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.
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 firstname.lastname@example.org.
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