Maybe plain-vanilla stock and bond mutual funds will do the job after all.
Long-short funds -- the newfangled mutual funds designed to give common investors a hedge fund experience and protection during downturns -- recently went through one of their first major tests. And they flopped.
In July and August, with investors concerned over subprime loans and a credit squeeze, the benchmark Standard & Poor's 500 stock index went down 9.4 percent. Long-short mutual funds -- which are designed to hedge risk by betting on some stocks to rise and others to fall -- went down 8.4 percent, according to Lipper Inc., a mutual fund tracking firm.
You would have thought long-short funds would come to the rescue of investors. That's why investors buy them.
But the funds dropped, along with their peers in the hedge fund arena -- where only the rich and institutions such as pension plans are allowed admission.
"We've seen a lot of investor interest in these funds, but they are by no means a magic formula," said Morningstar analyst Marta Norton.
Hedge funds and mutual funds that act like hedge funds were rolled out in large numbers during the last few years -- a reaction to the 49 percent downturn in the S&P 500 index between 2000 and 2002. Investors wanted protection from such severe conditions. They also were worried about making better returns when market forecasters were predicting stocks would climb just 7 or 8 percent a year for the foreseeable future.
The long-short fund was supposed to be an alternative that investors could drop into a typical portfolio of stock funds and bonds. Instead of simply buying stocks and holding on to them as they drop, long-short funds buy two varieties of stock -- those the fund manager thinks will climb, and those the manager thinks are positioned to drop.
When the manager thinks he's spotted a winner, he goes "long," or buys a stock with the intention of making money as the price goes up.
When the manager thinks a stock will be a loser, he "shorts" it. With that strategy, the manager borrows shares of a stock and sells them. Eventually he will have to buy the shares to replace those he borrowed. But if he's right and the stock price falls he will be able to buy shares at a lower price and make money.
The beauty of the strategy -- if it works -- is that the fund can make money even when the stock market is in a downturn.
But finding the right stocks to short, and the right timing, isn't easy. The funds showed that when they fell between July 19 and Aug. 15, during the broader market's downturn.
Of course, one period can be an anomaly, but analysts and financial planners have their doubts now.
"I'm unconvinced that most investors need a long-short fund, and I'm even less convinced that most of the new long-short funds are a good value proposition," Morningstar analyst Christine Benz said in a recent report.
The flows of money in and out of the funds suggest investors are thinking the same way. In mid-July, when the market peaked before heading down, investors poured $527 million into long-short funds, but "when the funds did very badly, there was a huge burst of outflows," said Bob Adler of AMG Data Services.
In August investors pulled $776 million out of the funds, and in September another $105 million, he said.
It was the first time since December 2005 that investors withdrew money from the funds. They have about $20.3 billion in assets, and the flows have stabilized in October, Adler said.
Financial planners such as Ray Benton of Denver are examining now whether they can count on long-short funds. "I am more reticent now," he said. "Rather than diversifying a portfolio they all went down together."
Instead of the new funds helping, "It was the old-fashioned way that carried people through this; it was having bonds," Benton said.
Typically, investors are told to hold some bonds in portfolios to buffer downturns in the stock market. A classic, or moderate, mixture generally puts 60 percent of an investor's money into large-cap, small-cap and international stocks, and 40 percent into bonds.
An investor who would have followed that model with what's called an "asset allocation" fund would have lost only 5.8 percent during the July/August downturn, according to Lipper.
Since the Federal Reserve lowered interest rates the stock market has bounced back. For the year the moderate mixture is up 7.8 percent, S&P 500 index funds are up about 10 percent, and long-short funds are up 8.3 percent.
Another type of fund aimed at hedging against downturns -- market-neutral funds -- is up 3.5 percent for the year, after declining 3.6 percent during the downturn. Market-neutral funds tend to go half long and half short with their portfolio.
Morningstar analyst Norton said the long-short and market-neutral funds struggled in the downturn because many stocks that declined were not fundamentally weak investments. Hedge funds, worried about investors panicking and pulling money from funds affected by subprime mortgage-related bonds, sold some of their best stocks in order to have cash on hand to pay investors wanting to get out.
A single downturn does not clearly illustrate how a type of mutual fund will perform in the future but Norton said long-short and market-neutral funds take on a lot more risk than investors understand.
Although the idea of shorting stocks during a downturn is attractive, Norton noted that fund managers won't perform well unless they pick the right stocks to short.
"It comes down to expertise, and lots of managers aren't impressive," she said.
One long-short fund that did well in July and August was Hussman Strategic Growth Fund, she said. Although the subprime mess took many fund managers by surprise, she noted that the Hussman fund had noted serious concerns about the economy and stock market in early July and had "hedged away all the risk using options."
It climbed 2.28 percent between July 19 and Aug. 15 and is up 3.4 percent for the year.
Gail MarksJarvis is a Your Money columnist. Contact her email@example.com.