Funds craft lures for skittish investors

CHICAGO -- The mutual fund industry has realized something about their investors: They really, really hate losing money.

All the buzz at the Morningstar conference here is about funds that mitigate stock risk. Will that stop investors from hating the stock market? Probably not, but it will help registered investment advisers steer clients into stock funds.

The Standard & Poor's stock index bottomed on March 9, 2009, and since then has soared 96%. But that hasn't erased investors' memories of the 2000-2002 and 2007-2009 bear markets. The S&P 500 is 9.8% lower than it was at the start of the century.

Not surprisingly, investors have yanked about $182 billion from actively managed stock funds since March 2009, according to trade group the Investment Company Institute. "I've never seen it so pessimistic for individual investors," says Craig Hodges, who, with his father, runs the Hodges fund. "My father says that it rivals only 1974-1975, when investors were positively belligerent towards people in the business."

That aversion to losses extends to registered investment advisers, now a main driver of assets into stock funds. These advisers typically charge a percentage of a client's assets, usually 1%, for their services. When clients leave — or just lose money — advisers lose income. The result: an explosion of "alternative funds," which use strategies borrowed from hedge funds:

•Long-short funds, which buy stocks they like — called going long — and bet against stocks they think will fall — called going short.

•Volatility funds, which rise or fall based on how violently the market moves.

•Bear funds, which rise when the stock market falls.

•Absolute return funds, which aim for positive returns in most environments by buying different assets (commodities, currencies, emerging markets).

Morningstar said it would start giving analyst ratings to 40 alternative funds, or about 70% of assets in alternative categories. Its analyst ratings use ratings of gold, silver, bronze, neutral and negative.

Don Phillips, Morningstar's president, says he has some reservations about the burgeoning universe of alt funds. Morningstar stresses keeping expenses low, using proven strategies, and investing in funds you can understand. "Alts tend to be high-priced, new and complex," Phillips says.

Morningstar has a gold rating on just one fund (TFS Market Neutral) and negative ratings on six.