Funds That Tame Bull And Bear

Until recently, mutual-fund managers who wanted to protect shareholders against falling stock prices were limited in what they could do. A 61-year-old restriction known as the "short-short" rule barred mutual funds from generating more than 30% of their gross income from gains on stock held less than three months or from short sales, in which borrowed stock is sold with the hope it can be replaced with shares purchased at a lower price.

Then Congress passed the Taxpayer Relief Act of 1997, which did away with the short-short rule. The repeal permits money managers to respond quickly to changing market conditions by using short-selling strategies long practiced by hedge funds. For example, when IBM took over Lotus in 1995, Caldwell & Orkin Market Opportunity Fund had a huge short-term gain on its Lotus holdings. So portfolio strategist Michael Orkin had to sell other stocks he might have otherwise kept to stay within the limits of the short-short rule. "The removal of the rule will allow us to be more flexible, with lower administrative and cost burdens," Orkin says.

"LATITUDE." Outright bear funds such as Prudent Bear and contrarians such as Heartland Small Cap Contrarian and Crabbe Huson Special have also relied on short-term trading and short sales (table). These funds have seriously lagged the stock market during its bull run but have performed better during weak periods such as March and October last year. "We're not going to use the repeal of the rule to become a day trader," says Mason Cole, director of communications for Crabbe Huson funds. "But it might give us the latitude to capitalize on some positions earlier."

Besides removing a troublesome constraint for existing funds, the rule change has resulted in the advent of "market-neutral" mutual funds. Long popular among the hedge-fund crowd, market-neutral funds try to generate returns from stocks while eliminating the volatility of the overall market. How? They invest in stocks and offset that risk by putting an equivalent dollar amount into short sales of other stocks. If they successfully identify undervalued and overvalued stocks, in bull markets their longs should make more money than their shorts will lose. In down markets, gains on the shorts should offset losses on the longs.

Barr Rosenberg Mutual Funds introduced the first such fund, Barr Rosenberg Market Neutral, in December. It uses the same strategy as the company's successful hedge fund, which started in 1989. Montgomery Asset Management also plans to bring out a market-neutral fund in the first half. Other groups are expected to follow.

BALANCING ACT. Will Jump, who manages Barr Rosenberg and its sister hedge fund, says he tries to maintain a balance across sectors. "If the fund is long 5% of its assets in computer stocks, it will also try to be short about 5% in other computer stocks," he explains. Sectors he's focusing on: electronic components and retail/wholesale. Over the last three years, he has earned a total return of about 18% a year, after fees, with less risk than an intermediate government bond fund. That compares with about 31% for the Vanguard Index 500 Fund, an investment with greater volatility.

The Merger Fund follows another long-short strategy. It plays the arbitrage game by buying shares of a company being taken over and shorting shares of the acquirer. The fund has delivered steady, though not spectacular, returns with low volatility.

While market-neutral funds aim to hedge market risk no matter which way stock prices are heading, their success can be undermined by the mismatching of long and short positions. And if the market continues to defy gravity, returns could be modest compared to those equity funds that do no short selling. Still, if you're willing to accept lower returns in bull markets in exchange for better performance when stocks take a fall, the death of the short-short rule is opening up new opportunities.

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