Today we take a look at mutual funds that are not structured like typical mutual funds, that is, funds that don’t invest exclusively in stocks and bonds. These can be powerful additions to the risk management of our investment portfolio.

As the SEC has loosened the rules on mutual funds shorting stock and investing in options, a small group of funds has emerged that share many of the characteristics of hedge funds. These can be purchased like any other mutual fund, unlike hedge funds, which are only available to accredited investors (e.g. those with a net worth of more than one million dollars).

Appropriate use of these mutual funds can be quite effective in providing both diversification and hedging of your investment portfolio. According to the Securities and Exchange Commission, there are several types of hedge funds. However, one of the more conservative strategies is the Long/Short fund.

Long / Short Funds:

Long/Short which includes sector and market neutral/relative value funds. These funds try to exploit perceived anomalies in the prices of securities. For example, a hedge fund may buy bonds that it believes to be under priced and sell short bonds that it believes to be overpriced. No matter what happens to overall interest rates, as long as the spread between the two narrows, the fund profits. Conversely, if spreads widen, gains can turn quickly into losses. Long/short equity is the most frequently used strategy among hedge funds.

Arbitrage Funds:

Another of the lower risk strategies is Risk/Merger Arbitrage. These funds attempt to profit from pending merger transactions by, for example, taking a long position in the stock of the company to be acquired in a merger, leverage buyout or takeover and simultaneously taking a short position in the stock of the acquiring company.

Since these approaches to hedging are fairly conservative, they are ones that would be most appropriate in managing portfolio risk. Since most of these have a low correlation to the overall market some investment advisors even recommend using these mutual funds as alternatives to bond funds in your portfolio.

As these types of funds have become more common over the last few years, Morningstar has even added a category called Long/Short to its listing of mutual funds. Morningstar has arbitrage funds fall into that same category.

There are many new entrants into this field. While there may be several of the newer funds that are excellent offerings, the most straightforward way to judge the risk management performance of these funds is to look at their history during at least some part of the most recent bear market (2000 2002).

Some example mutual funds that fared reasonably well in the last bear market include:

Merger Fund (MERFX):

This fund has been around for over 10 years. The basic approach is to capture the spread between the share price of companies that might be acquired and the proposed purchase price. This is done by buying the shares of the target firms of deals and occasionally shorting the stocks of the acquiring firm. This fund did fairly well during the bear market, although it had only fair performance in 2005.