NEW YORK (TheStreet) -- Last year investors had little reason to applaud the performance of hedge funds or alternative mutual funds. During 2011, the Morningstar MSCI Composite Hedge Fund Index dropped 2.7%, a bad showing in a year when the S&P 500 gained 2.1%. Alternative mutual funds, which use strategies employed by hedge funds, also declined. Morningstar's long/short category lost 2.8%, while market-neutral funds lost 0.3%.

The results were especially disappointing because hedge funds sell short and use other techniques that are designed to excel in the kind of difficult markets that prevailed last year. Hedge fund managers offered a variety of explanations for the poor showing. Weak markets in Europe and the emerging markets hurt funds that invest abroad. Managers in the U.S. and overseas had trouble distinguishing themselves because stocks of all kinds rose and fell together. In addition, commodities funds suffered because markets were choppy and indecisive. That made it hard for traders who do best when trends move in clear directions.





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While the markets undoubtedly were difficult, some alternative mutual funds rose above the crowd and delivered decent returns in 2011. Among the best performers were

American Century Equity Market Neutral

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Can the top funds continue their competitive showing? Probably. In recent years, the best funds have achieved their goals, diversifying portfolios in downturns while delivering positive results in good times. But investors should not expect miracles. The top funds typically deliver single-digit long-term returns. In other words, the alternative funds will not make you rich -- but they could help you to avoid becoming poor.


A steady performer is Gateway, a long-short fund that returned 3% in 2011. Gateway returned 4.9% annually during the last 15 years, outdoing 66% of competitors. Over that period, Gateway lagged the S&P 500 by a bit, but the fund's real achievement was that it provided significant diversification. A low-volatility portfolio, the long-short fund excels in bear markets. In the downturn of 2002, Gateway outdid the S&P 500 by 17 percentage points. During the collapse of 2008, the fund surpassed the benchmark by 23 percentage points.

If Gateway only delivers single-digit returns, why not buy a bond fund instead? The reason to consider Gateway is that it can provide diversification that bonds don't offer. When interest rates rise, bond prices fall. But Gateway is not tied to the bond market. "We tend to have good performance when the bond markets are having difficult times," says Gateway portfolio manager Mike Buckius.

To deliver its unusual returns, the fund starts by buying a portfolio of about 250 stocks that closely tracks the S&P 500. Then the portfolio managers sell index call options and collect premiums from investors. Investors buy the options because they offer a leveraged way to bet that the S&P 500 will rise. Some years Gateway collects premium income that amounts to more than 10% of the value of the fund's portfolio. If the market falls, Gateway's stocks also decline. But the loss is reduced by the amount of income that the fund gets from selling the option premiums. If the market rises, Gateway's stocks climb, but the gain is reduced because the fund must make payments to option investors who bet correctly that the market would rise.


Marketfield Fund uses a free-ranging approach. Portfolio manager Michael Aronstein can sell short or shift to bonds when he can't find stocks to own. Big short positions helped the fund outdo the S&P 500 by 24 percentage points in 2008. In 2009, the fund put most of its assets in long positions and gained 31%, outdoing the S&P 500 and 92% of long/short competitors.

Timely shifts enabled the fund to return 3.7% in 2011. Short positions helped the fund record gains when stocks sank during the summer and fall. Among the best moves were short positions on emerging-markets ETFs. Aronstein began turning negative on the emerging markets when some central banks sought to cool economies by raising rates.

"We thought that the tightening by the banks would have a severe effect on the economies and their capital markets," he says.


American Century Equity Market Neutral holds an equal amount of long and short positions. The goal is to deliver decent returns whether the market is rising or falling. The strategy worked in 2011 when the fund returned 5.7%. The portfolio managers take long positions in undervalued stocks that show relatively strong earnings and share prices. The fund shorts stocks that lack the desired characteristics.

The American Century managers favor companies with solid balance sheets. That provided a boost in 2011 when high-quality companies outperformed. But the fund lagged most competitors in 2009, a year when shakier companies provided the best gains.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.