HOW TO PLAY IT: Despite dismal stocks, opportunities remain

THE ISSUE: Despite the recent equity market rally, many mutual funds have failed to beat their benchmarks, leaving investors to wonder which funds still offer opportunity. Here are three strategies.

By Jessica Toonkel

Europe's economic woes, a lingering debt overhang and the threat of a global slowdown, could mean underperformance will continue.

So far equity funds are still lagging their benchmarks, despite the recent rally in the markets.

As of Monday, 23 percent of mutual funds have underperformed their indices by more than 500 basis points, up from 20 percent who missed at the beginning of the month, according to J.P. Morgan.

Still, some mutual fund categories have beat their indexes -- or at least matched them by using hedging strategies or investing in companies that yield dividends. And on average during periods of market volatility about one-third of active funds beat their indices, said Russel Kinnel, director of research at Morningstar Inc.

The trick is finding them.

GO NEUTRAL

For investors whose priority is to preserve wealth -- even if it means not getting a piece of a market rally, equity market neutral funds are a good option, analysts said.

By taking long and short positions on stocks, these funds try to immunize themselves against volatility. So far this year, they have returned 0.48 percent, while the S&P 500 is down 1.78 percent, including reinvested dividends, for the same period, according to Lipper.

"This is the asset class that people go to dampen volatility," said Tom Roseen, a senior analyst at Lipper.

Many of the top-performing funds are closed to new investors. Among those that are open, American Century Investments' Equity Market Neutral Fund , has returned 4.25 percent so far this year, ranking it fourth in its category, according to Lipper.

But, true to form, its three-year return is 0.54 percent, compared to a 12.72 percent return for the index. The five-year return of 0.33 percent captures another stretch of volatility -- the 2008 financial crisis-- when the index returned less, 0.21 percent.

Pair market neutral funds with long-short equity funds to take advantage of upswings while protecting wealth, said Nadia Papagiannis, a Morningstar analyst. These funds have more long exposure, so they have the ability to capture the upward movements in the market, she said.

One pairing that Papagiannis suggests: The AQR Diversified Arbitrage Fund , which has returned 0.09 percent year-to-date, with the Wasatch Long/Short Fund , which has returned 2.16 percent, according to Morningstar.

SEEK INCOME

For gun shy investors who want a bit more upside potential, equity income funds that mostly invest in dividend-paying companies are an option.

"Dividends are in vogue" because they are one of the few places investors can still find yield, said David Kathman, a senior mutual fund analyst at Morningstar.

For the most part passively-managed dividend ETFs have beat the S&P 500, including dividends. Seven of the 12 U.S.-based dividend ETFs have beaten the index so far this year, according to IndexUniverse.com.

Some funds do outperform the ETF, although expenses could eat the extra gains.

The Vanguard Dividend Appreciation ETF , based on a customized index created by The Vanguard Group, has returned 3.10 percent year-to-date. Meanwhile, the firm's Dividend Growth Fund has returned 6 percent. For the past five years, the ETF has returned 2.54 percent, while the mutual fund has returned 3.72 percent, according to Morningstar. But the Vanguard mutual fund costs 0.34 percent, while the ETF costs 0.18 percent.

Even so, Roseen says active fund managers can sidestep market movements that could affect dividend-paying companies.

"Active managers in the dividend space can pick and choose where they are going," Roseen said. Financial services companies have historically paid dividends, for example, but have taken a beating this year making it a sector active fund managers might be avoiding.

TAKE OFF THE REINS

Global equity funds have been pummeled this year. But flexible global allocation funds, in which portfolio managers can allocate globally among stocks, bonds, cash, gold and other asset classes have been able to sidestep some of the deepest market declines.

On average, global flexible funds are down 6.45 percent for the year. Global multi-cap growth funds are down almost twice that amount, 11.36 percent, for the same period, according to Lipper.

"No fund is going to protect investors from every market environment, but the more tactical managers have done pretty well," said Michael Herbst, an analyst at Morningstar.

Some are even posting gains even as the category sees losses overall. The GMO Benchmark-Free Allocation III Fund has returned 2.14 percent so far this year, has a three-year return of 8.31 percent and a 5.99 percent return for the last five years, according to Lipper.