Play stocks like a hedge fund

By Tim Middleton

Steve Leuthold, who runs a private hedge fund as well as a public mutual fund, Leuthold Core Investment (LCORX), is so bullish on stocks that, he says, "I don't have a single short position right now."

Shorting, or borrowing stock and selling it in the expectation it will soon decline and can be bought back more cheaply, is what hedging is -- a bet that stocks will fall rather than rise. Leuthold is running without a hedge, though, because he foresees the stock market rising around 7% in the early months of this new year.

But then, he says, watch out. "You're getting late in the cycle," he explains. The economy, already cooling, is likely to slip into recession in 2008. The market usually goes down six to 12 months before the economy does. By the end of 2007, therefore, "I think we're going to be down 7% or so" from where we are now, he says.

After nearly four years of heady growth, which has taken the S&P 500 Index ($INX) up 70%, we investors have plenty of profits we need to protect. A hedge fund is the ideal place to put them, but few of us can meet the hedging world's million-dollar minimums.

Instead, we can turn to long/short mutual funds. These are portfolios that own some stocks and sell others short. Morningstar numbers about 40 of them in its database, of which about a half-dozen have good performance records. Sometime this year, and probably within a few months, I intend to put up to 10% of my equity assets into one of them.

Ratcheting down risk

Long/short funds are not the only way to hedge a financial portfolio. All-short portfolios and other bear-market funds are candidates. So are two traditional redoubts from stocks and bonds -- gold and commercial real estate.

But bear market funds hemorrhage cash the two-thirds of the time that markets go up. Gold and property stocks are at or near financial peaks -- they bring risk to the equation rather than taking it away.

Top long/short funds, past three years	Performance	Standard deviation	Beta
Diamond Hill Long-Short A (DIAMX)	18.4	8.17	0.49
Schwab Hedged Equity Select (SWHEX)	13	6	0.53
Robeco Boston Partners Long-Short* (BPLSX)	13.4	6.76	-0.13
Alpha Hedged Strategies (ALPHX)	9.6	5.6	0.41
Notes: As of 12/22/2006. S&P 500 represented by Vanguard 500 Index (VFINX). Fund performances since October-December 2003; exact reporting period varies with the fund. Standard deviation and beta are measures of volatility. *Closed to new investors.

Hedging is all about managing risk. The usual measure of financial risk is standard deviation, or price variability. But when it comes to hedging stocks, a more useful measure is beta, or correlation with the stock market. The market itself has a beta of 1.0, or 100%. Most long-short funds have a beta around 0.50.

You could achieve a beta in that range by creating a portfolio that is 50% stocks and 50% cash. The problem is, that portfolio's potential for gains is only one-half the market rate. Long/short funds generally aim to provide more upside potential, and lately they have certainly delivered it: In the last three years, several of them have easily topped the market's 10.7% annualized gain.

These funds are able to outperform their beta because they invest as much as 100% of their assets in stock ownership -- long positions -- and then lard on the short. Rather than subtracting from assets, these add to them: The shorted stocks are sold, producing cash. So a long/short fund typically controls holdings equal to about 150% of its assets, two-thirds in long positions and one-third in shorts.

Exactly what they hold is hard to discover, particularly those short positions. Companies whose stocks are being shorted are prone to sue their detractors, and for competitive reasons managers don't want their rivals to know what they're up to.

Schwab Hedged Equity is slightly transparent in that it chooses both long and short positions from the company's proprietary stock-ranking system, which rates virtually every stock with a market capitalization of $1 billion or more.

The fund goes long stocks ranked A or B, and chooses its shorts from among those rated D and F. (You have to be a Schwab customer to gain access to the rankings.) Recently, Chevron (CVX, news, msgs) was upgraded to a B based on fundamental factors like improved cash flows and market factors like a strengthening stock price.

ConocoPhillips (COP, news, msgs), another oil company, was downgraded to a D, based on factors like poor fundamentals and a weakening market price.

Vivienne Hsu, co-manager of the Schwab fund, says its picks tend to be contrarian, shorting what others find popular and buying laggards. "People tend to be on the wrong side of the market, chasing past performance," she says. She notes mutual funds were flooded with assets last spring, after an ebullient first quarter, just in time to take a skinning in the second period's downdraft.

An expensive bargain

Mutual funds will likely be flooded with cash this quarter, too, after last year's surprisingly strong rally. If Leuthold is right, investors face another skinning later this year, ahead of a recession he is hardly alone in predicting. (My colleague Bill Fleckenstein has been beating this drum hard.)

If Leuthold is right, by the way, investors in another of his mutual funds, Grizzly Short (GRZZX), will finally enjoy some profits. This short-only portfolio has lost money for four consecutive years.

That's the problem with bear-market funds, and that's why I find the long/short idea more appealing. Long/short funds have provided real gains as well as portfolio insurance throughout this period.

Diamond Hill Long-Short A, which unlike the younger Schwab fund was around when the stock market crashed in 2001 and 2002, delivered positive returns in the former year of 6.1% and lost only half as much as the S&P 500, 10.4%, in the latter.

One rap on long/short funds is their high costs. In addition to a front-end load, Diamond Hill charges 1.78% in annual expenses, about a quarter-point more than the typical all-long fund. Schwab, a no-load fund, charges 1.92%. (A companion fund with a lower minimum investment charges 2.05%.)

That's the price of long/short insurance -- but it could be worse. Leuthold's hedge fund charges much more, 12% of profits, and most hedge funds charge 20%. So mutual fund expenses are a relative bargain, even if they are relatively high.

And these two funds in particular have delivered double-digit gains after expenses. (So has Robeco Boston Partners Long-Short I, but it is closed to new investors.) I will need some gains if the market itself delivers losses.

At the time of publication, Tim Middleton didn't own any securities mentioned in this article.