Market-Neutral Funds Get Highest Ratings

Stock funds that go both long and short reduce risk, which helped in the equity market's slide.
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Eight of the 10 best-rated stock mutual funds employ variations on market-neutral strategies, which tend to work better in bear markets.

One balances stocks with currencies and gold, and the other went into cash as the manager waits for the market to bottom before jumping back into domestic growth stocks. All of the funds earned a rating of A-plus for the period ending Feb. 27.

The best-rated stock mutual fund last month, when the benchmark

S&P 500

index fell more than 100 points to about 700, was the

JPMorgan Market Neutral Fund

(JMNAX) - Get Report

, averaging a return of 5.4% over the past three years. Market-neutral funds can use long and short positions on stocks to balance overall market risk. This fund looks for mid- and large-capitalization stocks considered to be overvalued for short sales and balanced against undervalued stocks to buy within the same sector.

Favored long positions, which make money for the fund's shareholders as they rise, include

Abbott Laboratories

(ABT) - Get Report

,

Verizon Communications

(VZ) - Get Report

and

Qualcomm

(QCOM) - Get Report

. Some of the largest short positions from which the JPMorgan Market Neutral Fund hopes to gain as their share prices sink include

Texas Instruments

(TXN) - Get Report

,

Johnson & Johnson

(JNJ) - Get Report

and

Intel

(INTC) - Get Report

.

The second-best-rated fund was the

Arbitrage Fund

(ARBFX) - Get Report

, which posted an average annual return of 4.18% over three years by placing merger-arbitrage bets on publicly announced takeovers, leveraged buyouts, tender offers and other reorganizations.

The fund's manager seeks acquisition target companies that sell for a discount to their announced sale price. When one company proposes to buy another they generally offer 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. When the acquiring company is offering stock instead of cash, the acquiring company can be sold short simultaneously with buying the target in an arbitrage transaction to immediately pocket the difference.

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.

The most highly rated stock fund that doesn't follow a market-neutral strategy is the

Permanent Portfolio

(PRPFX) - Get Report

. The fund uses categorical diversification in gold, silver and Swiss franc assets to balance equity risk from real estate, natural resources and aggressive growth stocks.

Finally, the

Shepherd Large Cap Growth Fund

(DOIGX)

liquidated all its stock holdings and held cash as of mid-September, smartly missing out on this bear market.

For more information, check out an

explanation of our ratings

.

Kevin Baker became the senior financial analyst for TSC Ratings upon the August 2006 acquisition of Weiss Ratings by TheStreet.com, covering mutual funds. He joined the Weiss Group in 1997 as a banking and brokerage analyst. In 1999, he created the Weiss Group's first ratings to gauge the level of risk in U.S. equities. Baker received a B.S. degree in management from Rensselaer Polytechnic Institute and an M.B.A. with a finance specialization from Nova Southeastern University.