How to Hedge Your Portfolio

What a difference a crash can make. After labeling hedge funds as risky for years, fund companies now think their tactics are the answer for smaller investors. It’s easy to see why. Last year, hedge funds were down an average of only 20 percent—bad, but nowhere near as bad as the 37 percent loss for the average stock fund.

Already, the hedge fund look-alikes, often called alternative or tactical-allocation funds, make up 5 percent of the 346 funds launched in the past year, according to Morningstar. Their names and strategies can be confusing, but the basic idea is simple: By mimicking the flexibility enjoyed by hedge funds, mutual funds are giving themselves “an expanded tool kit” to deal with the ups and downs of the market, says Karen Dolan, Morningstar’s director of mutual fund analysis.

Their approaches run the gamut. They sell stocks short to profit when stock prices fall, borrow money to increase the capital they have to invest and try to time the market. Turner Investment Partners’ new Spectrum fund attempts to limit volatility with six “long-short” strategies the firm has been using for its partners’ money. The more-aggressive Legg Mason Partners Permal Tactical Allocation fund (LPTAX) goes in the other direction, trying to take advantage of market volatility by switching between global asset classes. Yet another approach comes from hedge fund heavyweight Cliff Asness, whose firm AQR Capital Management launched its Diversified Arbitrage mutual fund (ADANX) to profit from the price swings associated with mergers.

How useful are the new funds? Financial planner Harold Evensky says he’s been looking at the Diversified Arbitrage fund to add diversification to clients’ portfolios. Others are more skeptical. While hedge funds typically limit withdrawals, these new mutual funds don’t carry such restrictions, which could dampen performance, says Jeff Ivory, partner at wealth-management firm Stonebridge Financial Partners. And though less expensive than hedge funds, the new funds are not exactly cheap. Permal’s new fund has a 5.75 percent sales charge and a 1.75 percent expense ratio — so an investor starting with $10,000 would pay a $575 sales charge and $175 in fees in the first year alone.

Some question whether the spate of alternative offerings is just the latest industry pitch to bolster assets. The Mutual Fund Store’s Adam Bold suggests using precious metals or energy stocks to diversify and good old cash to reduce volatility.