We look at mutual funds that are not structured like typical mutual funds, that is, funds that don't invest exclusively in long only positions in stocks and bonds. These can be powerful tools to manage the risk management of our investments.

As the SEC has loosened the rules on mutual funds shorting stock and investing in options, a small group of funds has emerged that invest like some hedge funds. These can be purchased by almost anyone, unlike hedge funds, which are only available to accredited investors (e.g. those with a net worth of more than one million dollars).

Appropriate use of these mutual funds can be quite effective in providing both diversification and hedging of your investment portfolio. According to the Securities and Exchange Commission, there are several types of hedge funds.

However, we will examine some of the more conservative strategies. One of these is the Long/Short fund.

Long / Short Funds:

Long/Short which includes sector and market neutral/relative value funds. These funds try to exploit perceived anomalies in the prices of securities. For example, a hedge fund may buy bonds that it believes to be underpriced and sell short bonds that it believes to be overpriced. No matter what happens to overall interest rates, as long as the spread between the two narrows, the fund profits. Conversely, if spreads widen, gains can turn quickly into losses. Long/short equity is the most frequently used strategy among hedge funds.

Arbitrage Funds:

Another of the lower risk strategies is Risk/Merger Arbitrage. These funds attempt to profit from pending merger transactions by, for example, taking a long position in the stock of the company to be acquired in a merger, leverage buyout or takeover and simultaneously taking a short position in the stock of the acquiring company.

Since these strategies are fairly conservative, they are ones that would be most appropriate in managing portfolio risk. Also, they have a low correlation to the market so some advisors see them as alternatives to bond funds in your portfolio.

Morningstar has added a category called Long/Short to its listing of mutual funds. Morningstar puts arbitrage funds into that same category as well.

There are many new entrants into this field. While there may be several of the newer funds that are excellent offerings, the most straightforward way to judge the risk management performance of these funds is to look at their history during at least some part of the most recent bear market (2000 2002).

Some example mutual funds that fared reasonably well in the last bear market include:

Merger Fund (MERFX):

This fund has been around for over 10 years. The basic approach is to capture the spread between the share price of companies that might be acquired and the proposed purchase price. This is done by buying the shares of the target firms of deals and occasionally shorting the stocks of the acquiring firm. This fund did fairly well during the bear market, although it had only fair performance in 2005.

Schwab Hedged Equity Fund (SWHIX):

A clone of its older sibling (SWHEX) that has significantly lower minimum investment, its managed by a group that has a long history of success in the small cap stock arena. The volatility of this fund is well below the market, and its returns have been good for a long/short fund.

Gateway Fund (GATEX):

This fund has been around for years. It has a unique approach of holding large cap stocks with high dividend yields and selling covered calls for extra income, while holding put options to guard against a market downturn. Once again did reasonable well in the bear market years.

Calamos Market Neutral (CVSIX):

One of the older offerings in the long/short group, it has a good track record that extends back through the 2000-2002 bear market. This fund utilizes a convertible arbitrage approach to target an 8-10% long term annual return. (This one has a sales load.)

Hussman Strategic Growth (HSGFX):

This is a hard one to categorize. John Hussman runs the fund, and buys stocks based on his valuation models, and then hedges against market risk by synthesizing a short position in a couple of the major indices with short call options. The hedge varies based on his appraisal of current market conditions. This is not your typical mutual fund, but over the last several years has had a very low drawdown, with reasonable returns.

As you can see, the universe of mutual funds that adopt the best strategies of hedge funds is increasing. These funds are a powerful tool in building a diversified, low risk portfolio, hedging away some of the market risk while keeping a reasonable return for your investments. But keep in mind that while all these fall into Morningstars category of long/short funds, they each have unique approaches to the concept of hedging. So before you invest in any of them be sure you understand the specifics of each approach to ensure it is a good fit for your portfolio.