This article on hedge mutual funds was originally published in 2006. Many of these hedge funds have done reasonably well in the recent market tumult, and it may be time to look into these funds again.

In today’s volatile markets we are always looking for ways to increase our portfolio returns while limiting the downside risk in our investment portfolio as well. There are many more options to do so than even just a few years ago. One recent development are mutual funds that are not structured like typical long only mutual funds. These are funds that don’t invest solely in stocks and bonds.

The SEC has loosened the rules on mutual funds. They now allow shorting stock and and also putting some of the funds assets in options. With this new freedom a small number of funds has emerged that share many of the favorable properties of hedge funds. The advannatage to the average investor is that these funds can be purchased like any other mutual fund, unlike hedge funds, which are only sold to accredited investors (e.g. those individuals with a net worth of more than one million dollars).

Using these mutual funds can help in providing both asset diversification and hedging of your investment portfolio risk.

The Securities and Exchange Commission has classified several types of hedge funds. These classifications include:

Market Trend Funds (Directional/Tactical) Strategies

(These intend to use strategies to exploit broad market trends in equities, interest rates or commodity prices.)

Macro: Macro funds may take positions in foreign currencies (often unhedged) based on their analysis of various countries’ macroeconomic fundamentals. As an example, when a country’s economic policies look inconsistent to the funds manager and its ability to sustain its exchange rate with the other major currencies appears problematic, macro funds may take positions that should profit from devaluation. Usually this is done by selling the currency short.

Long/Short Funds: ( this includes sector funds and market neutral/relative value funds): Long/ short funds attempt to find anomalies in the prices of securities. As an example, a long/ short hedge fund could buy bonds that it estimates to be underpriced and sell short bonds that it that it perceives to be overvalued. In this case, regardless of what happens to overall interest rates, if the spread between the two bonds narrows, the fund will realize a profit. Alternatively, if the spread widens, the fund will see a loss. Long/short equity is one of the most frequently used strategy among hedge funds, and could be considered a true “hedge”.

Event-Driven Strategies

(These funds attempt to exploit discrete events. Examples of such events include bankruptcies, mergers, and takeovers.)

Distressed Securities: These funds will take long and/or short positions to profit from pricing inconsistencies among the various securities that have been issued by companies going through bankruptcy or reorganization.

Risk/Merger Arbitrage: Merger arbitrage funds look at pending mergers and attempt to profit from pricing discrepencies. For example, they might take a long position in the stock of the company being acquired in the merger while simultaneously shorting the stock of the acquiring company.

Arbitrage Strategies

(Arbitrage strategies attempt to exploit pricing discrepancies between closely related securities. These funds are designed to be among the lower risk hedge fund types. Arbitrage can also play a role for funds in the event-driven and long/short categories.)

Convertible Arbitrage: This strategy involves taking long positions in a company’s convertible bonds, preferred stock, or warrants that are deemed to be undervalued while taking short positions in the company’s common stock.

Of these approaches to hedging, the ones that would be most appropriate in managing portfolio risk would be those that either use a long/short strategy (sometimes known as market neutral approach), or an arbitrage approach. Since most of these have a low correlation to the overall market some investment advisors even recommend using these mutual funds as alternatives to bond funds in your portfolio.

As these types of funds have become more common over the last few years, Morningstar has even added a category called Long/Short to its listing of mutual funds. Morningstar has also chosen to put arbitrage funds in that same category.

Note: As always, you should seek the advice of your investment adviser before investing any money in these funds.

There are many new entrants into this field. While there may be several of the newer funds that are excellent offerings, the most straightforward way to judge the risk management performance of these funds is to look at their history during at least some part of the most recent bear market (2000 2002).

Some example mutual funds that fared reasonably well in the last bear market include:

Merger Fund (MERFX): This fund has been around for over 10 years. The basic approach is to capture the spread between the share price of companies that might be acquired and the proposed purchase price. This is done by buying the shares of the target firms of deals and occasionally shorting the stocks of the acquiring firm. This fund did fairly well during the bear market, although it had only fair performance in 2005.

Schwab Hedged Equity Fund (SWHIX): A clone of its older sibling (SWHEX) that has significantly lower minimum investment, its managed by a group that has a long history of success in the small cap stock arena. The volatility of this fund is well below the market, and its returns have been good for a long/short fund.

Gateway Fund (GATEX): This fund has been around for years. It has a unique approach of holding large cap stocks with high dividend yields and selling covered calls for extra income, while holding put options to guard against a market downturn. Once again did reasonable well in the bear market years.

Calamos Market Neutral (CVSIX): This fund is one of the older funds in the long/short group. It has been around long enough that it has a track record that extends back through the 2000-2002 bear market. This fund utilizes a convertible arbitrage system to target an 8-10% long term annual return. (Note this fund has a sales load.)

Hussman Strategic Growth (HSGFX): This fund has a fairly unique approach. John Hussman runs this fund, and his approach is to buy stocks based on his valuation models, and then he hedges against his estimate of the overall market risk by synthesizing a short position of the major indices with short call options. The hedge varies based on his quantitative appraisal of the overall current market conditions. This is not your typical mutual fund, but over the last several years has had a very low drawdown, with reasonable returns. His focus is capital preservation.

The family of mutual funds that are using some of the best strategies of hedge funds is growing. These funds are one more powerful tool for investors building a well diversified, low risk portfolio They allow a hedge for some of the market risk while simultaneously keeping a competitive return on your investments. But stay aware of the fact that while all these fall into Morningstars long/short funds category, each one has a unique approache to the concept of a hedge fund. So , as usual, before you invest any money in them be sure you understand the specifics of each fund to be sure it is a good match for your investment portfolio.