Three Mutual Funds, the Hedge Fund Way

With the recent craze around hedge funds, I've been getting plenty of e-mail from readers looking for mutual funds that have some hedge fund traits. And, judging by the increased numbers of such funds that are popping up, fund companies appear to be getting the same kind of requests.

Among these funds, most fall into two camps: funds following long-short strategies or funds employing so-called market-neutral strategies. The former allows funds to own a mix of stocks by "going long" on those it thinks will rise in price, while "shorting" those it believes will decline in price. However, the extent to which managers devote assets to shorting is entirely left up to them. The latter strategy, meanwhile, requires that managers equally divide long and short positions so that the portfolio is effectively hedged against market direction.

So, should you be chasing these funds? My quick and dirty answer: "Be cautious." Many of these funds are too expensive, and it's also clear that some of the most talented mutual fund managers continue to use long-only strategies. (Some, such as Bill Miller, who shorts stocks at  Legg Mason Opportunity (LMOPX), are only marginally borrowing elements of hedge-fund strategies.) Moreover, we've already had plenty of instances in which these types of funds have crashed and burned: Anyone remember Crabbe Huson Special?

Still, for those who want to pursue this angle, there are three funds that stand out from the pack. Not only do I like them from a fundamental basis, but I also think that the final two can help diversify most investors' portfolios.

 Gateway Fund (GATEX)
This fund makes money by selling index call options. To cover the call options, the fund owns a broadly diversified portfolio of stocks. When stock prices go up, the fund's ownership of stocks compensates for losses on call options. To protect the fund from large losses in a declining market, management buys index put options. The result is a conservatively positioned portfolio that gives investors exposure to stocks while muting some of the volatility associated with investing in the asset class. So, while its correlation with the S&P 500 is high, its volatility is much lower. If the stock market moves sideways and interest-rate hikes start hurting bonds, this fund’s relative returns are going to shine.

 Hussman Strategic Growth (HSGFX)
Although billed as a traditional growth fund, this entrée is different enough that it bears consideration among those seeking an alternative-investments fund. Manager John Hussman, who holds a doctorate in economics, analyzes price trends and trading volume as well as valuation measures to assess the general market climate and the attractiveness of individual stocks. Depending on his market assessment, Hussman may use S&P 100 and Russell 2000 Index put and call options to hedge the portfolio. He can also use calls to simulate 150% market exposure when the climate is very favorable by purchasing a limited amount of call options on individual stocks. Finally, it's worth noting that, by mandate, the fund can't go net short, so its most bearish positioning would be fully hedged. Thus, while the strategy is fairly risky, we like the way Hussman executes it.

 Diamond Hill Focus Long-Short (DIAMX)
This fund supplements its equity-only portfolio by shorting stocks. Managers Chuck Bath and Ric Dillon are drawn to companies with sustainable competitive advantages and shareholder-friendly practices. But a stock must trade at a discount to their estimate of intrinsic value to earn a spot in the long portfolio. By the same token, the short portfolio is populated with stocks trading at a premium to management's value estimates. We like the manager's value discipline and experience. They strike us as one of the more talented stock-picking teams operating in the long-short space.