Academic journal article Financial Services Review

Performance of Alternative Mutual Funds: The Average Investor's Hedge Fund

Academic journal article Financial Services Review

Performance of Alternative Mutual Funds: The Average Investor's Hedge Fund

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Alternative mutual funds (AMFs) are relatively new entrants into the mutual fund industry. As characterized by Morningstar, they are also known as hedged mutual funds or non-traditional mutual funds. It is important for financial planners, advisors, and investors to be knowledgeable of the performance and costs of these funds when making investment recommendations or decisions. These funds follow investment strategies similar to those of hedge funds and are attractive to individual investors who are often unable to invest in hedge funds because of high initial investment requirements and longer lock-up periods. AMFs normally have a goal of providing individual investors with access to investment strategies that offer non-correlated returns and diversification benefits. This goal of AMFs is in contrast with traditional or long only funds that try to beat a benchmark such as S&P 500 or Russell 1000.

AMFs have grown rapidly in the last few years. The growth in assets under management (AUM) has been significant. According to Goldman Sachs Asset Management (2012), inflows into these funds were $29.7 billion in 2005 (11% of the total mutual fund inflows). By 2009, these funds experienced inflows of $121 billion (25% of total mutual fund flows). Further, by December 2011, total assets under management for all the surviving funds were $132.82 billion.

AMFs have more flexibility than long only funds. They can buy underpriced securities and short overpriced ones. These funds can also use leverage, derivatives, options, and swaps (like hedge funds) to seek higher returns (see Appendix Al for an explanation of nine different types of AMFs). Even though AMFs have more flexibility than traditional mutual funds, they have more constraints than hedge funds. Some of the regulations with which AMFs must comply include daily liquidity, covering short positions, borrowing less than one-third of total assets, limiting investments in illiquid assets to less than 15% of assets under management.1

AMFs' active management strategy of buying undervalued securities and shorting overvalued ones could increase returns manifold, if managers make good investments; it can also increase risk, if managers make poor choices. Therefore, the investment manager's skill in buying and shorting securities is extremely important. AMFs are more actively managed than traditional long-only mutual funds.2 Studies by Brooks and Porter (2012) find that the returns from actively managed funds dominate the returns from passively managed funds and Dowell and Mann (2004) reached a similar conclusion in regards to fixed income funds. However, previous research by Carhart (1997), Elton, et al. (1995), and others does not support the existence of skilled or informed mutual fund managers.3

Although AMFs funds are relatively new, there has been some research in this field. Koski and Pontiff (1999) and Deli and Varma (2002) find that the flexibility to use derivatives, sell securities short, and borrow money to create leverage help managers to control expenses, risk, and manage cash flows more efficiently that makes the AMFs appear to be an attractive alternative to standard mutual funds and subject to analysis. Agarwal, et al. (2009) look at the performance of 52 hedged mutual funds over the period 1994-2004. They find that these hedged mutual funds outperform traditional mutual funds, but underperform similar hedge funds. Broussard and Neely (2011) study a similar sample of 36 long/short and marketneutral funds and find that managers of these funds do not create any alpha.

Our article adds to the literature by analyzing the performance of AMFs during the recent financial crisis that began in 2007. We also utilize the Fabozzi and Francis (1979) model to test the monthly performance of these funds in both up and down markets. This analysis is important as many of these funds are sold to individual investors with the promise of absolute returns regardless of market conditions. …

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