Some Mutual Funds Offer Lower-Octane Hedge Options

Investors who want to hedge their portfolios can take a less volatile route than using high-octane short-selling funds.

One alternative is a relatively new breed of mutual funds that seek to duplicate what professional hedge funds have long done for wealthy investors.

Professional hedge funds are unregulated investment vehicles that have virtually unlimited ranges in terms of buying stocks, shorting stocks and using so-called derivative securities to try to beat the market.

But such funds have generally been open only to the richest investors and at high fees.

In 1997, however, Congress eliminated a 60-year-old rule that effectively prohibited conventional mutual funds from selling stocks short. The repeal spawned a number of hedged mutual funds, also called “long-short” funds or “market neutral” funds.

For the most part, hedged mutual funds don’t try to take the huge risks that their professional hedge fund kin can.

“These are different animals than hedge funds,” said Rick Lake of Lake Partners, a Greenwich, Conn., investment consulting firm. “They are kinder, gentler and subject to Securities and Exchange [Commission] regulations. You won’t see any leverage meltdowns.”

In fact, SEC regulations limit a mutual fund’s use of leverage--borrowing to make portfolio bets--to one-third of the value of fund assets. Traditional hedge funds don’t have such limitations.

Minimum investments for hedged mutual funds can range from $1,500 to $10,000. That’s a far cry from the financial commitment for a traditional hedge fund, which can run between $100,000 and $1 million for a minimum investment.

Also, the cost of ownership is lower: Managers of hedged mutual funds usually charge a fee based on performance, while traditional hedge fund managers normally charge 1% of assets annually but also may take 20% of any profits.

Lake estimates that hedged mutual funds have grown to more than $60 billion in assets.

Strategies can differ significantly among hedged mutual funds.

Bill Horne, representing the Caldwell & Orkin Market Opportunity Fund, said his fund has succeeded through a diversified investment approach.

“We invest all over the place. You can’t peg us in one box. We’re trying to generate positive returns without riding the wave of the market,” Horne said.

The fund gained 26.7% last year, when the blue-chip Standard & Poor’s 500 index fell 9.1%.

Calamos Funds in Napierville, Ill., is among the fund families offering market-neutral funds, which generally try to go “long” in some stocks (a normal investment bet) while shorting other stocks in the same industry, and also generating income with short-term Treasury securities or other safe investments.

The central idea is to grind out fairly steady returns over time.

“Whether stocks go up or down, the return is pretty static,” said John P. Calamos, chief executive of Calamos Funds. “The more volatile the market, the better we like it. We’re selling stability.”

Walter Sall, chairman of Gateway Investment Advisers, manages about $3.2 billion and three mutual funds, two of which are hedged. “We hedge in two ways--through [stock] index call options and the purchase of market index puts to protect portfolios against catastrophic losses,” Sall said.

The Gateway Fund rose 6.6% last year after a 13% return in 1999 and a 12.3% return in 1998.

Needham Growth Fund, which also can use options to hedge, rose 7.4% last year, when the average mid-cap growth stock fund fell 6.9%.

Hedging via such mutual funds is slowly growing in popularity with investment counselors seeking protection for their clients as the stock market becomes more volatile, Lake said.

“We’re very pleased with [hedging’s] risk control. Ultimately, investors want a return on their money. They’ll look where they can find it. Our objective is to smooth out the daily volatility,” said Lake.

But Calamos acknowledges that many investors and investment advisors find hedging strategies too complex.

“It’s too hard to explain. As soon as you say ‘short sale,’ it blows their mind,” he said. Still, Calamos said he tries to pitch hedged mutual funds as an alternative to investing in the bond market.

Lake cautioned that although hedged mutual funds are growing in popularity, many financial advisors still are educating themselves about the technique.

“It’s going to require a learning curve” for advisors and their clients, he said.