Diversify your portfolio with these funds that don't move in tandem with the stock market. By Thomas M. Anderson, Contributing Editor August 5, 2009 Diversification got a black eye during the 2007-09 bear market. About the only things that made money during the downturn were Treasury bonds and cash (money-market funds, CDs and the like). Just about every other kind of investment was demolished.The idea behind assembling a diversified portfolio is to own some investments that zig when other stuff zags. The fancy way to say that is you want to own investments that don't correlate with each other. Correlation measures the degree to which investment returns move together. A correlation of 1 means returns of assets move in tandem. A correlation of -1 means an asset's value will move in the opposite direction of the asset with which it is being compared. A correlation of zero means that returns of two assets are independent of each other. Adding to a portfolio an investment with negative or low correlation should reduce the volatility of the entire package and, if chosen properly, provide higher returns with less risk. Globalization and financial innovation have increased correlation of many assets. From January 2000 to September 2007, emerging-markets stocks, as tracked by the MSCI Emerging Markets index, had a correlation of 0.73 to the Standard & Poor's 500-stock index. During the last bear market (from October 2007 to March 2009), the correlation of emerging-markets stocks to the S&P 500 rose to 0.84 (see www.assetcorrelation.com for historical correlation data). Advertisement To help you better diversify your portfolio, we've identified six mutual funds that exhibit relatively low correlations with the U.S. stock market. All of the funds performed relatively well during the 2007-09 bear market, during which the S&P 500 lost 55%. Although the sextet charge higher fees than the typical mutual fund, they offer access to risk-reduction strategies that are typically employed by hedge funds and university endowments. Arbitrage Fund R (symbol ARBFX) is all about the deal. Manager John Orrico buys shares of a company that is being acquired after the takeover has been announced. The target's shares usually jump after the announcement, but not all the way up to the deal price. The spread between the price at which the stock trades and the deal price reflects the risk that the transaction will fail or have to be renegotiated, as well as the time value of money, because there is usually a lag of several months between the takeover announcement and the consummation of the deal. Merger arbitrage, if done correctly, should produce positive returns regardless of what the overall market does. During the 2007-09 down period, Arbitrage Fund returned 1.1% and had a correlation to the S&P 500 of 0.49. Over the past five years through August 4, the fund returned an annualized 5.2%, while the S&P 500 was essentially flat. The fund, which carries an expense ratio of 1.9%, is up 6.5% for the year, half the gain of the S&P index. You have another option when it comes to merger arbitrage. The much larger Merger Fund (MERFX), with $1.7 billion in assets, focuses on bigger deals than does Arbitrage, which has $379 million in assets. Advertisement Over the long run, Merger, run by Fred Green, Roy Behren and Mike Shannon, has delivered returns comparable to Arbitrage's, but it has exhibited slightly closer ties to the overall stock market. Merger lost 3.5% during the bear market, with a correlation to the S&P 500 of 0.63. Over the past five years, the fund returned an annualized 4.4% and gained 5.2% year-to-date. The expense ratio is 1.47%. Long-short funds march to their own drumbeat by owning some stocks the old-fashioned way while selling some short in a bet on falling share prices. The funds aim to generate stock-like returns with low, bond-like volatility and behave differently from either asset class. Two funds that have practiced this arcane art better than most are Akros Absolute Return (AARFX) and Hussman Strategic Growth (HSGFX). Brady Lipp, manager of the Akros fund, uses a growth-at-a-reasonable-price strategy to pick stocks. When he sells short, he looks for overvalued companies and sectors. In the past, he has shorted exchange-traded funds that invest in real estate investment trusts, as well as those that focus on financials and homebuilding stocks. Having gained 17.3% so far this year, Lipp is less bullish on stocks. "The easy money in this bull market has already been made," he says. Lipp plans to sell call options on the S&P 500, a move that will limit potential gains but will generate extra income for his fund. Advertisement Akros, which means "high point" in Greek, lost 5.8% during the bear market. Since its inception in September 2005, the fund returned an annualized 3.6%. It exhibits a 0.65 correlation to the S&P 500. Expenses are 1.99% per year. John Hussman, manager of Hussman Strategic Growth, has frequently found the stock market to be overvalued since he launched his fund in July 2000. Under such conditions, he hedges his long holdings by using options and futures to sell short the S&P 500. During the bear market, the fund lost 4.6% and had a 0.46 correlation to the S&P 500. Since its inception in 2000, it returned 8.9% annualized, outpacing the S&P 500 by an average of 11 percentage points per year. Axel Merk worries first and foremost about the soundness of a nation's monetary policy. That has led him to shun the U.S. dollar and hold an assortment of foreign currencies, as well as a bit of gold, in Merk Hard Currency (MERKX). Although the euro is his largest holding, he also prefers money of countries with strong commodity exports, such as the Australian dollar, the Canadian dollar and Norwegian krone. Hard Currency, which charges 1.32% a year for expenses, is similar to a money-market fund except that its holdings are denominated in foreign currencies. The biggest risk for the fund is that the dollar will strengthen, causing investments in other currencies to translate into fewer greenbacks. Merk minimizes interest-rate risk by investing in debt with short maturities (the fund's average maturity is 120 days) and reduces credit risk by holding only government-backed IOUs. He holds no currencies of emerging markets and, unlike many currency speculators, he doesn't borrow money to invest. Advertisement Hard Currency had a 0.56 correlation to the S&P 500 during the bear market, during which it lost 6%. "Typically, our fund shouldn't move in tandem with the stock market, although there are times when it might," Merk says. From its May 2005 start, Hard Currency returned an annualized 6.5%. When it comes to zigging when the rest of the world zags, it's hard to top Rydex/SGI Managed Futures Strategy H (RYMFX). The fund invests in a 50/50 mix of commodity futures and futures on financial instruments, including currencies and Treasury bonds. The fund employs a trend-following strategy, favoring what's working well and betting against what's faltering. It can "go long" any of the investments on its menu or bet against them by selling short (although it may not sell short energy futures). This unusual fund showed its mettle during the bear market. During that period, it returned 12% and had a correlation with the S&P 500 of -0.59. Year-to-date, it lost 2.9%. The fund's no-load Class H shares carry an expense ratio of 1.75%. All of these funds can give you a dose of diversification. But don't go overboard. These specialty funds should make up no more than 10% of your portfolio.