Even as stocks continued their collapse last year, most hedge funds achieved one of their primary goals, protecting principal. In 2001, the average hedge fund returned about 4 percent, according to the Hennessee Group, almost 16 percentage points more than the Standard & Poor's 500 stock index.

Seeing those results, most retail investors could only look on enviously. Designed for institutions and wealthy individuals, many hedge funds still require large initial minimum investments from high-net-worth investors (although, as noted on page 39, minimums are falling).

Thankfully, for the small retail investor, there are more mutual funds — with initial minimum investments of $1,000 to $25,000 — have begun adopting hedge fund techniques, including selling short, hedging with options, and merger arbitrage.

Make no mistake, however, the new breed of mutual funds should not be confused with their institutional cousins. Hedge funds are largely unregulated, while mutual funds must operate under close SEC supervision. While hedge funds can sell short as much as they want, mutual funds are limited by SEC rules and their own charters, which are designed to serve investors of varying degrees of sophistication.

The mutual funds described below are part of an elite group, most often producing decent results in up and down markets. Following hedge-like strategies, they have very low volatility and little correlation with the stock and bond markets. That makes them ideal diversifiers for portfolios of all kinds.

These steady funds attracted little interest during the 1990s' bull market when go-go technology specialists held center stage. But lately the hedge vehicles have proved their resilience in difficult times. And if the markets continue to struggle, as some analysts expect, these funds could gain a wide following.

In 1999, plenty of growth funds climbed, but most suffered badly during the next two difficult years. One of the few that managed to hang on to its gains is Quaker Aggressive Growth. The fund has returned 24.9 percent annually during the past three years, 26 percentage points more than the S&P 500. “This is a poor man's hedge fund that is very nimble,” says Joel Weiner, a registered rep for National Planning Corp. in Breinigsville, Pa.

While Quaker is listed as a large-cap growth fund, its strategy is very different from its peers. Portfolio manager Manu Daftary typically puts most of his assets in growing blue chips selling at modest prices, such as Johnson & Johnson and Citigroup. He also buys some value stocks selling at P/E multiples of 10 or less, such as Georgia-Pacific. In addition, he shorts mid-cap stocks that seem likely to produce big earnings disappointments. When he can't find any compelling stocks to buy or short, Daftary takes shelter in cash, sometimes holding around half of assets there.

Another steady fund is Gateway, which has returned 7.9 percent annually during the past five years, while recording modest volatility. In some respects, this track record resembles that of an intermediate-term bond portfolio. But Gateway often rises when bonds fall, and it suffers only minimal losses when stocks sink.

The fund produces its strong results by relying on complicated options trading. Portfolio manager Patrick Rogers starts by buying the stocks of the S&P 500. Then he spends money on put options, which give the owner the right to sell securities in the future at a predetermined price. Because their value increases as prices fall, Gateway's puts act as an insurance policy, partially offsetting any losses in the S&P 500 stocks.

At the same time he buys puts, Rogers sells call options on the stocks. When an investor sells a call, he receives cash in exchange for a promise to deliver a security in the future at a fixed price. Rogers typically uses the calls to bet that the price of stocks will not rise much. In that case, he can pocket the cash from the option sale and owe nothing to the call buyer who will own a worthless contract.

If the market stays flat, the fund records income from its option sales and breaks even on the stock portfolio. The gains are reduced by the cost of the put insurance. At the moment, the fund is collecting option income at a 20 percent annual rate and spending money on puts at a 6 percent rate. “If the market doesn't fall and option prices hold, we will return about 14 percent this year,” says Rogers.

While Gateway dipped a bit into the red in 2001, Phoenix-Euclid Market Neutral has stayed in the black for the past two difficult years. Like other market neutral funds, Phoenix aims to make money whether stocks are rising or falling. To accomplish this, it buys stocks with above-average earnings growth and below-average prices. At the same time, the fund shorts stocks with the opposite characteristics.

The Poor Man Hedge (Mutual) Funds
Fund Ticker One year 3-year return 5-year R-Squared Beta Expense ratio
Gabelli ABC GABCX 4.12% 8.03% 9.51% 29 0.09 1.45%
Gateway GATEX -5.61 4.66 7.65 81 0.34 0.98
Phoenix-Euclid EMNAX 9.3 1.88 NA 28 -0.19 2.33
Market Neutral A
Quaker Aggressive QUAGX -6.83 23.21 24.54 8 0.32 1.35
Growth A
Source: Morningstar.
Data through Jan. 31, 2002

To separate the wheat from the chaff, portfolio manager Carlton Neel uses a quantitative model that looks at 35 different factors, including cash flow and share price momentum. Seeking consistent performance, Neel owns a mix of growth and value stocks from a variety of industries. He often buys one stock in an industry and shorts its competitor. For example, the fund was recently long on Cooper Tire & Rubber and short on Goodyear Tire & Rubber.

During the bull market, market neutral funds lagged the S&P badly, and clients had little interest in the complicated funds. That may be changing. “Clients like the idea of something that can go up when the market is going down,” says Eliot Weissberg, a financial planner with Raymond James Financial Services in Avon, Conn.

To provide a cushion, Phoenix always holds a cash stake. After borrowing a stock and selling it short, the fund receives cash, which it invests in short-term securities. Interest earned on the cash provides a margin of safety, and helps the fund achieve its goal of outdoing Treasury bills in all kinds of markets.