Stocks don't have to go up to make investors money. Investors can "short" a stock. This means the investor borrows the stock from a broker and sells it at its current price. The investor agrees to buy the stock back later. If the stock goes down, the investor buys it for less than he sold it for. He then gives the stock back to the broker and keeps the profit. Mutual funds can do this for you.
Mutual funds that specialize in shorting stocks are called short funds. The fund managers look for stocks they think will go down in value, either because the company is in trouble or because the stock market itself is faltering. When funds borrow stock to sell it, they have to keep the full value of the stock in cash. This is where your money comes in. The fund uses investors' money to pledge as collateral for borrowing the stock. One of the benefits to you is that you don't need what is called a "margin account." This is an account that lets you borrow from a broker. The fund already has a margin account. Two examples of short funds are the Prudent Bear Fund and the Grizzly Short Fund.
Some mutual funds buy stocks the regular way and also short them. This is called being "long" and "short" at the same time. This means they buy some stocks that they expect to go up in price, and they short other stocks they expect to go down. This combination can make money if the fund manager is right. The strategy is based on the fact that some stocks go down even in a rising market, due to company mismanagement or financial difficulties. Examples of long-short funds include Diamond Hill Long-Short and Security Alpha Opportunity.
If a mutual fund is wrong about a short stock, it may have to deposit more money with the broker. Since the broker loaned the stock, he has a right to ask for more collateral. If the stock goes up instead of down, the fund is losing money on its short position. If the broker asks for more collateral at that point, the fund must come up with the cash. This is money it could have invested elsewhere. If you have money in such a fund, you are losing on this particular trade in two ways: The stock is working against you, and your money could have been used to buy a winning stock instead of using it to cover the margin call.
Strategies for Short Funds
When choosing between a pure short fund and a long-short fund, you have several issues to consider. With a short fund, the manager is committed to the shorting strategy, no matter what the general market does. One Wall Street saying goes, "A rising tide lifts all boats." This means that if the market is going up, all stocks will benefit and rise with it. If this is true, committing to a short strategy could cost money. The long-short approach may appeal to investors who think that it could be wise to be prepared to go long in a good market and then switch to a shorting strategy if the market turns downward.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.