Mutual Funds That Hedge Aren't Hedge Funds

NEW YORK (TheStreet) -- Many companies have been introducing mutual funds that sell short and use other techniques pioneered by hedge funds. If you own a hedge fund, should you dump it and switch to the new mutual funds?

Probably not. On average, hedge funds have been outpacing the competing mutual funds. From the beginning of 2003 through the end of June this year, the Morningstar(MORN)1000 Hedge Fund Index returned 7.8% annually, compared with 5.5% for long-short mutual funds, and 4.2% for the S&P 500.

Of course, hedge funds and mutual funds are very different vehicles. Hedge funds are aimed at wealthy individuals and institutions with millions to invest, while mutual funds are designed for the average joe. But these days, it is worth comparing hedge and mutual funds because the distinctions between the two are blurring. Some hedge funds are aiming to attract minimum investments of $100,000. Many of the new long-short mutual funds are being sold to institutions.

One of the most important differences between hedge and mutual funds is the amount of risk they can take. Hedge funds have outperformed partly because they take more risk, says Nadia Papagiannis, a Morningstar analyst who follows alternative investments.

Under federal rules, mutual funds can only use a limited amount of short selling and leverage. Hedge funds are largely free to do whatever they want. As a result, many hedge funds borrow heavily. The leverage magnifies returns -- and increases risk. "Hedge funds gain more in up markets -- and they lose more in down markets," Papagiannis says.

During the market collapse of 2008, the hedge funds tracked by Morningstar lost 22%, lagging long-short mutual funds, which lost only 15%. But when the markets rebounded last year, hedge funds led the way, returning 20% for the year compared with a gain of 11% for long-short funds. Both hedge funds and mutual funds are less volatile than the S&P 500, which dropped 37% in 2008 and gained 27% last year.

Besides using leverage, hedge funds also increase returns -- and risk levels -- by investing in illiquid securities. These include private equity, which doesn't trade on public exchanges, and bonds that rarely trade. Because the securities are difficult to buy and sell, many investors shy away from them. That depresses prices and gives hedge funds opportunities to obtain outsized returns. Mutual funds are prohibited from buying illiquid securities.