Most of the time, mutual funds try to shoot for the moon by seeking out chances to create stellar performance. One new fund, though, is placing its bets on a much more modest future for the stock market -- and it's setting up its investing strategy to take maximum advantage if it turns out to be correct.

The Collar Fund opened to investors in June, and it has an investment objective that's fairly unusual. Rather than simply owning stocks, it combines what appears at first glance to be a pretty typical portfolio of large-cap companies led by Intel (NASDAQ:INTC), Electronic Arts (NASDAQ:ERTS), and Pfizer (NYSE:PFE) with a strategy involving buying and selling options. The net effect may be exactly what nervous investors are looking for right now.

This is not your dog's investment
The fund's name comes from the particular options strategy that the fund uses to achieve its objective. A collar puts a limit on the amount you can gain or lose on a stock. In order to create a collar, the fund has to do two things:

  • It writes covered call options on the stocks that it owns. Typically, the fund will choose options that give whoever buys them the right to buy the fund's shares at a higher price than the current market price. That way, the options won't get executed unless the fund can lock in a profit on its stocks.
  • At the same time, the fund takes the money it receives from writing the call options and uses it to buy put options on the same stocks. The fund picks put options that give it the right to sell the stocks it owns at prices somewhat lower than their current market prices. That doesn't give the fund complete protection against losses, but it makes the put options less expensive than they would be if the fund protected itself from any loss.

The collar effectively guarantees that the fund will always receive a minimum amount for the shares it owns, but also limits potential gains by allowing other investors to buy shares above a certain maximum price. If it wishes, the fund can execute the collar strategy in such a way that the cost of the put is completely offset by the proceeds from writing the call.

Hedging its bets
Perhaps the most interesting thing about the Collar Fund's strategy is that it allows the fund to invest in high-risk sectors while dampening its potential volatility. For instance, as of October, the fund had an allocation to materials stocks that was five times as big as the S&P 500. The stocks it owns include both precious-metals plays like Coeur d'Alene (NYSE:CDE) and Freeport-McMoRan Copper & Gold (NYSE:FCX) as well as basic materials companies such as Monsanto (NYSE:MON) and Cliffs Natural Resources (NYSE:CLF).

One potential problem for investors stems from the incentives the fund's strategy creates. During its first months of existence, the fund has severely underperformed the overall market, probably because the market has risen so quickly that the upper end of the fund's collars have forced the fund to sell some of its better-performing stocks for less than their current market value.

The flip side, though, is that during bad markets, the protection from the collar will give the fund a huge performance advantage. Yet that performance will still only be relative; depending on where the fund sets its collars, investors could still lose a substantial amount of their principal, albeit less than they'd lose without the collar.

Wait and see ... or do it yourself
It will be interesting to see how the Collar Fund evolves in a rapidly changing stock market. Regardless, though, the fund's collar strategy is something you can use to protect your own stock portfolio. If you're concerned about a possible rally reversal yet don't want to give up on future profits just yet, mimicking the fund with a collar on your stock might reduce your risk to exactly the level that makes you comfortable.

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