Mutual funds that use sophisticated strategies to control stock-market risk are coming out from behind their hedges.

Long-short funds, which attempt to profit whether stock prices are rising or falling, were recognized as a distinct category of funds by investment researcher Morningstar Inc. on March 1. A list of about 30 funds is now available.

And fund tracker Lipper Inc. plans to roll out separate groupings in mid-April for long-short funds and their cousins, market-neutral funds, which aim to insulate investors from wide stock-price swings. Morningstar includes market-neutral funds in its long-short category.

Institutions and hedge funds routinely use both long-short and market-neutral tactics for capital appreciation and capital preservation. But these professional tools are increasingly geared to retail investors and financial advisers for whom the 2000-2002 bear market is still a painful memory. Large fund companies such as Janus Capital Group Inc. (JNS) , American Century Investments and Franklin Resources Inc. (BEN) , for example, manage such funds or intend to offer them.

In a long-short fund, "long" refers to stocks owned outright, while "short" refers to short-selling stocks that an investor believes will tumble. Short sellers borrow shares and sell them to other investors, hoping to buy back the shares later at lower prices.

The strategy gives a manager flexibility to be bullish in one market sector and bearish in another. Long-short funds typically hold mostly long positions and tweak the portfolio's percentage of short candidates depending on market conditions. These funds are making a directional bet, and — if a manager's stock selection is on target — can do well in both market rallies and corrections.

Market-neutral funds, by contrast, generally hold nearly equal amounts of long and short positions — hence the "neutral" label. A manager looks to keep the portfolio on par with a stock-market benchmark, typically the Standard & Poor's 500 Index (SPX) , and tries to capture excess return through stock selection. While returns tend to lag in bull markets, market-neutral funds can shine when stock prices are falling.

Investment considerations

Long-short funds and market neutral funds aren't magic investment bullets. Short-selling is a challenging strategy, so experience counts with these hedge-like funds. "It's really about stock picking," said Dan McNeela, Morningstar's associate director of fund analysis.

In addition, many of these offerings carry higher management fees than traditional stock funds and have delivered lackluster results. Yet several funds stand apart in both performance and low expenses. McNeela points to Diamond Hill Focus Long-Short Fund (DIAMX) and Calamos Market Neutral Income Fund (CVSIX) as models for their respective strategies. The Diamond Hill managers have "proven themselves," McNeela noted, while the Calamos team "has a long track record of success."

Long-short and market-neutral funds are most often used to diversify a portfolio. "Shorting stocks has proven to be a pretty tough strategy to follow and make money at," McNeela said. "The real value is that these funds do something different than the rest of your portfolio.

Stock investors would have been grateful for that diversification in 2002, when the S&P 500 tumbled 22%. That year, for example, the adroit Hussman Strategic Growth Fund (HSGFX) gained 14%, while the Calamos market neutral fund gained almost 7%, according to Morningstar.

But true to form, many funds in Morningstar's long-short category have trailed the S&P 500 in the past three years as U.S. stocks recovered.

"By their nature and design, these funds don't necessarily keep up as well as long-only funds," said Christopher Dalto, a financial adviser with Delessert Financial Services in Waltham, Mass. "In an ideal scenario, you get consistent growth with a smoother ride than a long-only fund."

A sampling of noteworthy long-short and market-neutral funds:

Source: Morningstar Inc. (Data as of 3/3/06)

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