Beaten down by market turmoil? The case for hedged mutual funds

August 11, 2011

The following is a guest post by Juliette Fairley. A frequent contributor to USA Today, Investor’s Business Daily, Bloomberg Wealth Manager and The New York Times, she is also the author of three personal finance and investing books. The opinions expressed are her own.

With the markets so volatile, financial advisers are screaming “diversify” from the rooftops. One small corner of the market that might attract attention in down times: hedged mutual funds.

Before the latest downturn, the hedged equity mutual fund category, which is comprised of only about 100 funds, was up 1.72 percent year-to-date. That’s less than the average equity mutual fund, of which there are about 10,000, which up 4.97 percent.

But in the tumult since the debt deal, the ratio turned to a 5.69 percent loss for hedged funds compared to a 7.83 percent loss for non-hedged funds, according to data from Lipper, a Thomson Reuters company, through Aug. 10, 2011.

That kind of split is why the hedged equity mutual fund remains a small specialty instrument in the toolbox of many financial advisers. Advisers like hedged mutual funds because they keep clients’ portfolios afloat in a down market, despite lower returns over the long-term.

“Hedged mutual funds act as a diversifier and can both reduce losses or make money. They are designed to return a small amount in any market. In balance, they are good by adding choice and selection to the client’s menu,” says John Longo, a registered investment adviser in Morristown, New Jersey.

Another advantage to hedged funds: lower fees. Traditional hedge funds, such as Paulson & Co. or Avenue Capital, charge two percent of the top 20 percent of any profit.

Hedged mutual fund fees can be as high as two percent of assets compared to one percent for a stock fund and half of a percentage point for a bond fund, Longo says.

And while traditional hedge funds are only available to accredited investors or a qualified purchaser, hedged mutual funds are more accessible because they have a lower minimum investment. The minimum for the Schwab Hedged Equity Fund, for example, is $100. The fund invests in stocks that have at least $1 billion in market capitalization in sectors including telecom and financials. Since inception in September 2002, the fund’s annualized return is 5.46 percent while the S&P return’s is 5.36 percent through August 10, 2011, according to Lipper.

“We short sell 20 to 60 cents opportunistically and then the cash we get from shorting is held as segregated cash,” says Vivienne Hsu, managing director and portfolio manager of Schwab Hedged Equity mutual fund. “The fund is diversified across the board so that within the sectors we are picking stocks to go along with the ones we think will underperform the stocks in that sector that go short.”

Overall, that’s the role of a hedged equity mutual fund in a portfolio: Not to rack up performance but to manage risk. “The fund is trying to deliver lower volatility. Because of shorting, we net out some of the risk inherent when investing in stock,” says Hsu.

And because hedged mutual funds aren’t correlated to the markets, they can be used to counter the price movements of a traditional investment portfolio. “The hedged mutual fund holds long and short positions simultaneously, which is where the returns come from. Managers make money in all markets by being long on stocks that are going up and short on stocks going down so that they are making money on both,” says Jeff Tjornehoj, head of Lipper Americas Research in Colorado.

The pitfall is in the fallibility of the fund’s manager. “Sometimes these funds can be wrong in their ability to time the market. The manager may go deeply into a stock at the wrong moment and then the bottom falls out of the market and your hedged equity mutual funds decline in value like the rest of your long-only mutual funds,” says Tjornehoj.

The top four hedged mutual funds that were Lipper Leaders in 2010 include:

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