Hedge Your Portfolio

It can pay to play defense in a market often buffeted by fast and furious one-day drops.

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It can pay to play defense in a market often buffeted by fast and furious one-day drops. In small doses, funds that use hedging strategies can reduce risk in your overall portfolio because their performance doesn't move in tandem with the stock or bond markets. Using sophisticated techniques such as short-selling and options, these funds aim to guard against market declines and still produce respectable long-term returns.

When former economics professor John Hussman's market outlook is gloomy, he can hedge some—or all—of his Hussman Strategic Growth fund using options to bet against major market indexes. The fund is currently fully hedged, its most bearish position. The portfolio holds more than 100 stocks Hussman thinks are somewhat cheap relative to their growth potential. "We're also hedged with indexes that behave similarly and reflect the stocks we own," says Hussman. "The idea is to earn the difference in the stocks' performance." The fund, which returned 11 percent a year on average from its July 2000 launch through December 1, charges a below-average 1.17 percent in annual expenses.

Michael Orkin hedges his Caldwell & Orkin Market Opportunity fund by short-selling—or betting against—individual stocks or sectors. Orkin's bets against the home-building and subprime mortgage sectors helped the fund gain a whopping 33 percent over the past year. It returned an annualized 7 percent over the past decade, 1 percentage point ahead of the S&P 500, with significantly less volatility. The fund charges 1.75 percent in annual fees.

You can execute your own hedging strategy by investing in an exchange-traded fund (ETF) that bets on the decline of an index, investing style, or sector of the market. ProShares' short-selling etfs produce inverse returns of a particular index. For instance, the Short Dow30 bets against the Dow Jones industrial average. The firm also offers a line of "ultra" funds, which essentially return double the opposite of an index's daily gain. Although these funds aren't as risky as pure short-selling, approach them with caution.