Here's how our picks for funds that use hedging strategies have weathered the recent stormy markets. By Elizabeth Leary, Contributing Editor December 10, 2007 Mutual funds that employ hedging strategies, such as those that sell stocks short or that buy and sell options, can smooth returns when the market behaves erratically. Last spring, we wrote about four such funds (see Protection for Stormy Markets), which we thought would keep their cool if volatility were to heat up. The market's wild gyrations the past five months have been a major stress-test for the funds' hedging strategies. Since we went to press with our article last April, two funds have excelled and two have delivered lackluster, though not horrific, results. The steadiest showing came from Hussman Strategic Growth. Manager John Hussman's approach defines flexibility. Depending on his views of the market, he alternately uses options and short-selling to hedge against losses and employs leverage to enhance gains. Advertisement In commentary published on the Hussman Web site on July 16, he declared the stock market to be overvalued and said he had fully hedged his fund's stock holdings against the possibility of a market downturn. "Based on prevailing market conditions, we have no evidence on which to accept market risk here," he wrote. Just three days later, the market began a decline that lasted through August 15. During that period, Standard & Poor's 500-stock index lost 9.0%. Strategic Growth, on the other hand, gained 2.5% -- our sole pick to stay in the black. Hussman remains bearish and is keeping his fund positioned defensively. Over the past year through December 7, Strategic Growth (symbol HSGFX) has lagged the S&P 500's 9.0% gain by five percentage points, but it has done so with less than half the volatility. Returns have been flat since the market's autumn peak, reached on October 9. Since then, the S&P 500 has lost 3%. The Gateway fund's performance has been impressive. Gateway sells call options on the S&P 500 to earn extra income and bolster returns. The price of call options rises in tandem with market volatility, so the amount of income the fund can generate with this approach has climbed steadily over the past year. Advertisement "We're trying to take advantage of that volatility as it comes," says co-manager Paul Stewart. The fund also buys puts -- or options to sell stocks at set prices over set date ranges -- to insure against dramatic short-term drops. The approach has held up marvelously. Gateway's returns have also been flat since the market's peak on October 9, and the fund contained losses over the July-August drop to less than 4%. Over the past year, the fund (GATEX) has managed to match the index's 9% gain, but with only a fraction of the volatility. Gentlemen, hats off. Long-short funds combine ordinary stock positions with short-sales, both to make money off individual stock declines and to hedge their exposure to market bumps. Schwab Hedged Equity runs computer models to choose a portfolio of stocks to own and another to short, with an aim of replicating the S&P 500's total returns with less volatility. Although the fund has mitigated volatility over the past year, it hasn't done so well on the return end. Since we recommended it, Hedged Equity has eked out a 1% gain, while the S&P 500 has returned 7%. Since the market's peak on October 9, the fund (SWHIX) has performed the worst of our picks, losing 1.7%. Moreover, it matched the S&P 500's 9% loss from July 19 to August 15. Advertisement The performance of Laudus Rosenberg Value Long/Short Equity is tougher to gauge. Manager William Ricks strives to deliver returns independent of market movements by holding short positions equal to the value of the fund's long holdings. The fund, which modestly measures itself against the risk-free 90-day Treasury bill, has actually lost a small amount of money since we recommended it. During the July-August period, it lost 3%, trailing the 90-day T-bill's 1% return. Historically, the fund (BRMIX) has outperformed in down markets-it gained 65% in the 2000-02 bear market, during which the S&P 500 lost 47%. In that light, the fund's 2.5% gain since October 9 is somewhat reassuring.