Hedged Mutual Funds: 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

Article excerpt

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 3c1 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.

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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. …