Small investors try big-time tactics

Consider the record of funds tracked by Morningstar. Of several dozen that use some hedge-style tactics, the average annual return over the past three years was 8.4 percent. That's good, but far below the roughly 16.4 percent gains enjoyed by the overall US market.

But hedge-style funds outperformed the stock market over the past five years, a period when stocks fell early on. Since January 2001, hedge-style funds averaged 3.8 percent annual gains, while the Dow Jones Wilshire 5000 index returned an annualized 2.1 percent.

That's not scientific proof of how well hedge funds can or can't do. But it does hint at two key points: Many of these funds take seriously the goal of reducing risk, and that means their returns can lag behind during bull markets.

In a bear market, the blend of long and short positions may soften the declines, but not necessarily eliminate them. The results depend on the skill of the manager. So look at the track record, and read up on the fund.

Fund manager Dr. Hussman puts it this way: "Investors ... should be concerned with what the overall average return of any of those funds has been when you measure over a full market cycle."

Hussman's fund has averaged 12 percent annual returns over five years, with much less volatility than the S&P 500. His approach involves hedging when he sees unfavorable market conditions.

Hedge-like mutual funds come in many flavors. Some focus on companies involved in mergers. Others dabble in a wide range of strategies. One new fund, Rydex Absolute Return Strategies, typifies a broad-ranging approach. Its stated goal is performance "consistent with the return and risk characteristics of the hedge fund universe."

A sibling of the hedge fund is the so-called "bear market fund." These funds, many offered by either Rydex or ProFunds, effectively allow the investor to sell short a given segment of the market. For example, one fund wins when energy stocks do badly. Another profits from a bear market for bonds. These can be bought on their own, or investors can simultaneously buy two opposing mutual funds - one "long" and one "short."

But predicting the timing of a bear market is notoriously difficult. And the results of being in a bear-market fund at the wrong time are not pretty.

For all hedge funds, "buyer beware" remains a good rule. Read the prospectus carefully - and well before bedtime.

Hedge funds have gained in popularity right alongside the rise of what may be their polar opposite: index funds.

Their twin success symbolizes a question that hangs over the investing world: Will the future be more about passive investment strategies or active ones?

Those who support the passive approach view markets as "efficient." The idea is that, with so many smart people buying and selling, it's hard to beat the collective intelligence of the market. So they buy and hold funds that track market indexes. In this view, the key fact is that index funds beat a majority of actively managed funds over the long haul.

Those who use hedging strategies say that, at least sometimes, markets are inefficient. They argue that even if most investors don't beat the market, those with the best strategies do. The key, in their view, is to find the most skilled investment manager.

Even fans of hedge funds wonder if their strategies will face diminishing returns over time, as more investors chase the same profit opportunities. Another argument for indexing involves costs. Investors often face both a "load" (one-time fee) and relatively high annual expenses with a hedge-style fund.

"They will be sorry," says William Bernstein, a booster of index funds and the author of "The Four Pillars of Investing."

Still, the notion of investing by autopilot isn't for everyone.

And of course, some investors put a little money in both camps. That's what many large pension funds are doing, for example. In the process, they hope not only to cut risk - softening their portfolio's overall volatility - but also to capture the possibility of strong returns by a skilled manager.

Meanwhile, don't expect the "active" versus "passive" debate to end anytime soon.

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