Herd mentality has always been a powerful force in investing circles, and with billions of dollars now running to hedge funds, many clients might feel tempted to join the stampede.

The fact remains, however, that hedge funds are not right for every investor — or even for most investors. Despite the industry's efforts to democratize hedge funds, most still require steep minimum investments. Further, with hundreds of new hedge funds opening every year, many rely on untested managers. Academic studies have concluded that the flood of novices already is contributing to a serious problem for hedge funds — namely, a decline in average alpha (the amount of returns produced in excess of benchmarks).

For clients who cannot — or will not — try hedge funds, there is a compelling alternative: mutual funds that follow hedge-like strategies. These specialized funds use short-selling, merger arbitrage and other techniques. To be sure, mutual funds are tightly regulated, so they cannot hope to match the huge results of free-swinging hedge champions, such as George Soros. Still, hedgelike mutual funds can help to diversify portfolios, producing results untethered from the stock or bond markets. A few top performers boast experienced managers with solid records for delivering alpha and strong risk-adjusted returns as measured by Sharpe ratios.

Moving Forward in Neutral

For clients who worry about protecting assets, so-called market-neutral funds can be intriguing. Market-neutral funds typically start by buying some stocks. Then they sell short a roughly equal amount. The short sales can keep a fund stable in difficult markets. “A good market-neutral fund can make money nearly every year — even when stocks are falling,” says Stanley Katz, a principal with First Alliance Asset Management/Access Financial Group, a registered investment advisor in Dayton, Ohio.

Worried that rising interest rates could punish stocks and bonds this year, Katz has been shifting some client assets to James Market Neutral, a relatively tame choice that has made money for the past five consecutive years. James keeps risk in check by usually keeping about 30 percent of assets in cash and holding a diversified group of stocks. In 2004, the fund had an 8.6 percent total return. (See table page 73.)

Portfolio manager Barry James screens 9,000 stocks, ranking them according to valuations and earnings strength. Shares with low price-to-earnings ratios and healthy earnings momentum rise to the top of the list. He buys about three dozen of the strongest candidates and shorts a roughly equal number of unappealing names. “Stocks in the bottom few percentiles of the rankings do exceptionally poorly, and they make good shorting candidates,” James says.

Another market-neutral fund with a record for delivering alpha is Laudus Rosenberg Value Long/Short Equity. The fund aims to stay broadly diversified, buying long positions in about 550 stocks. “We are trying to find a lot of stocks that are slightly misvalued,” says Stephen Dean, a portfolio manager on the fund.

Laudus holds a broad cross section of industries. In each industry, the fund keeps long stakes in undervalued stocks and balances that with short sales of stocks that appear overpriced.

For a purer dose of short-selling, consider Prudent Bear. Portfolio manager David Tice specializes in spotting companies with accounting problems and other time bombs that are about to explode. “We always retain a short exposure because clients use us as a hedge,” he says.

Tice often shorts richly valued stocks. He scored big gains in 2002 by shorting Cisco and other high-priced technology names. During bull periods, Tice sometimes loses money. During the market gains of 2004, he limited red ink by holding long positions in some winning gold stocks. Tice figures that at a time when the dollar is weakening, the value of gold will keep climbing.

Mayday! Payday!

Along with short-selling, hedge funds have achieved positive returns in down markets by investing in distressed securities, stocks and bonds of companies that are bankrupt or close to it. Portfolio managers aim to buy troubled securities at big discounts. Then if the businesses revive, the stocks can skyrocket — even during periods when most other shares are falling. Distressed debt has produced healthy results for Mutual Qualified, a mutual fund that keeps about 15 percent of its assets in alternative instruments, including short sales and distressed debt.

Mutual Recovery, a sibling of Mutual Qualified aims to keep most of its assets in distressed debt and merger arbitrage. Like many arbitrage hedge funds, Mutual Recovery buys stocks that are targets of merger announcements. Such stocks frequently sell at discounts to the announced takeover price because investors doubt that the deal will go through. If the takeover proves successful, the stock jumps to the takeover price and arbitrage funds can pick up small gains. Mutual Recovery targets mergers that other investors consider risky. “We are looking for deals where there is a substantial discount and we can get meaningful returns,” says portfolio manager Michael Embler.

Mutual Recovery holds both distressed securities and merger stocks because the two areas are negatively correlated; when one segment flourishes, the other is often stuck in the doldrums. Distressed opportunities are most appealing when the economy is sour. That is exactly when there are relatively few mergers, because companies with depressed stocks don't necessarily go on the acquisition trail. When the economy strengthens, there are fewer bankruptcies, but more merger activity.

While Mutual Recovery targets narrow niches, Leuthold Core Investment takes a broader approach. Leuthold holds a variety of asset classes, shifting weightings as the portfolio managers seek bargains. The fund typically holds at least 30 percent of assets in equities and can raise the figure to 70 percent. Worried that stocks had gotten expensive in 1999, the fund lowered its equity position to the minimum and sold some stocks short. The move proved well-timed and helped the fund gain more than 22 percent in 2000, a sterling achievement in a year when the S&P 500 sank 9.2 percent. In 2002, the Leuthold managers turned positive and shifted to their maximum equity position, another move that produced big returns.

Normally Leuthold holds some bonds, but lately the fund has turned negative on fixed income, fearing that interest rates will rise. To capitalize on its forecasts, Leuthold is selling short zero-coupon Treasury bonds. “We are making a pure bet on higher interest rates,” says Andy Engle, a portfolio manager.

With its variety of strategies, Leuthold resembles some of the best hedge funds. But Leuthold's minimum initial investment is $10,000, a fraction of what most hedge funds charge. Seeing the fund's low price and compelling long-term track record, many retail clients may be tempted to try mutual funds that thrive by short-selling and other hedge fund strategies.

Hedging Their Bets

Mutual funds that employ hedge-like strategies.

Fund Ticker 12-Month Return 3-Year Return 5-Year Return Alpha Maximum Front-End Load
James Market Neutral JAMNX 8.6% 4.4% 6.1% 4.3 0%
Laudus Rosenberg Value Long/Short Equity BRMIX 2.5 7.0 5.6 8.1 0
Leuthold Core Investment LCORX 8.3 12.9 10.9 9.8 0
Mutual Qualified TEQIX 16.3 9.6 10.1 6.5 5.75
Prudent Bear BEARX -14.1 7.8 11.9 12.0 0
Vanguard 500 Index VFINX 10.7 3.5 -2.4 -0.11 0
Source: Morningstar. Returns through 12/31/04.