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Mutual Funds That Thrive When Stocks Sink

NEW YORK (TheStreet) -- Managed futures mutual funds emerged as one of the stars of the financial crisis. While the S&P 500 lost 37% in 2008, managed futures funds gained 8.3%.

The strong showing attracted attention. Seeking protection, shell-shocked investors poured into managed futures and other mutual funds that are considered alternative investments. The category includes a variety of strategies that do not necessarily move in lockstep with stocks or bonds. Common approaches involve holding precious metals or selling securities short, betting that they will decline.

At a time when many investors remain wary of stocks, alternative funds have ranked as the fastest-growing category tracked by Morningstar. Assets have increased from $62 billion at the end of 2008 to $179 billion now. But most alternative funds have proved disappointing. While the S&P 500 returned 19.9% annually during the past five years, managed futures lost 4.6%.

Morningstar analyst Adam Zoll says that most alternative funds have failed in their primary mission of providing diversification. To determine which investments can diversify stock portfolios, Zoll measured the correlation of different assets and the S&P 500. If an asset moves in lockstep with the index, then it is said to have a correlation of 1.0. If the asset moves in the completely opposite direction of the index, then it has a correlation of -1.0.

To provide diversification, an investment must have a low or negative correlation with stocks. The investment-grade bonds of the Barclays Capital Aggregate U.S. Index can provide diversification because they have a correlation of 0. Many alternative funds record high correlations. With a correlation of 0.95, long/short funds may provide little cushioning when stocks sink.

Should you avoid alternative funds altogether? Not necessarily. But you need to shop carefully.

Many funds are hard to understand and charge steep expense ratios. Only a few alternative funds have provided diversification and solid returns. Top choices include MainStay Marketfield (MFLDX) and Wasatch Long/Short (FMLSX). During the past five years, both funds delivered double-digit annual returns while being much less volatile than the S&P 500.

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