7 picks that give you the benefits of hedge funds without getting clipped. By David Landis, Contributing Editor May 31, 2006 If you feel excluded from the elite club of hedge-fund investors, get over it. Yes, it's true you need deep pockets to get beyond the velvet rope (minimums can range as high as $1 million). But the club itself is no great shakes. Hedge funds are overpriced and often fail to deliver on their promises. Plus, you have to watch out for shady operators (see "9 Simple Truths About Hedge Funds," March 2005).Besides, who needs hedge funds anyway? A growing number of mutual funds offer nearly all of the benefits of hedge funds with none of the drawbacks. And all you need to get through the door is a minimum investment of $1,000 to $2,500. RELATED STORIES The Economics of Stock Buybacks Extreme Contrarian Investing How to Find a Financial Adviser The Money Monster Blog The principal benefit of hedge-fund-like funds is that they can make money even when the stock market sinks. Sometimes such funds own categories, such as commodities, that may appreciate when stocks slump. More often, they make money by betting on the decline of a stock (or the overall market) through options or futures or by selling short -- selling borrowed shares in hopes of buying them back later at a lower price. Betting against the market can be risky, but most of these new funds combine traditional stock ownership with selling short to create relatively low-risk hedged positions. Because of the hedging, these funds often show little response, if any, to movements of the broad stock market. As a result, the funds will usually lag in a bull market. But in return you get a fairly stable investment that should hold up well in bear markets and lower the overall risk in your portfolio. If that sounds dull, it's supposed to. "I want my overall portfolio to be as boring as watching paint dry," says Matthew Tuttle, a Stamford, Conn., financial adviser. Advertisement These new mutual funds are also a good buy, at least compared with traditional hedge funds. The latter typically charge a 2% annual management fee, and they take an exorbitant 20% of portfolio gains as an "incentive fee." But all of the hedge-fund-like mutual funds profiled below have annual expense ratios of 2% or less (not counting the cost of paying dividends on stocks sold short) and no incentive fees. In addition, mutual funds buy back your shares at all times, while hedge funds often insist on keeping your money a year or longer and permit cash-outs only a few times a year. When choosing a hedge-like mutual fund, look for good relative performance in down markets and veteran managers who articulate their strategies clearly and stick to them. These seven funds exhibit those characteristics. Long and short of it The most popular hedging strategy is a simple one called long-short. You buy stocks you think will rise (the long side) and sell short the ones you think will sink. Obviously, the strategy depends on a stock picker who is equally adept at identifying losers (it's harder than you might think) and winners. A computer handles the job for Schwab Hedged Equity. It grades more than 3,000 U.S. stocks on a scale of A through F, based on a variety of value, risk and momentum factors. The fund's three managers then decide which of the A- and B-rated stocks to buy, and which D- and F-rated stocks to sell short. The aim is to produce a mixture of long and short positions that stabilizes the fund's results, making it significantly less volatile than the overall stock market. But the percentage of assets invested in stocks the traditional way will always exceed the percentage sold short. "Our intent is to maintain a portfolio that delivers better-than-market returns with less-than-market risk," says Vivienne Hsu, one of the managers. Advertisement The Investor share class, with its $2,500 minimum initial investment, began in 2005 and lacks a long-term track record. Another share class, Select, with a $50,000 minimum but an identical portfolio, began in September 2002. Over the past three years to April 3, it returned an annualized 18%, compared with 17% for Standard Poor's 500-stock index. Over that period, the Schwab fund was about 20% less volatile than the index. You could use Schwab Hedged as your primary fund for midsize- or large-company stocks, but don't expect this fund to emerge from a catastrophic bear market unblemished. Right down the middle Practicing strict neutrality, James Advantage Market Neutral invests half its assets long, half short. The result is a fund with modest but almost always positive returns that have minimal connection to the market's ups and downs. Thus, a 10% or 15% stake in a fund such as James Market Neutral is a good way to smooth out the returns of a stock-and-bond portfolio. The fund excelled during the last bear market. It earned 16% in 2000 and 2% in both 2001 and 2002. The SP 500, by contrast, lost 9%, 12% and 22%, respectively, in those three years. The fund returned 4% annualized over the past five years. In 2005, a ho-hum year for stocks and bonds, James returned a respectable 8%. Although long-short mutual funds have been proliferating, market-neutral funds remain relatively scarce because the strategy is difficult to pull off. With no tailwind from a rising market, a fund's success depends on the quality of its stock picks. Like the Schwab fund, James Market Neutral relies on computer models to identify promising stocks to buy and ugly ones to short. Frank and Barry James, a father-and-son team of statistics experts, run the fund from Xenia, Ohio. Frank James developed the fund's model, which tends to favor bargain-priced stocks for purchase and overpriced stocks to short. Advertisement No market timing John Hussman takes a different approach to hedging. His fund, Hussman Strategic Growth, invests in companies of all sizes. But if stocks become overvalued, or if the market exhibits