By Gunjan Banerji

Americans have poured money into funds promising shelter from the stock market's wild swings. They don't always work as expected.

Assets under management for so-called equity hedged exchange-traded and mutual funds tracked by Morningstar have surged to $56 billion this year, roughly double the figure just five years ago. More than two dozen have launched since the start of 2024.

Wall Street advertises them as protection against scary times in markets, kind of like stock insurance. But between high fees and complicated strategies, some haven't delivered as well lately as just staying invested and compounding returns.

AQR Capital Management analyzed a slice of equity hedged funds with at least five years of performance and found the majority failed to deliver either better returns or less severe drawdowns than a portfolio of stocks and cash.

Here's what you should know before wading in:

How they work

The funds tap a variety of strategies to buffer against big market declines, and there are more than 100 funds in the Morningstar category tracking the investments. Many involve options, which are contracts giving investors the right to buy or sell stocks at a specific price, by a stated date.

For example, an investor might buy a "put option" that gives the right to sell shares of Tesla at the price of $330, a roughly 5% drop. If the stock drops to $320, owning the put means that investors can still cash out at the higher level.

Some claim to provide protection from declines in the S&P 500 or Nasdaq-100 indexes, while others trade in the futures market. Some get even more complicated.

The cost

Many of the funds are pricier than plain vanilla index funds tracking stocks. Around half of hedged funds tracked by Morningstar have expense ratios of more than 1 percentage point -- or $100 annually on a $10,000 investment. To compare, a popular exchange-traded fund tracking the tech-heavy Nasdaq has fees of around one-fifth of a percentage point, about $20 on a $10,000 investment.

Ups and downs

Some funds have struggled this year, underscoring how tricky it can be to profit from the market's wild gyrations.

The Invesco S&P 500 Downside Hedged ETF, for example, has around $100 million in assets and uses complex bets on market volatility to achieve "positive total returns in rising or falling markets," according to its prospectus. The fund is down almost 8% this year, far worse than the 0.5% rise for the S&P 500.

Others have done better. The JPMorgan Hedged Equity Fund, one of the category's behemoths, with more than $20 billion in assets, was down 11% at the S&P 500's low for the year, better than the index's 15% decline. Hamilton Reiner, the fund's portfolio manager, said that helped keep people invested during a haywire stretch.

The challenges

Hedges are costly, and options' regular expiration requires fund managers to pay up repeatedly, chipping away at returns, AQR found. Meanwhile, the protection is often weaker than simply reducing your stockholdings.

AQR's Cliff Asness and Daniel Villalon said that investors looking to take less risk in markets would be better off simply keeping more of their portfolios in cash.

For example, they said 78% of these funds tied to options fared worse during this year's steep market decline than a portfolio of stocks and cash, according to an analysis through April.

Many of the funds also follow a strict set of rules that don't adapt to changing markets, said David Boole, managing director at BayCrest, an options brokerage. That can lead them to struggle at times, surprising investors who expect them to flourish during market swoons.

"Many have perceptions -- likely misperceptions -- on what these products do," Boole said.

What to look for

Think about when you need the money, said Paul Staneski, founder of the consulting firm Derivatives Solutions.

If you plan to hold on to stocks for long enough, staying in index funds might be a better bet, he said. In the short run, it could make sense to give up the potential for big, future gains for the safety of smaller, intermediate returns. Some of the funds might be attractive to investors fearful of a severe market crash, who need to protect their nest eggs for a brief period.

"It's critical to keep your time horizon in view," Staneski said.

Write to Gunjan Banerji at gunjan.banerji@wsj.com

(END) Dow Jones Newswires

June 01, 2025 07:00 ET (11:00 GMT)

Copyright (c) 2025 Dow Jones & Company, Inc.