Three Funds That Cut Risk

Hedge funds, which borrow money to take whatever risks they please, and hedging are different concepts. Then you have mutual funds that hedge. Those are something else entirely. If the current market limits your appetite for risk, look to three mutual funds that have a mandate to hedge against a declining stock market but still try to make a few bucks for you.

Unlike the hedge funds whose actions have added drama to the workings of the U.S. financial system, these hedge-like mutual funds use a variety of methods to evade bear markets. They own assets like commodities or stocks of commodity-producing companies that may gain when the overall stock market slumps.

The funds also make money by betting on the decline of a stock or an index by using options or futures or selling the security short. Short-selling means selling borrowed shares in hopes of buying them back at a lower price and profiting from the stock's decline.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Hedging is not a free lunch. Funds that try to mitigate a bear market usually lag when stocks are rising. But for that trade, you get a stable investment that should hold up well in bear markets and lower the overall risk in your portfolio. These three no-load funds do it well.

Former economics professor John Hussman, founder and manager of Hussman Strategic Growth (symbol HSGFX), plays the market both ways. He uses options and futures to reduce exposure to stocks when he thinks they are overpriced and buys stocks when he doesn't.

He also uses leverage --borrowed money -- to accentuate his moves. The result is as advertised: decent gains in good times and narrow losses or small gains when the market is in a tailspin.

The fund's stock holdings have been fully hedged against the possibility of a downturn since July of last year, or just about when the market turned bearish. From July 19 to March 17, Hussman Strategic Growth gained 4% compared with a 16% loss in the Standard & Poor's 500-stock index.

Over the past five years, Hussman's fund returned an annualized 8%, or 2 percentage points a year less than the S&P 500. The fund, which launched in July 2000, missed the start of the 2000-02 bear market. But it gained 15% in 2001 and 14% in 2002 compared with double-figure percentage drops in the S&P 500 in both years.

James Market Neutral (JAMNX) sticks to a strict code of neutrality. Regardless of market conditions, its managers invest half of the fund in stocks the regular way and half in shorted stocks. This strategy, called long-short, is difficult because shareholders do not benefit from the direction of the market. The success rests on stock-picking alone.

Frank and Barry James, a father-and-son team, run the fund with several analysts. They use computer models to identify promising stocks to buy and unattractive ones to short.

The James fund has handled the recent unpleasantness well. From July 19, 2007, to March 17, James Market Neutral gained 4%. It excelled during the previous bear market in 2000 to 2002, with a 17% gain to the S&P 500's 47% loss.

Permanent Portfolio (PRPFX) takes a kitchen-sink approach. It invests in gold, silver, Swiss francs, real estate, natural-resources stocks, and Treasury bills and bonds. The fund dates to 1982, founded just after a period of high inflation, then-record oil prices and crippling interest rates. Michael Cuggino has been at the helm since 1991.

That eclectic mix of assets has duly resisted all bear markets, including this latest one. From July 19 to March 17, Permanent Portfolio gained a whopping 11%. The fund has suffered only one down year since Cuggino took over, losing 3% in 1994 as the S&P 500 gained 1%.

Although Permanent Portfolio badly lagged most stock funds during the 1990s, it returned 16% in the 2000-02 bear market. Over the past five years, it earned 14% annualized, which beat the S&P 500 by an average of 4 percentage points per year.

Cuggino, by the way, also manages Permanent Portfolio Aggressive Growth Fund (PAGRX), which has a good record in rising markets. It's fully invested in stocks. So think of it once you imagine stocks are ready to rally for more than a day at a time.