disturbing trading patterns, Hussman uses options or futures to neutralize the fund's exposure to the market. It then becomes, in effect, a market-neutral fund -- but only temporarily. In a bull market, he can ditch the hedges and take full advantage of rising prices. He can even juice returns by buying options. Currently, the fund is heavy on large growth companies (Pfizer and Johnson Johnson are its biggest holdings). It is also mostly hedged, a result of Hussman's unfavorable view of stock values and market conditions. A former economics professor, Hussman draws a sharp line between his hedging moves and market timing. "A market timer tries to forecast," he says. "I make no attempt to pick bottoms or tops or to forecast short-term direction." Rather, he looks at current conditions when deciding whether to take on or shun market risk. The fund delivered remarkable bear-market returns of 15% in 2001, its first full year, and 14% in 2002. It also gained a healthy 21% in 2003, a year in which the SP returned 29%. The fund is safe enough to serve as a primary holding for large-company stocks, but it can also be used in small amounts to diversify a portfolio. Advertisement Urge to merge Once two companies announce plans to merge, the target company's stock tends to rise toward the announced purchase price -- but not all the way. Those final few bucks per share reflect the risk that the deal will fall apart or the companies will renegotiate the terms. By buying the target's shares after a takeover is disclosed, you can turn a nice profit. But because deals do fall through about 5% of the time -- the target's stock usually plunges when that happens -- it's best to leave so-called merger arbitrage to the specialists. There are few mutual funds in this arena, and none that can match the longevity or track record of the Merger fund. Run by Frederick Green and Bonnie Smith, Merger has had only one down year (-6% in 2002) since its 1989 launch. Over the past decade, it gained 7% annualized, two percentage points less than the return of the SP 500, but with only one-third of the index's volatility. That makes Merger, which recently reopened to new investors, a good choice for diversifying a portfolio. It could also serve as a substitute for a bond fund. The fund went through an unusually rough patch in 2004 and 2005, when it scratched out returns of just 3% and 1%. Roy Behren, of Westchester Capital Management, the fund's adviser, blames a lull in corporate deal making. But mergers are back with a vengeance. What's more, "the quality of deals is high," says Behren, which means they're less likely to fall apart and saddle the fund with investment losses. The lure of stuff It may seem obvious, but if you want to reduce your portfolio's dependence on stocks and bonds, buy something else. Commodity prices often head in the opposite direction of both. That makes commodities ideal diversifiers. The best commodity fund is Pimco CommodityRealReturn Strategy. The fund doesn't actually own commodities. Instead, it buys financial instruments known as derivatives, which mimic the return of the Dow Jones-AIG Commodity Total Return index. Manager John Brynjolfsson tries to add a little extra to the index's returns by holding inflation-protected bonds rather than ordinary Treasuries as collateral for the derivatives. Over the past three years the fund returned an annualized 18%, beating the index by four percentage points per year. A recent federal tax ruling will force the fund to start using a different type of derivative in June, but it doesn't appear the change will have a major impact on performance. A new way to add stuff to your portfolio is Deutsche Bank Commodity Index Tracking Fund, an exchange-traded fund. Launched in February, it tracks crude oil, heating oil, gold, aluminum, corn and wheat. If the idea of being able to trade commodities in the middle of the day appeals to you, you'll like this fund. Asset potpourri Everything's here but the kitchen sink: Permanent Portfolio invests in a mix of gold, silver, Swiss francs, U.S. and foreign real estate, natural-resources stocks, shares of fast-growing U.S. companies, Treasury bills, and bonds. It was launched in 1982, following a period of inflation, high oil prices and crippling interest rates. "There was a feeling that regardless of what investors did, they were losing money," says manager Michael Cuggino, who joined the fund in 1991. "So the objective of the fund was to preserve what you had and to provide low-risk growth." Over the past 24 years this potpourri of assets has done just that. The fund has suffered only three down years since its launch, and none since 1994. Its top holdings are U.S. bonds, T-bills and cash, so don't expect outsized gains. It badly trailed most stock funds during the go-go 1990s, but made up for it by posting gains of 6% in 2000, 4% in 2001 and 14% in 2002. Over the past five years it earned 14% annualized. Key numbers: The lowdown on hedge-like mutual funds Mutual funds that employ hedging strategies have two big advantages over traditional hedge funds: lower expenses and lower initial minimum investments. It's also much easier to get your money out of mutual funds. FUND SYMBOL ONE-YEAR TOTAL RETURN THREE-YEAR ANNUALIZED RETURN EXPENSE RATIO MIN. INVEST. TOLL-FREE NUMBER Deutsche Bank Commodity Index DBC NA NA 1.30% 1 share 877-369-4617 Hussman Strategic Growth HSGFX 5.7% 11.8% 1.14 $1,000 800-487-7626 James Advantage Market Neutral JAMNX 1.0 5.6 2.53* 2,000 800-995-2637 Merger Fund MERFX 5.4 6.1 1.77* 2,000 800-343-8959 Permanent Portfolio PRPFX 15.7 15.8 1.35% 1,000 800-531-5142 Pimco CommRealReturn Strategy D PCRDX 1.7 17.6 1.45% 5,000 800-426-0107 Schwab Hedged Equity Select SWHEX 11.9 17.7 1.77* 50,000 800-435-4000 SP 500 STOCK INDEX 11.7% 17.2 Data is to April 3. NA not applicable. *Includes cost of dividends paid to the buyer of stocks that the fund has sold short. Source: Standard Poor's.