Small investors try big-time tactics

First they were for the very rich. Then big pension funds and other institutions climbed aboard. Now, small investors have found a way to ride on the bandwagon known as hedge funds. A growing number of mutual funds now employ hedge-style strategies. The question is: Who should buy them?

Their reputation is virtually synonymous with risk. Yet the word "hedge" refers to something very different. Many of these funds have the conservative goal of seeking strong returns while taking on less risk than the overall stock market.

What they offer is a way to diversify beyond traditional stock or bond funds. In any given year, having a hedge fund in your mix could spice up total returns, soften the blow of a bear market - or do neither.

"You should have a firm handle on what role the fund is going to serve in your portfolio - and have realistic expectations," says Dan McNeela, a senior mutual-fund analyst at Morningstar Inc. "In the short run, I'd be cautious."

Many of these funds charge high fees, he notes, and they lack a significant track record.

The term "hedge fund" is a loose one, covering any number of strategies that go beyond the simple purchase of a portfolio of stocks. Some do increase risk; they may use leverage (borrowing) to place a larger amount of money in an investment. In this way, gains are multiplied - and so are losses.

But the more common tactics involve some hedging of bets. Some fund managers will buy a few favored stocks, as well as a bearish futures contract on a broad stock index. That way, if the stock market goes down, they have a built-in cushion. If the market goes up, the futures contract weighs against their performance, but the managers still hope to profit from the stocks they bought.

Sound complicated? It is. And these funds are surely not for every investor. But in the past few years - an era of choppy stock-market returns - hedge funds have experienced a headlong rush of investors, lured by the promise of attractive returns and controlled risks. Hedge-fund assets, beyond the realm of mutual funds, now total more than $1 trillion.

In short, investors are seeking a new road to riches. At the same time, they've become focused as never before on managing risk.

Mutual-fund investors often spread risk by selecting a broad range of stocks and bonds. But it's not uncommon for both stocks and bonds to perform poorly at the same time. That's why interest in "alternative asset classes" has grown in recent years. A small stake in commodities, gold, or real estate can help ensure a smoother ride. It's a kind of insurance policy against the whole portfolio moving in a bad direction all at once.

Hedge funds can also serve that purpose. "The one thing you can almost be assured of, with most of these hedge-like investments, is that they will not closely track the market indices," says John Hussman, who manages the Hussman Strategic Growth Fund, which uses hedge strategies.

But the decision to buy such a fund goes beyond risk reduction. A fund isn't very compelling, says Mr. McNeela of Morningstar, if its best selling point is a less-bumpy ride than the stock market. It also should offer the hope of solid returns.

Several funds with hedge-like strategies have earned the highest rating from Morningstar, in part for their strong risk-adjusted returns. One example is Diamond Hill Focus Long-Short. Over the past five years, the fund has racked up annualized returns of 9.3 percent, handily beating the US market. And the gains came with less volatility than the overall market. The fund's strategy is implied in its name. It goes "long" on some stocks (buying them) and "short" on others - arranging to profit when their share prices fall. This style is typical for many hedge funds.

In theory, a long-short blend reduces the risk of big losses. The approach aims to deliver a measure of success whether the overall stock market rises or falls.

Some hedge managers take this tactic to a higher level of discipline. "Market neutral" hedge funds try to carve out performance that is completely independent of whether the market is rising or falling. But since stocks historically go up more than they go down, such strategies don't always produce the hottest returns.

"Over the long run it's been a great thing to have exposure to the stock market," McNeela says. "When funds offer to minimize the risk ... it's important to remember where the returns are coming from."

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