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Will long-short stock funds make a comeback?

Statues of a bear and a bull outside the Frankfurt Stock Exchange
Hannelore Foerster | Bloomberg | Getty Images
Statues of a bear and a bull outside the Frankfurt Stock Exchange

Managers of long-short equity hedge funds have faced tough times in recent years amid broad market gains, but the strategy may see a comeback ahead.

"Long-short equity managers didn't do as well as the market last year is because the markets basically were supported by the central banks," said Anuj Khanna, CEO for South Asia at Pictet Wealth Management, which oversees around $446 billion in assets. "That's why everything went up," he said, adding long-short managers can't operate effectively in that environment.

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Long-short funds, also called market neutral funds, take both bearish and bullish positions, hoping to profit from "dispersion," or variance in the performance of different securities.

"As (central banks) start withdrawing QE (quantitative easing), markets perform with more volatility, which means less predictability," Khanna said. Pictet's "balanced" portfolio has increased its recommended allocation to long-short funds to 3 percent.

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"Some segments will do very well and others will do badly, based on their earnings capacity and their business models," he said. "The long-short equity managers will do well."

The strategy has stalled out the past couple years. Hedge Fund Research's Equity Market Neutral Index rose 6.5 percent last year, sharply underperforming the S&P 500's over 30 percent rise for 2013. HFR's index gained 3.0 percent in 2012 after falling 2.1 percent in 2011. So far this year, the index is up 1.0 percent.

Allocations to the funds appear to be increasing. Around $53.7 billion has flowed into long-short equity funds so far this year, according to data from EurekaHedge, compared with $81.3 billion last year and outflows the previous two years.

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To be sure, one of the reasons the segment sees strong fund flows is because the number of funds available is one of the most sizable in the hedge fund space, noted Kemmy Koh, managing director at Paamco, a fund-of-hedge-fund manager with around $9.4 billion under management.

But Koh said she's seen some anecdotal evidence of increased interest in long-short funds.

"In recent months, given the volatility in the market, how investors look at long-short equity may be different as they look to take less directional risk," she said.

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Fund flows to the strategy may suffer some headwinds from its popularity, however.

"Many good managers out there have closed or are closing (to new funds)," Koh said. "There are some capacity constraints, especially with the bigger institutional hedge fund guys out there that have performed well."

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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