While the debate over the proper regulatory structure for hedge funds rages on, more mutual funds are utilizing hedge fund strategies, providing diversification from a long-only equity approach to investments.
Despite their rapid growth. hedge funds remain a mystery to many people. They are labeled with a scarlet "R" for risk. But the greatest distinction between hedge funds and the more familiar mutual fund universe is structure and regulatory oversight. Yes hedge funds have more freedom when it comes to short sales, leverage and fee structure, but the relaxation of short sales and other rules has allowed some mutual funds to create trading programs that mirror hedge funds. This is most true of the most basic hedge fund strategy long/short equity.
While it is fashionable to refer to the term "hedge fund" as a misnomer because all strategies do not technically hedge, "absolute return strategies" is probably a better label for the myriad of strategies utilizing the 3d and 3c7 registration exemptions that fall under the hedge fund structure umbrella, the most common strategy is still long/short equity, which attempts to hedge out general market risk or market volatility and create a return stream based on a manager's talent.
Even the use of leverage is misinterpreted by many analysts and regulators. While any use of leverage can add risk and opportunity, the use of leverage is more determined by the type of strategy and not the managers' appetite for risk. It is best understood in terms of futures style margining. The more risk a position holds, the higher the margin requirement. The less risk a particular strategy entails, the greater opportunity to safely employ leverage. The hedge funds strategies that use the most leverage are often the ones with the most conservative return streams.
While some of the more exotic hedge fund strategies could not be executed through a mutual fund structure, several can, and are the structure behind a growing group of hedged mutual funds. In January, "Hedge Funds for Retail Investors? An examination of Hedged Mutual Funds," a paper released by Vikas Agarwal of Georgia State University, Nicole M. Boyson of Northeastern University and Narayan Y. Naik of the London Business School, examined the phenomena and performance relative to traditional hedge funds and mutual funds of hedged mutual funds.
The study noted that Morningstar and Lipper had created new categories, "Long/Short" Equity and "Market Neutral" to cover this growing field of mutual funds available to retail investors at minimums of $5,000 and less.
In the paper's abstract the authors note, "We believe that hedged mutual funds will play an increasingly important role in the field of investment management as they provide access to hedge fund-like strategies with the fee structure, liquidity and regulatory requirements of mutual funds."
The paper reports that hedged mutual funds have grown from $743 million in investments in 1994 to $18 billion in investments through 2004. It also found that traditional mutual funds show greater risk with a higher standard deviation, more negative skewness and lower kurtosis than hedged mutual funds.
The study results supported three hypotheses presented by its authors regarding hedged mutual funds. The first is that hedged mutual funds would underperform hedge funds due to greater regulation and less incentives for manages. It found hedged mutual funds underperformed hedge funds by as much as 4.1% net of fees. The second hypotheses was that hedged mutual funds would outperform traditional mutual funds due to the ability to produce returns in different market conditions. It found that hedged mutual funds outperformed traditional mutual funds between 2.6% and 4.8%. The third hypotheses held that managers of hedged mutual funds with hedge fund experience would outperform those without hedge fund experience. And that proved true too with experienced managers producing returns between 3.3% and 5.6% higher.
Boyson points out that the majority of hedge fund allocations go to the top 100 managers, so there are plenty of experienced hedge fund managers with capacity. She says creating hedged mutual funds allows them to take in allocations from another source. "It helps them build their assets," she says.
One fund utilizing hedging is the Hussman Strategic Growth Fund. Its prospectus states, "The fund is designed for investors who want to participate in the stock market, and [who] also want to reduce their exposure to market risk in conditions that have historically been unfavorable for stocks." The fund does this through buying put options on individual stock and stock indexes, writing covered calls or by establishing short futures positions on stock indexes correlated with its portfolio. According to the prospectus, if the manager views market conditions as extremely negative, the fund's portfolio could be fully hedged. It also can use options to leverage its long exposure in positive market conditions.
Any hedged strategy will likely underperform long-only strategies in a climate where stock indexes are consistently setting all-time records.
John P. Hussman addresses this in an April 30 letter to investors. "There is no question that our willingness to hedge risk in overvalued, overbought and over-bullish conditions can be uncomfortable at times. That's particularly true here; during a short squeeze/speculative blow off in a late stage...these points are often followed, at least in the short term, by further gains of a few percent, but invite deep and abrupt declines that can erase weeks or months of upside progress in a few days," he says.
