5 mutual funds to help you hedge

Investing tip of the month from Morningstar Investment Research Center by Russel Kinnel, Director of Mutual Fund Research.

Things don't look so gloomy after the great spring and summer rally we enjoyed. Many say that the market is now fairly valued, so the great fire sale is over.

The economy has improved tremendously but some people expect another slow down. The government has to unwind its huge position in bonds, banks, insurers, and automakers. If all the stimulus works, we might have economic growth but also rising inflation. If it doesn't, we could have deflation and be stuck in a rut like Japan in the 1990s.

When stocks were supercheap and commodities superpricey, there weren't many hedges that I liked, but now it seems reasonable to consider them. Here are some funds that could hold up well if we get a bout of disappointing news.

Harbor Commodity Real Return (HACMX)
If inflation comes back, this fund could provide some protection. I particularly like it for portfolios that are heavily weighted to fixed income and, therefore, are vulnerable to a spike in inflation. Run by PIMCO in a fashion similar to PIMCO Commodity Real Return Strategy (PCRDX), this fund tracks a basket of commodities and then adds in a Treasury Inflation-Protected Securities overlay that effectively gives you exposure to TIPS as well as commodities. We recommend the Harbor fund over the PIMCO fund because of its low expense ratio. Beware of the fund's volatility and be sure to keep it to a single-digit weighting in your portfolio. Ideally, it should be held in a tax-sheltered account.

Hussman Strategic Growth (HSGFX)
This long-short fund takes the edge off market downturns. John Hussman takes long positions in individual stocks but offsets some of that market exposure by shorting indexes. While that has limited the fund's upside, it has made it a standout in difficult times. It lost 9% in 2008 but enjoyed positive returns in every other calendar year since its inception in 2000. The fund's expense ratio recently fell to 1.04%.

Calamos Market Neutral Income (CVSIX)
The implosion of hedge funds makes this fund more appealing. The three Calamoses (Calami?) running this fund employ a strategy that's popular in the hedge fund world: convertible arbitrage. The idea is to find convertible bonds that are cheaper than the underlying stock they convert into and buy the convert while shorting the common stock. They also write covered calls.

When it works, the strategy provides a modest but fairly dependable return. In 2008, the hedge fund collapse and recession hurt the convertible market, and the fund lost 13%. However, it earned positive single-digit returns in the previous bear market, and its hunting grounds won't be so picked over now that the hedgies have gone.

Caldwell & Orkin Market Opportunity (COAGX)
This is the boldest of the funds here. Manager Michael Orkin has wide latitude and can go from 100% net long all the way to 60% net short. He uses a multifactor model to quickly shift among long and short equity positions, bonds, and cash. At the end of July, the fund was 47% long equities, 17% short, 3% in options, with the rest in bonds and cash. Although Orkin sometimes zigs when he should zag, the long-term performance is excellent.

Over the past 15 years, the fund has returned an annualized 9% gain, yet its worst loss was a 6.6% drop in 2003. The fund charges an expense ratio of 1.13% as of October 2008, but when you factor in short interest, that figure pops to 1.95%.

Gateway Fund (GATEX)
Gateway holds about 300 of the 500 names in the S&P 500 and sells S&P 500 call options and buys puts, too. The end result is a fund that brackets the index so that you have limited upside and downside relative to the index. For example, it lost about 14% in 2008, which was a big 23 percentage points better than the S&P 500. But in 2003, it gained about 12%, which was 17 percentage points less than the index. Here's part of the analyst's take by Nadia Papagiannis, our long-short specialist:

This unique fund attempts to generate income on a portfolio of about 300 of the S&P 500 Index's stocks (enough to closely track the index) by writing S&P 500 calls. These calls are "covered" in the sense that any potential losses on the calls (if they are bought back at a higher price or exercised against) should be offset by gains on the portfolio of stocks. If the portfolio of stocks declines, the income received from the calls will offset some of the decline. Furthermore, put options, which give the fund the right to sell the index at a preset price, are bought on a portion of the portfolio, which also protects against downside risk. Its strategy has certainly helped since October 2007: It has lost less than half of what the S&P 500 Index has lost, as it did in August 2000 through September 2002.

A version of this article appeared on Morningstar.com on August 17, 2009.

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