Everyman Hedge Funds for Bear Markets

At a time when hedge funds have suffered setbacks, should you give the new mutual funds a look? Perhaps. To appreciate why, consider what happened to hedge funds last year. During 2008, the average hedge fund lost 22%, according to Hennessee Group. The losers included funds that sold short and used other strategies that should excel in downturns.

While that was a dismal showing, hedge funds outdid the S&P 500, which lost 39%. And many hedge funds did substantially better than the Hennessee average. According to Hennessee, categories that made money included merger arbitrage and health care. So investors could have trimmed their losses by adding a diversified basket of hedge funds to stock portfolios.

After witnessing the market turmoil, some investors may be inclined to dump hedge funds and shift to bonds, which outperformed last year. But there is no guarantee that bonds will outdo hedge funds in future downturns. Suppose interest rates and inflation rise sharply, as some economists now expect. If that happens, bond prices could fall, and stocks would face headwinds. "To prepare for future downturns, it makes sense to use some alternative strategies that can diversify portfolios," says Sanjay Yodh, managing director of alternative strategies for Security Global Investors, an investment adviser.

Those who decide to use a fund that hedges should recognize that most aren't cheap. Hedge funds typically charge 2% of assets as an annual fee, plus 20% of the profits. Mutual funds are less costly, but they still charge plenty because short selling and other strategies are expensive to execute. The average long-short mutual fund charges an expense ratio of 2.08%, according to Morningstar(MORN Quote).