Uneasy Investors Buy Funds That Short Stocks

More investors are turning to mutual funds that sell short or use other techniques employed by hedge funds.
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NEW YORK (TheStreet) -- How can you cope with falling markets? More investors are turning to funds that sell short or use other techniques employed by hedge funds.

Top short-selling funds have demonstrated that they can limit losses in downturns and deliver steady returns in bull markets. During the past decade, long-short funds returned 3.6% annually, outpacing the S&P 500 by more than four percentage points, according to

Morningstar

(MORN) - Get Report

.

Perhaps the most important trait of long-short funds is that they can diversify portfolios. Many of the funds have little correlation with stock markets.

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Of course, bonds can diversify stock portfolios, and most investors prefer using fixed-income funds for safety instead of complicated short-selling strategies. But bonds come with significant risks. When interest rates rise, bond prices fall. If rates rise next year, as many economists expect, then bond fund investors could be disappointed. To avoid relying too heavily on bonds, investors should consider long-short and other hedge investments, which can rise during periods when stocks and bonds are falling.

Among the steadiest long-short performers is the

JPMorgan Research Market Neutral Fund

(JMNAX) - Get Report

, which returned 3.1% annually during the past decade. The goal of the fund is to churn out modest returns, outpacing Treasury bills by 2 percentage points annually.

Manager Terance Chen buys undervalued stocks and sells short names that appear rich. Chen puts about half his assets in long positions and half in shorts. He is currently long

Merck

(MRK) - Get Report

and short

Johnson & Johnson

(JNJ) - Get Report

.

The fund has shined during downturns. While the S&P 500 lost a total of 38% during the three years ending in 2002, JPMorgan Research gained 11% for the period. In 2008, the fund lost 1.1%, outpacing the S&P 500 by about 36 percentage points.

Another solid choice is the

Highland Long-Short Equity Fund

(HEOAX) - Get Report

, which lost 0.2% annually during the past three years, outdoing the S&P 500 by 9 percentage points. The fund lost 10% in 2008, outdoing the S&P by 27 percentage points. Highland returned 18% in 2009, lagging the S&P by 8 percentage points.

Manager Jonathan Lamensdorf says he is satisfied with the recent performance. "We want to capture 60% of the market's gains in up markets, and only suffer 30% of the market losses in downturns," he says.

Lamensdorf varies the percentage of assets that he puts into long positions. During the worst days of 2008, he had about half his assets in long positions and half in shorts. With markets more stable, he has two-thirds of assets in longs and one-third in shorts.

For his longs, he favors undervalued stocks that seem to have little downside because of their underlying assets. A favorite holding is

Crosstex Energy

(XTXI)

, a processor of natural gas. Faced with soft gas prices, the company reported losses and eliminated its dividend. But management has cut costs and paid down debt. Now Lamensdorf figures that the company will restore its dividend soon, a move that would boost the stock price. Highland's shorts include

Energizer Holdings

(ENR) - Get Report

and

Blackstone Group

(BX) - Get Report

.

Investors seeking to diversify portfolios should consider the

Gateway Fund

(GATEX) - Get Report

, which has returned 2.3% annually during the past ten years. The fund starts by assembling a stock portfolio that resembles the S&P 500. Then the managers sell S&P 500 index options.

Investors who buy options from Gateway are betting that the stocks will rise. Many buyers like options because they provide leverage. By paying a small amount of money, the investor can profit from rises in a large block of stock.

In typical years, investors give Gateway cash payments equal to about 20% of the value of the fund's stock portfolio. If stocks stay flat or decline, Gateway may be a big winner. The fund can pocket the cash premiums paid by investors. If stocks rise, Gateway still keeps the cash payments. But the fund must pay investors for the value of any stock appreciation. In effect, Gateway gives up any chance to benefit from market appreciation.

After obtaining the premiums from investors, Gateway takes part of the cash and buys puts on the S&P 500. These increase in value as the market declines. The puts serve as an insurance policy, reducing Gateway's losses in downturns.

However, the puts don't provide complete protection. In 2008, Gateway lost 14%. It was the fund's worst showing ever. Most often Gateway generates steady annual returns ranging from 5% to 10%. That kind of solid results can help investors build nest eggs.

--

Reported by Stan Luxenberg in New York

.

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