Fund name: Wasatch-1st Source Long/Short (FMLSX).

Objective: The fund’s investment objective is capital appreciation which it pursues by maintaining long and short equity positions. It typically invests in domestic stocks (92% as of the last portfolio) and typically targets stocks with market caps of at least $100 million. The managers look at both industry and individual stock prospects when determining whether to invest, long or short. The managers may, at any point, position the fund as net long or net short. It is not designed to be a market neutral offering

Adviser: Originally 1st Source Corporation Investment Advisors, a wholly owned subsidiary of 1st Source Bank, but now Wasatch Advisors of Salt Lake City, Utah. The Long/Short managers will continue to live in Indiana. Wasatch has been around since 1975. It both advises the 18 Wasatch funds and manages money for high net worth individuals and institutions. Across the board, the strength of the company lies in its ability to invest profitably in smaller (micro- to mid-cap) companies. As of December 2008, the firm had $4.5 billion under management. That represents a drop of more than 50% in 18 months.

Managers: Ralph Shive and Mike Shinnick. Mr. Shive was Vice President and Chief Investment Officer of 1st Source when his fund was acquired by Wasatch. He has been managing money since 1975 and joined 1st Source in 1989. Before that, he managed a private family portfolio in Dallas, Texas. Mr. Shive co-manages Wasatch-1st Source Income Equity fund and oversees 35 separate accounts. Mr. Shinnick co-manages both this fund and Income Equity with Mr. Shive.

Management’s Stake in the Fund: Each of the managers has between $100,000 and $500,000 in the fund. Curiously, Mr. Shive’s investment in this fund is substantially larger than his investment in his five-star, flagship Income Equity (FMIEX) fund

Opening date: August 1, 2003.

Minimum investment: $2,000 for regular accounts, $1,000 for retirement accounts and for accounts which establish automatic investment plans.

Expense ratio: 1.67% on assets of $98 million.

Comments: Long/short funds come in two varieties, and it’s important to know which you’re dealing with. Some long/short funds attempt to be market neutral, sometimes advertised as "absolute returns" funds. They want to make a little money every year, regardless of whether the market goes up or down. They generally do this by building a portfolio around "paired trades." If they choose to invest in the tech sector, they’ll place a long bet on the sector’s most attractive stock and exactly match that it with a short bet on the sector’s least attractive stock. Their expectation is that one of their two bets will lose money but, in a falling market, they’ll make more by the short on the bad stock than they’ll lose in the long position on the good stock. Vice versa in a rising market: their long position will, they hope, make more than the short position loses. In the end, investors pocket the difference: frequently something in the middle single digits.

The other form of long/short fund plays an entirely different game. Their intention is to outperform the stock market as a whole, not to continually eke out small gains. These funds can be almost entirely long, almost entirely short, or anywhere in between. The fund uses its short positions to cushion losses in falling markets, but scales back those positions to avoid drag in rising ones. These funds will lose money when the market tanks but, with luck and skill, they’ll lose a lot less than an unhedged fund will.

It’s reasonable to benchmark the first set of funds against a cash-equivalent, since they’re trying to do about the same thing that cash does. It’s reasonable to benchmark the second set against a stock index, since they aspire to outperform such indexes over the long term. It’s probably not prudent, however, to benchmark them against each other.

Wasatch-1st Source Long/Short is an example of the second type of fund: it wants to beat the market with dampened downside risk. Just as Oakmark’s splendid Oakmark Equity & Income (OAKBX) describes itself as "Oakmark with an airbag," you might consider FMLSX to be "1st Source Income Equity with an airbag." The managers write, "Our strategy is directional rather than market neutral; we are trying to make money with each of our positions, rather than using long and short positions to eliminate the impact of market fluctuations."

Since then, CGM Focus has tanked while two other funds – Amana Growth (AMAGX) and Yacktman Focused (YAFFX) – joined FMIEX in the top tier. That’s an awfully powerful, awfully consistent record especially since it was achieved with average to below-average risk.

Which brings us back to the Long/Short fund. Long/Short uses the same investment discipline as does Income Equity. It just leverages that discipline to create bets against the most egregious stocks it finds, as well as its traditional bets in favor of its most attractive finds. So far, that strategy has allowed it to match most of the market’s upside and dodge most of its downside. Over the past three years, Long/Short gained 3.6% annually while Income Equity lost 3.9% and the Total Stock Market lost 8.2%. The more impressive feat is that over the past three months – during one of the market’s most vigorous surges in a half century – Long/Short gained 21.2% while Income Equity gained 21.8%. The upmarket drag of the short positions was 0.6% while the downside cushion was ten times greater.

That’s pretty consistently true for the fund’s quarterly returns over the past several years. In rising markets, Long/Short makes money though trailing its sibling by 2-4 percent (i.e., 200-400 basis points). In failing markets, Long/Short loses 300-900 basis points less. While the net effect is not to "guarantee" gains in all markets, it does provide investors with ongoing market exposure and a security blanket at the same moment.

Bottom Line: Lots of seasoned investors (Leuthold and Grantham among them) believe that we’ve got years of a bear market ahead of us. In their view, the price of the robustly rising market of the 80s and 90s will be the stumbling, tumbling markets of this decade and part of the next. Such markets are marked by powerful rallies whose gains subsequently evaporate. Messrs. Shive and Shinnick share at least part of that perspective. Their shareholder letters warn that we’re in "a global bear market," that the spring surge does not represent "the beginning of an upward turn in the market’s cycle," and that prudence dictates that they "not get too far from shore."

An investor’s greatest enemy in such markets is panic: panic about being in a falling market, panic about being out of a rising market, panic about being panicked all the time. While a fund such as FMLSX can’t eliminate all losses, it may allow you to panic less and stay the course just a bit more. With seasoned management, lower-than-average expenses and a low investment minimum, FMLSX is one of the most compelling choices in this field.