That's Some Sharp Hedging

A fund in double digits since 2000

In 2003, when the average equity mutual fund delivered a 32% total return, the $771 million Hussman Strategic Growth Fund (HSGFX ) earned just 21%. But portfolio manager John P. Hussman need not make apologies. During the bear market, when most funds were awash in red ink, he ran one of the few diversified equity funds to rack up double-digit returns. Since the fund's July, 2000, launch, it has returned on average 19.5% annually. What's more, the 41-year-old Hussman produced these gains without making big bets in sectors that performed well then, such as real estate and gold.

Hussman's edge is that he hedges his portfolio, while most funds, as a matter of policy, do not. When he thinks market conditions are unfavorable, Hussman can take steps such as buying put options, which increase in value when stock indexes, such as the Standard & Poor's (MHP ) 500-stock index and the Russell 2000, fall. If conditions improve, as they did in 2003, Hussman removes all or part of the hedge. He's not a hyperactive hedger, making changes just once or twice a year. Nor does the hedging service add much to overhead. The expense ratio for this no-load fund is 1.35%, slightly below average.

Such flexibility sets Hussman Strategic Growth apart from bearish, or short-selling, funds, which go up when the market goes down, or market-neutral funds, which seek to neutralize the market's impact. Most of those funds lost money in 2003.

Hussman developed his strategy as a PhD candidate in economics at Stanford University. In his thesis on "market efficiency and information economics," he concluded that by analyzing both stock valuations and price movements, one could identify favorable and unfavorable market climates. Hedging during unfavorable ones would produce higher returns with less risk.

In 1988, while still a graduate student, he launched Hussman Econometrics Advisors to manage private accounts and publish a newsletter for institutional investors. He started a mutual fund, the Strategic Growth Fund, in 2000, and Hussman Strategic Total Return Fund (HSTRX ), an income fund, in September, 2002. In his spare time, Hussman pursues other interests, such as collecting -- and playing -- guitars and running a Web site, hussman.org, about nutrition and bodybuilding. (The mutual fund's Web site is hussmanfunds.com.)

OVERPRICED MARKET. Right now, Hussman argues, stocks are unattractive for two reasons. First, he compares the S&P 500's current price not to current earnings but to peak earnings -- the most recent high point in earnings. By that measure, the p-e is 21, vs. the historical average for price-to-peak earnings of 14. Then, Hussman looks at investor sentiment by measuring the advance-decline ratio -- how many stocks are rising vs. falling each day. "When you begin to see the average stock breaking down, even though the indexes are still up, it's a sign investors are becoming skittish," he says. "There has been a significant loss in market momentum, and certain key sectors such as utilities have weakened considerably." He's never out of stocks completely, and is now 50% hedged.

Hussman also uses valuation and price momentum to select individual stocks. Drugmaker Merck (MRK ), one of his largest holdings, has a p-e ratio that's about half the industry average. "Investors have been worried there are no new drugs in the pipeline," he says. So the stock has declined for each of the past three years. But Hussman recently noticed positive signs in its price movements. "When Merck canceled its testing of a new depression treatment on Nov. 12, its shares didn't respond," he says. "That's a sign the bad news is already priced into its stock." Other current holdings include Home Depot (HD ) and King Pharmaceuticals (KG ), a small drugmaker based in Bristol, Tenn.

One concern is that when Hussman is hedged, his returns depend entirely on his stock picks. That means if the market goes up, his stocks have to rise more to generate a positive return. But in the fund's 3 1/2-year history, he has demonstrated hedging smarts amid plenty of volatile markets. That's why his returns have left his competitors eating dust.

By Lewis Braham

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