Short selling has invaded the mutual fund industry. The reason: the repeal of the short-short rule under the Taxpayer Relief Act of 1997. The rule had previously penalized active trading by mutual funds. With that burden lifted, funds are now exercising their newfound freedom to create new products, the latest creature being the market-neutral mutual fund.

Market-neutral funds strive for returns of six to eight percentage points more than Treasury bills by hedging a number of diversified stock picks with an equivalent number of diversified short bets, using the S&P 500 as their playing field. Money earned from short sales goes into money market accounts. And unlike a normal retail trading account, institutional players have the clout to earn interest on their short sale proceeds--thats one advantage over doing this yourself.

Designed to perform in bullish or bearish times, market-neutral funds hope to make more on their long positions than they lose on their short positions during an up market, and to make more on their short positions than they lose on their long positions in a down market. Theyre touted as a defensive mechanism for an overvalued market. That claim assumes the funds managers can make the right choices, however. If the long positions and short positions dont behave, results could be flat.

Some investors have responded positively to the concept. The Barr Rosenberg Market-Neutral Fund (no-load) pulled in $250 million in assets as of June 10, 1998, since its December 1997 inception.

Regardless of the Barr Rosenberg funds early success at attracting investors, brokers need to introduce the details of market-neutral funds to their clients or prospects carefully. These products can be tough to understand.

Market-neutral funds are a complex sale because they have a sophisticated structure, so the explanation of how they work doesnt come off your lips that easily, says Harold Evensky, broker and principal of Evensky Brown Katz & Levitt in Coral Gables, Fla. Even so, Evensky is a big believer in the products. The funds can be an extraordinary addition to a portfolio due to their market-hedging capabilities.

Private accounts have been managed for years using the market-neutral strategy. But experts say making the concept work in a mutual fund wrapper is a different story. For one thing, market-neutral mutual funds require intensive management because they can have 1,000 or more holdings that need to be monitored daily.

The result: These funds have higher management fees than the average mutual fund, says Jim Whelan, a fee-based broker and mutual fund specialist with Dozier Whelan, an independent financial adviser in Annapolis, Md.

Whelan points to another risk: Barring a market crash, it will probably be two to four years before any sizeable assets move into them. If there is a crash, however, hot money may rush to these funds, which makes managing them even more difficult. Large cash in-flows and out-flows interfere with a market-neutral funds need to continually fine-tune its portfolio.

In addition to management fees that range from 2% to 2.5%, the tax consequences of the market-neutral concept can be nasty, too. Frequent trading--a core practice of market-neutral funds--generates lots of taxable distributions. Thats why Dick Saalfeld, president of Barr Rosenberg Mutual Funds in Orinda, Calif., recommends his companys market-neutral fund for retirement accounts.

Taking a Wait-and-See Attitude Whelan wants to see three-year performance histories before he recommends any market-neutral funds. If the funds performance numbers live up to expectations, you could sell them based on slightly better returns than bonds and lower volatility than stocks, he says.

Barr Rosenberg was first with the market-neutral offering this past year, and used results of its market-neutral private accounts in marketing the product.

Montgomery Asset Management in San Francisco is expected to roll out the Montgomery U.S. Market-Neutral Fund (load fund) in the third quarter of 1998. Other pure market-neutral funds on the drawing board include the Value Line Hedged Opportunities Fund and the Zweig Euclid Market Neutral Fund. Such pure funds invest nearly all of their assets in combined long-short positions.

In addition, Montgomery offers the Montgomery Global Long-Short Fund (load fund), which can short emerging markets and invest in options, futures and swaps. The fund invests 30% of its assets in short positions and 70% in long positions.

Because of the complicated nature of the funds, few investors should buy them without professional advice, thus the load, according to Pete Greenley, a Montgomery Asset Management spokesperson. Normally, our funds are no-load, but for funds like these that attempt to exploit positive and negative market swings through long and short positions, we believe investors should have some professional assistance, he says. The funds are for investors who want perhaps 10% or 15% of their portfolio in an investment vehicle that is not correlated with the market.

Market-neutral funds are being touted as a portfolio replacement for some of an investors safer money, like bonds. However, the comparison with fixed-income securities is a bit unfair. The funds success is driven entirely by stock-picking ability.

The products are really new animals. Even in a gloomy market, it remains to be seen how attractive their returns will be after expenses of 2% or more are included. And forget about keeping up in a bull market.

Meanwhile, conservative accounts may have trouble understanding what theyve invested in. But the market-neutral concept does bring to the little guy what wealthy hedge fund investors have enjoyed for years.