide range in performance characteristics exists within the asset class.

While many funds can have low volatility, others can actually increase risk. Indeed, in 2015, market gyrations sent many long-short funds to an untimely death. According to Reuters and Morningstar, 64 alternative funds were liquidated or merged out of existence in 2015, up from only 40 in 2014.

The rough year illustrates the two-sided nature of alternative funds and more specifically, short selling. With short selling, borrowed stocks are sold with anticipation that the stock price will decline. That way, the portfolio manager can buy the stock and return it to the lender. The difference in the selling price and buying, of course, will represent either a gain or a loss from the transaction.

At first blush, short-selling can seem like a simple approach to managing risk. After all, if equities decline, short sales will be profitable. Yet, that overlooks how the transactions are used by portfolio managers.

Some portfolio managers use short sales with hopes of juicing returns, while others seek to manage risk associated with existing positions, and others may use shorts for both functions. For risk management, using shorts to enhance returns can be a dangerous undertaking.

Consider the following scenario: a portfolio manager is bullish on technology while being bearish on energy. To benefit from expectations that technology will outperform and energy will underperform, the portfolio manager overweights the tech sector and underweights energy companies. In addition, the portfolio manage shorts the energy sector.

Needless to say, if the outlook for tech and energy is correct, the portfolio will probably outperform, but if the outlook is wrong, the results can be disastrous. Imagine a scenario where the overweight tech stocks decline substantially and the underweighted energy sector outperforms. Such a scenario can be discouraging, but having sizeable short exposure to the energy sector will just make the portfolio lose even more as the value of the short position will drop.

Now, consider a portfolio manager that uses short selling for risk management. Rather than make big sector bets, the portfolio manager can hedge existing long positions. While the shorts can partially offset gains when long positions advance, they can also help to limit the impact of portfolio holdings declining in value. In some instances, managing downside risk can actually result in superior performance over long-term market cycles.

For advisors, the challenge is to assess which funds manage risk with shorts rather than use the transactions to try to boost returns. Some asset managers will promote levels of net exposure, or long exposure minus short exposure.

On one hand, the statistics can help assess the extent of shorting with a portfolio. But, it doesn’t reveal if portfolio managers are taking sector bets. With that in mind, advisors should scrutinize a fund’s stated investment goals and historical data on sector weighting. For example, marketing materials that say that a fund uses shorts primarily to profit from declining stock prices may be more likely to take sector bets or bigger bets on individual companies.

Advisors should instead considering looking for funds that say they use shorts primarily to manage risk. Advisors should also compare sector weightings of different funds that they're considering.

Large sector overweights and underweights can be a warning sign that a fund is seeking to juice returns rather than manage risk. As with any fund, of course, advisors can also look at common risk measurement rankings, such as standard deviation relative to appropriate benchmarks.

In the process, advisors can explain to clients how they assess long-short funds to illustrate their expertise in analyzing portfolios and their desire to manage risk.

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