Small investors try big-time tactics

First they were for the very rich. Then big pension funds and other institutions climbed aboard. Now, small investors have found a way to ride on the bandwagon known as hedge funds. A growing number of mutual funds now employ hedge-style strategies. The question is: Who should buy them?

Their reputation is virtually synonymous with risk. Yet the word "hedge" refers to something very different. Many of these funds have the conservative goal of seeking strong returns while taking on less risk than the overall stock market.

What they offer is a way to diversify beyond traditional stock or bond funds. In any given year, having a hedge fund in your mix could spice up total returns, soften the blow of a bear market - or do neither.

"You should have a firm handle on what role the fund is going to serve in your portfolio - and have realistic expectations," says Dan McNeela, a senior mutual-fund analyst at Morningstar Inc. "In the short run, I'd be cautious."

Many of these funds charge high fees, he notes, and they lack a significant track record.

The term "hedge fund" is a loose one, covering any number of strategies that go beyond the simple purchase of a portfolio of stocks. Some do increase risk; they may use leverage (borrowing) to place a larger amount of money in an investment. In this way, gains are multiplied - and so are losses.

But the more common tactics involve some hedging of bets. Some fund managers will buy a few favored stocks, as well as a bearish futures contract on a broad stock index. That way, if the stock market goes down, they have a built-in cushion. If the market goes up, the futures contract weighs against their performance, but the managers still hope to profit from the stocks they bought.

Sound complicated? It is. And these funds are surely not for every investor. But in the past few years - an era of choppy stock-market returns - hedge funds have experienced a headlong rush of investors, lured by the promise of attractive returns and controlled risks. Hedge-fund assets, beyond the realm of mutual funds, now total more than $1 trillion.

In short, investors are seeking a new road to riches. At the same time, they've become focused as never before on managing risk.

Mutual-fund investors often spread risk by selecting a broad range of stocks and bonds. But it's not uncommon for both stocks and bonds to perform poorly at the same time. That's why interest in "alternative asset classes" has grown in recent years. A small stake in commodities, gold, or real estate can help ensure a smoother ride. It's a kind of insurance policy against the whole portfolio moving in a bad direction all at once.

Hedge funds can also serve that purpose. "The one thing you can almost be assured of, with most of these hedge-like investments, is that they will not closely track the market indices," says John Hussman, who manages the Hussman Strategic Growth Fund, which uses hedge strategies.

But the decision to buy such a fund goes beyond risk reduction. A fund isn't very compelling, says Mr. McNeela of Morningstar, if its best selling point is a less-bumpy ride than the stock market. It also should offer the hope of solid returns.

Several funds with hedge-like strategies have earned the highest rating from Morningstar, in part for their strong risk-adjusted returns. One example is Diamond Hill Focus Long-Short. Over the past five years, the fund has racked up annualized returns of 9.3 percent, handily beating the US market. And the gains came with less volatility than the overall market. The fund's strategy is implied in its name. It goes "long" on some stocks (buying them) and "short" on others - arranging to profit when their share prices fall. This style is typical for many hedge funds.

In theory, a long-short blend reduces the risk of big losses. The approach aims to deliver a measure of success whether the overall stock market rises or falls.

Some hedge managers take this tactic to a higher level of discipline. "Market neutral" hedge funds try to carve out performance that is completely independent of whether the market is rising or falling. But since stocks historically go up more than they go down, such strategies don't always produce the hottest returns.

"Over the long run it's been a great thing to have exposure to the stock market," McNeela says. "When funds offer to minimize the risk ... it's important to remember where the returns are coming from."

Consider the record of funds tracked by Morningstar. Of several dozen that use some hedge-style tactics, the average annual return over the past three years was 8.4 percent. That's good, but far below the roughly 16.4 percent gains enjoyed by the overall US market.

But hedge-style funds outperformed the stock market over the past five years, a period when stocks fell early on. Since January 2001, hedge-style funds averaged 3.8 percent annual gains, while the Dow Jones Wilshire 5000 index returned an annualized 2.1 percent.

That's not scientific proof of how well hedge funds can or can't do. But it does hint at two key points: Many of these funds take seriously the goal of reducing risk, and that means their returns can lag behind during bull markets.

In a bear market, the blend of long and short positions may soften the declines, but not necessarily eliminate them. The results depend on the skill of the manager. So look at the track record, and read up on the fund.

Fund manager Dr. Hussman puts it this way: "Investors ... should be concerned with what the overall average return of any of those funds has been when you measure over a full market cycle."

Hussman's fund has averaged 12 percent annual returns over five years, with much less volatility than the S&P 500. His approach involves hedging when he sees unfavorable market conditions.

Hedge-like mutual funds come in many flavors. Some focus on companies involved in mergers. Others dabble in a wide range of strategies. One new fund, Rydex Absolute Return Strategies, typifies a broad-ranging approach. Its stated goal is performance "consistent with the return and risk characteristics of the hedge fund universe."

A sibling of the hedge fund is the so-called "bear market fund." These funds, many offered by either Rydex or ProFunds, effectively allow the investor to sell short a given segment of the market. For example, one fund wins when energy stocks do badly. Another profits from a bear market for bonds. These can be bought on their own, or investors can simultaneously buy two opposing mutual funds - one "long" and one "short."

But predicting the timing of a bear market is notoriously difficult. And the results of being in a bear-market fund at the wrong time are not pretty.

For all hedge funds, "buyer beware" remains a good rule. Read the prospectus carefully - and well before bedtime.

Hedge funds have gained in popularity right alongside the rise of what may be their polar opposite: index funds.

Their twin success symbolizes a question that hangs over the investing world: Will the future be more about passive investment strategies or active ones?

Those who support the passive approach view markets as "efficient." The idea is that, with so many smart people buying and selling, it's hard to beat the collective intelligence of the market. So they buy and hold funds that track market indexes. In this view, the key fact is that index funds beat a majority of actively managed funds over the long haul.

Those who use hedging strategies say that, at least sometimes, markets are inefficient. They argue that even if most investors don't beat the market, those with the best strategies do. The key, in their view, is to find the most skilled investment manager.

Even fans of hedge funds wonder if their strategies will face diminishing returns over time, as more investors chase the same profit opportunities. Another argument for indexing involves costs. Investors often face both a "load" (one-time fee) and relatively high annual expenses with a hedge-style fund.

"They will be sorry," says William Bernstein, a booster of index funds and the author of "The Four Pillars of Investing."

Still, the notion of investing by autopilot isn't for everyone.

And of course, some investors put a little money in both camps. That's what many large pension funds are doing, for example. In the process, they hope not only to cut risk - softening their portfolio's overall volatility - but also to capture the possibility of strong returns by a skilled manager.

Meanwhile, don't expect the "active" versus "passive" debate to end anytime soon.