Talk about a temperamental market: One day, stocks soar on a string of upbeat quarterly results, and the next, they come crashing down on gloomy jobs or housing data. One way to navigate such turbulent market conditions is with a mutual fund that makes both bullish and bearish bets. Through the use of hedge-fund strategies, these funds aim to take part in the market's upswings yet protect against those gut-wrenching declines.
Despite their sophisticated strategies, hedged funds do have their shortcomings. One is steep annual fees: Most funds in this story charge more than the 1.44 percent average for actively managed stock funds. Another issue is that few funds in this fledgling category have a long-term record, although the unfolding credit crisis has put many to the test.
Here are three types of funds that hedge:
Long-short. This strategy is gaining some mainstream appeal, as fund tracker Morningstar created a "long-short" category in 2006. Such funds combine traditional, or long, stock positions with short-selling, which is a way to make money from individual stock declines. In a nutshell, short-selling involves borrowing a stock and selling it, with the hope of buying it back at a lower price and pocketing the profit.
One example of a long-short fund, Schwab Hedged Equity, uses computers to pick which stocks to short and which to buy. Comanager Vivienne Hsu says this technique allows the fund to profit from both rising and falling stock prices. "Shorting allows us to be more creative," Hsu says. "We can take advantage of the negative. With a long-only fund, the only thing you can do is cheer that you don't own a stock."
When the Schwab team has a bearish market outlook, it sells more stocks short, and when it's bullish, it takes more long positions. (For most of last year, the fund ranged from 35 percent to 40 percent short; currently, it's 50 percent short.)
So far this year, Schwab Hedged Equity is down 3 percent—but that's 2 percentage points better than the S&P 500 stock index's 5 percent decline. From the fund's September 2002 launch of its oldest share class through April 1, it returned an annualized 9 percent, the same as the S&P. But over that period, says Hsu, the fund has been about half as volatile as the index. The fund, which requires a $100 minimum investment, charges 2.19 percent in annual fees.
Other long-short funds include Caldwell & Orkin Market Opportunity fund, which is up 19 percent over the past year, boosted by manager Michael Orkin's bets against the home-building and subprime mortgage sectors. There's also Hussman Strategic Growth, a flexible fund that uses options to bet against major indexes when manager John Hussman thinks market conditions are unfavorable. The above funds charge annual fees of 1.75 percent and 1.17 percent, respectively.
Market neutral. Some funds that short stocks choose not to bet on the market's direction. Regardless of market conditions, James Market Neutral splits its long and short positions fifty-fifty. The desired effect of this "market neutral" technique is to protect the fund from market swings, leaving stock-picking as the driver of performance.
Father-and-son team Frank and Barry James also use computers to pinpoint stocks to buy and stocks to sell short. Recently, the fund's long holdings included truck manufacturer Paccar and truck-engine maker Cummins, and its shorts included Midwest Banc Holdings and medical technology company Cyberonics.
Thanks partly to gains during the 2000-02 bear market, the fund's annualized 4 percent return from its October 1998 inception through April 1 beat the S&P 500 by 3 percentage points. So far this year, the fund—which requires a $2,000 minimum investment and charges 2.29 percent in annual fees—is up 1 percent.
There are just a handful of funds in the market-neutral category. Morningstar likes Calamos Market Neutral Income, a fund that uses a complex strategy involving convertible arbitrage and covered calls. (The fund levies a 4.75 percent upfront sales charge and 1.15 percent in annual fees.)