As the stock market continues to make mincemeat out of buy-and-hold investors, hedge funds continue to garner more and more ado. Quite a mystique has developed around these private investment partnerships constructed for ultrawealthy investors and operated by brainiac managers who claim to be able to turn profits in any market environment.

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Unfortunately, their high minimum investment requirements make hedge funds untouchable for those who don't sport seven- or eight-figure portfolios. For those who can't afford to part with that much cash, or who aren't comfortable with the multiyear lockups these funds typically require, there are now a growing number of market-neutral mutual funds to choose from.

Mutual Hedgers

Until a few years ago, mutual fund managers who wanted to protect shareholders against falling stock prices were limited in what they could do. But a six-decade-old restriction known as the "short-short" rule, which had barred mutual funds from generating more than 30% of their gross income from gains held less than three months or from short sales, was put to pasture via the Taxpayer Relief Act of 1997.

While the newly deregulated market-neutral mutual funds provide many of the directional benefits of hedge funds, it still pays to sort the wheat from the chaff.

I'm especially enamored of the

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Leuthold Core Investment Fund, which boasts a beta -- a measurement of a fund's correlation to movements of the stock market -- of nearly zero. This means that the return of the fund is much more dependent on manager skill (or alpha) than on the general direction of the equity markets.

Manager Steve Leuthold's diversification methodology, which includes holding bonds and foreign equities and making short sales, has generated impressive returns since the fund's inception. The fund boasts a five-year average annual return of 11.3%, which is about 2 percentage points higher than the

S&P 500

index. But what makes this fund so unique is the risk taken to achieve this performance: With a standard deviation (a measure of variability in returns) of less than 10%, compared with about 18% for the S&P 500, Leuthold Core Investment has one of the most attractive risk-reward ratios in the mutual fund universe.

Bond Action

The

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Calamos Market Neutral Fund executes a strategy of buying convertible bonds (fixed-income securities that can be converted into shares of the company's stock) and short-selling the underlying equity to hedge out market risk. This methodology has produced a return of close to 10% per annum with less risk than a 10-year Treasury note. The fund has had only one small hiccup -- a small loss in 1994, which was caused by a lack of volatility in the stock market.

As has been reported numerous times on this site, market volatility has declined precipitously since last fall, and this has lowered the returns of most convertible arbitrage managers. An interesting counter to this low-volatility dilemma is the

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Pioneer High Yield fund. This fund specializes in "busted" convertible bonds (i.e., those whose company's stock price has fallen so precipitously that the chances of triggering its conversion into stock are remote). Because busted issues are especially credit-sensitive, they tend to rise in value when market volatility drops. As a result, they make an interesting combination with more traditional convertible arbitrage strategies. The fund has generated annualized returns of more than 13% since its inception in early 1998.

Different Bets

Although the funds mentioned above are quite similar, their underlying strategies differ dramatically. The Calamos fund is a bet on convertible arbitrage, while Pioneer is a wager on the continued buoyancy in the high-yield debt market.

Leuthold's fund, however, is a pure bet on manager Steve Leuthold's ability to make hay in a sideways market. In my opinion, he's up to the task, and if I had to pick one of these three funds, it would be his.

Ben Warwick is the chief investment officer of Sovereign Wealth Management, an investment firm that specializes in high net worth wealthy families and institutions. He is the author of five books, including

Searching for Alpha: The Quest for Exceptional Investment Performance

, and is a hedge fund industry consultant. At the time of publication, Warwick and Sovereign Wealth had no positions in securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback and invites you to send it to

Ben Warwick.

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