One of the oldest hedged mutual funds is the Needham Growth Fund. This fund has produced an average annual return of 18.92% since inception in 1996, outperforming all of the major stock indexes during its 11 years (see "Beating the indexes," page 61). As opposed to some funds that simply hedge with index futures or options, Needham sells stocks short. Current rules allow Needham to short up to 25% of its portfolio.
James Kloppenburg, fund manager for the Needham Growth Fund, says there are two ways of looking at short selling. "One you use it to maximize returns where you take more risk to get more returns, and the other approach is where you use it as a hedging strategy to reduce volatility and lower risk but you give up a little upside return to create more stable returns and protect downside. One is a capital maximization strategy and the other is a capital preservation strategy," he says.
Needham also has several hedge funds that preceded its hedge mutual fund product, supporting the findings of the study that posits managers with hedge fund experience outperform those without.
Needham shorts up to 25% because that is all he can short. Charles Gradante, managing principal of Hennessee Group LLC, sees hedged mutual funds as the answer to what the securities and Exchange Commission (sec) has called the problem of retailization of hedge funds. Gradante says hedge funds should not be forced to register but should not be made available to retail investors, even through pension plans.
"The sec should loosen up regulations to give hedged mutual funds more flexibility," Gradante says. He points out these funds have outperformed traditional mutual funds and that retail investors should have a 20% to 25% allocation to hedged mutual funds.
While various forms of long/short equity are the main categories of hedged mutual funds, other traditional hedge fund strategies are being utilized. "The Merger Fund" is one of several merger arbitrage mutual funds.
Merger arbitrage is a complex hedge fund strategy that involves investing in common stock of companies being acquired and selling the stock of the acquirer. Roy Behren, co-portfolio manager of the Merger Fund, says they run the fund similar to their merger arbitrage hedge funds. "We are a little bit hamstrung by 40 Act restrictions, but in concept we can do the same thing within the mutual fund that we can do in the hedge fund, which is buy shares of the target company and in the case of a stock for stock transaction, sell shares short of the acquiring company."
The Merger Fund has consistently tracked the performance of the Merger Arbitrage strategy despite the added regulatory cost involved in the mutual fund structure (see "Keeping up," page 63). Behren says that the research is the same for the mutual fund or the hedge fund. "It is a strategy that we have been able to employ in a mutual fund wrapper and we have not had problems with deploying that strategy inside a 40 Act vehicle," he says.
Behren adds the expenses of running the merger arbitrage strategy within the mutual fund structure is higher but the mutual fund's fees, approximately 1% of the investment annually, are lower. "The performance has been inline with our merger arbitrage hedge fund. Our own hedge funds are outperforming the mutual funds by a little bit but it is ballpark in line," Behren says.
"Our mutual fund is also managed more conservatively than our hedge fund and the majority of merger arbitrage hedge funds. We run it to minimize volatility and provide a safe absolute return product in any environment."
He adds that the more conservative approach is due to targeting the strategy to retail investors.
One of the most frustrating aspects of describing alternative investments is the still widely held notion that they involve increased risk versus traditional long-only mutual funds. While periodically there will be blow-ups like Long-Term Capital Management and Amaranth and some hedge fund strategies may include more risky strategies, in general their returns are less risky than long-only strategies. And while broad market indexes have experienced record highs this spring, there are warning signs on the horizon.
The Dow Jones Industrial Average has recently experienced a series of days in which it recorded 19 of 21 up days. This only happened once before, two months prior to the 1929 crash. It experienced similar market action just prior to the 1968 downturn (see "Dangerous precedent" page 31). Any long equity based strategy will suffer in such a scenario but traditional mutual funds that simply hope to reflect broad market returns are naked against such scenarios. It only makes sense for investors, particularly retail investors, to have some sort of diversification to offset the affects of such a scenario.
The growth of hedged mutual funds provide retail investors some measure of protection and is positive (see "Hedging your bets," left). Like hedge funds, many produce strong returns in bull market conditions yet offset the volatility in case of a significant market downturn. "We are using it in a way to smooth out some of the bumps. We accept in the really big years that we are going to be given up some performance. When the S&P is really screaming, if you are doing a good job hedging your returns - everything else being equal - its going to be a little less than if you are long-only," Kloppenburg says.
The sec has recently sought to limit access to exempt hedge funds to a very small percentage of the population (1.3%). If that occurs, it will be more important that investments that can produce positive returns in any market condition are available to the investing public. What will be the outcry if a 1929 type scenario occurs and we see the number of market experts and government regulators charged with informing and protecting the retail public how difficult they made it to invest in anything other than traditional longonly equity strategies. Hedged mutual funds provide investors with the ability to profit, or at least limit risk in a major downturn.…