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New Way to Hedge Risk

These two funds own bonds and bet against them, too.

Adding some investments that aren't tethered to the movements of either stock or bond prices might be one of the best things you can do for your portfolio. Holding such noncorrelated assets can make bear markets less destructive of your wealth and can actually boost your returns.

But finding noncorrelated investments requires venturing off the well-worn path. One strategy entails both owning bonds and selling them short (that is, betting that their prices will fall). Two promising funds in this category are Driehaus Active Income (symbol LCMAX) and Forward Long/Short Credit Analysis (FLSRX). Consider the former for a tax-deferred account and the latter, which focuses on tax-free municipal bonds, for a regular account.

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The Driehaus fund's results are impressive. From the time the current management team took over about three years ago through October 8, the fund returned 7.5% annualized. That lagged the Barclays Aggregate Bond index by a nose, and the fund did it with low volatility and almost no correlation with the bond index.

The enticing return flows from an esoteric strategy. Lead manager K.C. Nelson spends most of his time scrutinizing companies' capital structures -- that is, the range of sources that provide a company's capital, from senior bonds to common stock -- looking for a bond here or a stock there that is mispriced relative to the rest of a company's securities. He will then use a combination of long positions and short positions to bet that investors will eventually reverse a mispricing by buying the undervalued security or selling the overvalued one.

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Tamping down risk. Nelson also keeps a tight leash on volatility, in part by selling short Treasury bonds. His aim is to hold the portfolio's duration -- a measure of interest-rate sensitivity -- at zero. This means changes in interest rates should not affect the fund's share price. Driehaus requires a minimum investment of $25,000. However, you can buy the fund inside an IRA with just $2,000. The fund yields 3.2%.

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The Forward fund focuses on muni bonds. It has posted an annualized return of 13.5% since its inception in May 2008, clobbering the Barclays Municipal Bond index's annualized gain of 6.7%, and doing so with no correlation to bonds.

Co-managers Alan Hart and Guy Benstead take a freewheeling approach: Munis, corporate bonds and preferred stocks are all fair game. They comb through the terms of individual bonds and the finances of underlying companies. Then they purchase issues they find attractive and short those they find unappealing. Benstead says investors can expect about two-thirds of the fund's income stream to come from municipal bonds. However, the fund holds many high-yield munis, and Benstead typically uses some borrowed money to generate even more income. Expect the fund to be more volatile than your typical bond fund. It yields a mostly tax-free 6.1%.

Your jaw may drop when you see the expense ratios for these funds -- 2.09% for the Driehaus fund and 3.89% for the Forward fund. The percentages are so high because when a fund shorts a bond it must make interest payments on that bond out of its own assets until it closes the short position. Thus, those interest payments show up as part of each fund's expense ratio. The management fee (also part of the expense ratio) for the Driehaus fund is a reasonable 0.55% and a stiff 1.5% for the Forward fund.

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