Best-Rated Stock Funds Neutralize Risk

Eight of the 10 best-rated stock mutual funds inoculated themselves from the stock-market pandemic. They survived by neutralizing some market risk with long and short positions.

After excluding inverse and balanced funds, the most highly rated stock mutual fund is the Arbitrage Fund(ARBFX Quote). It averaged an annual return of 4.07% over the three years ending Dec. 31 and earned a rating of A+.

As the fund's name implies, its managers seek acquisition target companies that sell for a discount to their announced sale price. A company buying another generally offers to pay more than the prevailing market price.

In the best-case scenario, if the sale is completed, the position can be liquidated for a profit. Or, in a typical merger-arbitrage transaction where the acquiring company offers stock instead of cash, the fund can buy the target company and simultaneously sell short an equivalent amount of the acquiring company. The difference between the amount paid for the target company's stock and the credit from the short sale is the gain for the trade before commissions, margin interest or other expenses. Once the trade is in place, the stock prices of the two companies tend to move in tandem, making the trade neutral to the overall market. If the acquiring company is forced to raise its offer, the transaction does even better.

When a proposed merger fails to happen, the arbitrage strategy can lose money. The Arbitrage Fund uses stock options and short selling to minimize market risk and volatility.

Also rated A+, the JPMorgan Market Neutral Fund(JMNAX Quote) has averaged a 4.25% return over the past three years. Not only does the fund balance its portfolio of undervalued long positions with overvalued short sales to neutralize market risk, the managers also attempt to balance long and short weightings within each sector. At year-end, the fund was 11.7% long and 13.3% short health-care stocks, as well as 18.6% long and 21.5% short information-technology shares.