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Mutual Funds That Avoid Stock-Market Routs

Mutual funds that have little correlation with the broader stock market can be the best protection.

NEW YORK (TheStreet) -- The credit crisis dragged down not only stocks but also corporate bonds, precious metals and real estate. Government debt, a haven for the most conservative investors, was spared.

Investors were shocked to see that their diversification plans failed to provide protection. The downturn revealed a difficult reality: Under extreme conditions, most investments move in the same direction.

But there were a few mutual funds that proved resilient. Those investments aren't correlated with stocks or bonds. When the

stock market

sinks again, you can bet that uncorrelated funds won't move in lockstep with other investments. As the stock-market rally picks up steam, it may be worth considering such funds before prices get out of control.

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Still, the resilient funds don't make money every year. Some sell short or use other techniques that can lag behind during bull markets. Still, it could be worth putting a small portion of assets into such mutual funds.

One of the heroes of the downturn was

Rydex/SGI Managed Futures Strategy

(RYMTX) - Get Guggenheim Mgd Futures Strat A Report

. While the

S&P 500 Index

lost 37% of its value during 2008, Rydex/SGI made 8.5% for the year. The gain is particularly noteworthy because the mutual fund invests in commodities, which recorded huge losses. Rydex/SGI stayed in the black because it sometimes takes short positions, betting that prices will fall.

The mutual fund tracks the S&P Diversified Trend Indicator, a benchmark that follows 14 kinds of commodities, including livestock, industrial metals and currencies. To calculate the benchmark, S&P checks the spot price of each commodity once a month. If the price is above the average of recent months, the indicator takes a long position in the futures of the commodity. If the spot price is below the average, S&P goes short.

Commodity trend following has long been used by hedge funds. The strategy is based on the idea that once a commodity begins moving down or up, it tends to stay in that pattern for some time.

Since S&P began operating the index in 2004, the benchmark has mostly delivered annual returns in the high single digits or low double digits. But the approach works best when there are sharp moves. That happened in 2008 when there were big up-and-down shifts in currencies, gold and oil. In 2009, there were no consistent trends, and the benchmark recorded a loss.

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The Rydex/SGI fund tends to have low volatility, says Sanjay Yodh, managing director of Security Global Investors. This occurs because the different commodities rarely move in unison. "Coffee may be going up when sugar is going down," Yodh says.

Other funds that stayed in the black throughout the downturn included currency investments. With the Swiss currency remaining strong throughout the crisis,

CurrencyShares Swiss Franc

(FXF) - Get Invesco CurrencyShares Swiss Franc Trust Report

returned 7.6% for 2008.

Franklin Templeton Hard Currency


returned 1.1% by owning currencies from commodity-rich countries, such as Australia and Canada.

Currency moves are notoriously hard to predict. But currencies have little correlation with stocks. And these days, some foreign currencies provide higher yields than what investors can get in the U.S.

Long-short mutual funds, which hold stocks and also short them, fared relatively well in the downturn. A few of the funds made money, including

DWS Disciplined Market Neutral


, which returned 7% for 2008.

One of the more intriguing long-short choices is

Caldwell & Orkin Market Opportunity

(COAGX) - Get Caldwell & Orkin Gator Capital L/S Report

. While the mutual fund lost 4.7% of its value during 2008, it boasts a steady long-term record. During the past decade, Caldwell returned 3.7% annually, about 3.5 percentage points ahead of the S&P 500. The fund has no correlation with the S&P 500.

Besides shorting stocks, fund manager Michael Orkin sometimes limits risk by holding fixed-income securities. That helps the mutual fund perform well in downturns. In 2008, Orkin protected shareholders by shorting financials and holding a big cash position. By adding Caldwell & Orkin to a conventional stock portfolio, investors can be assured of obtaining some diversification when it's needed most.

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