You can hedge, but you can't hide

@Money December 8, 2011: 9:36 AM ET
Funds that limit stock volatility can be a good idea. Just know that mutual funds offering hedging strategies come with their own risks.

Funds that limit stock volatility can be a good idea. Just know that mutual funds offering hedging strategies come with their own risks.

(MONEY Magazine) -- Stock market history and the prospects for global growth suggest to me that we aren't lurching toward another long bear market.

Polls and my e-mail in-box, however, show that plenty of you fail to share my enthusiasm. That's made me want to look at what's available to retail investors who are willing to sacrifice some of the upside stocks offer in exchange for not having to endure all their gut-wrenching downside.

After all, you're more likely to ride out a volatile market if your investments are, well, less volatile; it's the whipsawing that tends to throw people from their seats.

The past 15 years have seen a proliferation of mutual funds offering hedging strategies to limit losses and moderate swings. MONEY editors aren't fans, citing high fees and uneven success. But if you're nervous about where stock prices are, I believe these types of funds can make sense.

12 money moves -- in 3 hours or less

Doug Flynn, co-founder of Flynn Zito Capital Management in Garden City, N.Y., suggests 10% to 20% of a portfolio could be allocated to stock alternatives like these and commodities.

Let's look at four strategies from most to least bearish.

From big bear to little bear

If you're convinced stocks are headed for a fall, buy an inversely correlated fund -- one that aims to give you the opposite return of a benchmark index like the S&P 500. "When most of the rest of your portfolio is having a bad day, they go up," says Jeff Tjornehoj, a senior research analyst at Lipper.

Less extreme are short-bias funds, in which the managers devote more money to the rather risky business of shorting -- borrowing and then selling shares in hopes of repurchasing them later for a lower price -- than they do to buying stocks they like.

In a long-short strategy, a manager buys, or goes long, stocks he thinks will appreciate, and shorts stocks or sectors he has no faith in. The manager can move back and forth between bullish and bearish positions.

Confused about mutual funds, etfs, and hedge funds? Send The Help Desk your questions.

Finally, there are market-neutral funds, which try to keep returns on an even keel, much as a balanced fund that owns stocks and bonds might. The difference: Market-neutral funds can short stocks. Tjornehoj warns, though, that despite high fees, "they tend to get a cashlike return."

After the deluge does no good

With any of these hedging strategies, the key is when to employ them.

"Where they really bring some value is when the market is hitting highs," says Flynn. Unfortunately, adds Tjornehoj, investors tend to buy in once the damage has been done.

The funds below beat the market in 2008, but had you invested after that, the only event you would have been hedging against is your making money. Now that the Dow is once again flirting with 12,000, pessimists have reason to start looking for shelter.

Bear huggers

These funds rise in down markets and can help smooth your returns. Here's how they've performed:

Rydex Inverse S&P 500 Strategy Fund (RYURX)

2008: 41.0%; 3-Year: -19.5%

Pimco StockPlus Total Return Short (PSTIX)

2008: 48.6%; 3-Year: -8.5%

Wasatch Long/Short (FMLSX)

2008: -21%; 3-Year: 13.2%

Calamos Market Neutral (CVSIX)

2008: -13.3%; 3-Year 7.9%

S&P 500 (SPX)

2008: -37.0%; 3-Year 14.4%

SOURCE: Morningstar, data as of Oct. 25, 2011  To top of page

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