The hedged equity mutual fund category is down -5.03% vs. down -7.32% for the average equity mutual fund category through September 13, 2011. Despite its lower return, the hedged equity mutual fund remains a tool for many financial advisors to keep their clients' portfolios afloat in a down market.

"Hedged mutual funds will diversify your portfolio and provide protection against downside risk, but they are a challenge because of the higher price of investing in them. Most advisors view them as a light holding, not as a core holding," says Morningstar analyst Ben Alpert, who added that hedged mutual funds are pricier than traditional long-only products because investors receive active management that requires more research.

Hedged mutual funds, also known as long-short equity mutual funds, offer more liquidity and transparency than traditional hedge funds but their returns tend to be lower.

"Returns are uneven because they have different strategies that are going to perform differently in different market conditions," says financial advisor Richard Bregman. "Every one of my clients' portfolios start off with at least one-third of the portfolio in alternative strategies as a hedge against unfavorable occurrences in the market. I use hedged mutual funds to lower or dampen volatility and to provide protection against a down market."

According to Lipper, the top four hedge mutual funds that were Lipper leaders in 2010 include Rydex/SGI alpha opportunity series at 23.5%, JP Morgan US Large Cap Value Plus Fund at 11.82%, Wasatch Long Short Fund at 9.41% and Schwab Hedged Equity Fund at 6.5%.

"The level of risk Lipper leaders took to earn their return was better than their peers. Ryder had a strong return and more risk but each unit of return it earned was greater than the unit of risk it took. That ratio was in their favor," says Jeff Tjornehoj, head of Lipper Americas Research in Colorado.

While traditional hedge funds are only available to accredited investors or a qualified purchaser, hedged mutual funds are more accessible and have a lower minimum investment.

"The hedged mutual fund holds long and short positions simultaneously, which is where the returns come from.  Managers make money in all markets by being long on stocks that are going up and short on stocks going down so that they are making money on both," says Jeff Tjornehoj, head of Lipper Americas Research in Colorado.

Alpert suggests that financial advisors introduce their clients to hedged mutual funds slowly. "Hedged mutual funds tend to underperform in bull markets and outperform in bear markets," he says.

The Schwab Hedged Equity Fund minimum is $100. It invests in stocks that have at least $1 billion in market capitalization. Its sectors include telecom and financials.

"The Schwab Hedged Equity Fund has had big swings. It lost more than 20% in 2008 compared to 15.9% for the category, but it is more fairly priced in terms of fees compared to its competitors," says Alpert. Schwab's management fee is 1.33%.

Since inception, Schwab's Hedged Equity Fund return has been 6.79% while the S&P return was 6.49%. "We short sell 20 to 60 cents opportunistically and then the cash we get from shorting is held as segregated cash," says Vivienne Hsu, managing director and portfolio manager of the Schwab Hedged Equity mutual fund. "The fund is diversified across the board so that within the sectors we are picking stocks to go along with the ones we think will underperform the stocks in that sector that go short."

There are nearly 100 mutual funds available in a hedge fund format currently on the market versus 10,000 traditional hedge funds. "Hedged mutual funds act as a diversifier and can both reduce losses or make money. They are designed to return a small amount in any market. In balance, they are good by adding choice and selection to the client's menu," says John Longo, a registered investment advisor in Morristown, N.J. 

The pitfall is the fallibility of the fund's manager. "Sometimes these funds can be wrong in their ability to time the market. The manager may go deeply into a stock at the wrong moment and then the bottom falls out of the market and your hedged equity mutual funds decline in value like the rest of your long-only mutual funds," says Tjornehoj.
The fees for hedged mutual funds are lower than those of traditional hedge funds but higher than those of stock mutual funds. Typically, traditional hedge funds, such as Paulson or Avenue Capital, charge 2% and 20% of any profit.

"On average, hedged mutual fund fees can be as high as 2% compared to 1% for a stock fund and half a basis point for a bond fund," says Longo.

The fee on Rydex hedged mutual funds when investing less than $100,000 is 4.75%.

"The ongoing fee once you're invested is 2.05% per year for Rydex," says Tjornehoj. "It's expensive because of the shorting capability. When you are short on a stock, the shareholder is responsible for paying the dividend that it produces, but hedged mutual funds are still cheaper than traditional hedge funds."

Overall, the role of a hedged equity mutual fund in a portfolio is not for performance but to manage risk.
"The fund is trying to deliver lower volatility. Because of shorting, we net out some of the risk inherent when investing in stock," says Hsu of Schwab's Hedged Equity Fund.

Used to counter the price movements of a traditional investment portfolio, it is the low correlation of hedged long-short mutual fund holdings that provide protection from the market's fluctuation.

For complete non-correlation, Alpert advises investing in the market neutral hedged mutual fund. "Long-short equity hedged mutual funds are going to have a long bias over time. A market neutral fund is going to have no systematic risk because it hedges away all systematic risk through derivative investments to get down to zero beta. Both are considered hedged mutual funds," says Alpert. "Being neutral means removing most of the relationship to broad equity index stocks. That's how market neutral mutual funds have less stock market risk."

An example of a market neutral hedged mutual fund is TFS Market Neutral mutual fund, managed by Kevin Gates in Pennsylvania, which is trying to deliver capital appreciation with 2,400 securities in its long portfolio and 1,275 in its short portfolio.

"Market neutral funds have had generally positive but lower returns than hoped for because their strategies are benchmarked to the risk free rate of return and the risk free rate of return is 1% right now," says Bregman.

A no-load fund, TFS Market Neutral mutual fund returned 6.23% in 2010, 16.64% in 2009 and 9.2% since inception, according to Morningstar. Its management fee is 2.25%.

"We have a constant short portfolio and a persistent hedge in place. The maximum position is 1% with our largest long position at 51 basis points and the largest exposure is 6% in consumer noncyclicals," says Gates. "The return stream we are trying to provide is separation between our long and our shorts. It's a full-time balanced approach."
TFS Market Neutral mutual fund, which is long 100% and short 70%, invests largely in small-cap companies using a quantitative bottom-up analysis.

Because Schwab's hedged equity mutual fund invests in large-cap stocks, it will diverge from the TFS Market Neutral mutual fund, according to Alpert.

"The TFS Market Neutral fund has stable performance over time, although it has had some down years too. It's more quantitatively driven than the Schwab hedged equity mutual fund," says Alpert. "TFS uses nine quantitative models and maintains a dollar long for 67 short. They stayed in the more smaller cap names where there's more opportunity."

TFS market neutral mutual fund remains deliberately diversified. "We are not picking any single stock or security position so they will not have any significant impact on the fund," says Gates. 

According to Morningstar, the top four market neutral hedge mutual funds year to date are Vanguard Market Neutral I at 7.11%, Eaton Vance Parametric at 5.66%, Alliance Bernstein Market Neutral at 4.44% and American Century Equity Market Neutral at 4.15%.

Other market-neutral funds include Montgomery U.S. Market Neutral, Value Line Hedged Opportunity and Zweig Euclid Market Neutral.

"Not so many mutual funds are shorting at the same time that they own a long position in other stocks. The long-short captures that hedge strategy," says Tjornehoj. "Market neutral funds tend to strike a balance between long and short and maintain that throughout a market cycle. Instead of being overly long or short, they tend to keep a mix that is steady."