Absolute-return mutual funds that seek to provide investors with positive returns whether equity markets are rising or falling, are growing in rapid numbers in today's volatile market and hoping to attract a loyal investor following.

But so far, it's largely been the fringe players, not the colossal mutual fund advisory firms, that have emerged with market-neutral, long-short, 130/30 and other funds that utilize hedging strategies to achieve positive returns, said Don Phillips, managing director at Morningstar of Chicago.

"For a lot of firms, it's a business decision," Phillips said. A majority of fund firms have realized that they don't have the size and performance to compete with the likes of such big boys as American Funds or T. Rowe Price, instead preferring to lock into a niche strategy.

The problem is their overall track records haven't been very good, Phillips added. But that is likely to improve over time, he predicted. Hedged mutual funds also may carry fees of 4% or more, dragging performance and putting investors' money at undue risk. Distressed debt and global macroeconomic and fixed-income arbitrage is also not transparent, and often means holdings must be tied up.

"We're just sticking to our models," said Rich Gates, founder of TFS Capital of West Chester, Pa., and manager of the $185 million TFS Market Neutral Fund, which hit a rough patch this past August when the markets tanked.

The fund has since rallied, and over the past 12 months returned 8.35%, according to Morningstar, with a three-year trailing return of 15.1%, nearly three times its peer group average. "We've been able to justify our existence," Gates said, noting the firm's policy that 75% of each manager's liquid assets must be invested in their own funds. "If the market continues to perform poorly, there will be a lot more people looking for alternatives," he added.

More recently, a second wave of larger players, including DWS Scudder, JPMorgan and RiverSource, have hit the market with new fund and innovative strategies designed to provide absolute returns. "Absolute-return strategies are perfectly timed for the aging Baby Boomer market," Phillips noted. "A long-only strategy may be great for investors with a 40-year time horizon, but not as good for those with a 40-month time horizon."

Not every fund group will decide they must offer funds with alternative investment strategies, nor will everyone who does jump into the fray, succeed.

"I don't feel that everyone will feel they have to do this," Phillips cautioned. Some firms, for example, are content offering absolute-return strategies in separate accounts but don't want to package it into the mutual fund structure, he noted.

It's easy to deliver so-called 130/30 long/short strategies (and up to 150/50 strategies) in a mutual fund format, said Dennis Bein, chief investment officer of Analytic Investors of Los Angeles, an Old Mutual affiliated investment management company.

"The greatest limitation is the ability to borrow stocks to short," he said.

Bein is also a vocal proponent of casting aside the 130/30 numeric reference and properly characterizing such long-short strategies as "short-extension strategies." Moreover, Bein argues that such funds should not be characterized as "alternative investments" because they do not represent a distinct and separate asset class the way other true alternative investments, such as timber, do.

Various 130/30 investment strategies, as well as other alternatives to long-only strategies, have become popular with mutual fund managers. But even data providers are perplexed and struggling to find the appropriate categories for such mutual funds.

Nonetheless, on May 23, Lipper will, offer a 130/30 category of mutual fund data and research. Up until now a list of such funds has been cobbled together only as requested.

Niche Managers Speak Out

The Rydex Managed Futures Fund, which debuted March 2007 and is advised by Rydex Investments of Rockville, Md., currently tops Morningstar's list of market-neutral and long/short funds with its A-shares returning an impressive 15.24% over the previous 12-months ended April 17.

The fund is also unique as it is the very first managed futures mutual fund. The fund's investment goal is to replicate the return of the S&P Diversified Trends Indicator Index, which invests 50% in physical commodities and 50% in non-U.S. currencies alongside Treasury securities. The fund provides exposure to the managed futures market without making a direct investment in it by investing in hybrid structured notes.

The fund's underlying index can take long positions in some sectors while shorting others (except for the energy sector, which is always long).

Most long/short mutual funds are highly correlated to the equity markets, said Ed Egilinsky, managing director, alternative investments with Rydex. "Managed futures are a different type of investment," he said.

He added that although there may never be a ton of managed futures mutual funds, other interesting mutual funds non-correlated to the equity markets will emerge.

Two years ago, the $15.5 million Top Flight Fund, managed by Rock Canyon Advisors of Lehi, Utah, purposefully added the long-short designation to its fund name to make its strategy clearer and clarify what fund category it did, and didn't, belong to, said fund manager Jonathan Ferrell. The fund has shown impressive performance of 11.46% over the past 12 months, versus the almost flat (-0.96%) average performance of its long/short and market-neutral peer group.

Market volatility has worked in favor of the fund's investment style, which includes using quantitative strategies plus some common sense. Ferrell foresees volatility expanding over the next three to four years and remaining high for seven or eight years.

"There has been a need for investors to find asset classes for portfolios," Ferrell said. "The long-short space is positioned for that and has outperformed." It's all part of what he calls, "the continued quest for alpha."

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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