Toll-Free: 800.687.6551

News & Blog

Part III. Hedge Fund Strategies in Mutual Fund Format

BLOG, EDUCATION  |  13 Apr 2010

So, you don’t qualify as an accredited investor, (It’s okay. There are lots of us.) but you’re yearning for those sexy and sophisticated hedge fund strategies? Or perhaps you are an accredited investor, but you can’t stomach the big initial investment required by most hedge funds? Well friends, when there is a demand for something that doesn’t exist, the market almost always responds by providing that something, and this case is no exception. Hedge funds have gone retail! Sort of. Actually, hedge fund strategies have gone retail. Yes, many of the tactics used by hedge fund managers are now available through mutual funds. This isn’t that recent of a development. In fact some of these mutual funds have been around for ten years or more. What is a recent development is the rapidly expanding number of these types of funds, and the willingness of the average investors to make these offerings part of their portfolios. What is behind all of this?

As we know by now, hedge funds invest in assets and employ strategies that go well beyond basic buy and hold strategies using stocks and bonds. Many investors are drawn to hedge funds because of their perceived potential to either beat the market or provide returns independently of it. Until recently, most people were not even aware that these types of investment strategies were available. The increased interest in these alternative investments is most likely due to the wild ride that the stock market has taken investors on for the last decade. Although hedge funds have been around a long time, they weren’t really talked about much in the main stream press until relatively recently. This could be due to the fact that in the past so few individual investors could own them, leaving big institutions as the primary investors. Now that there are reportedly 7.8 million millionaires in the US, hedge funds are more news and conversation-worthy. Initially it was the juicy returns that some famous hedge funds were churning out that brought them into the public eye. More recently it has been the catastrophic collapses of some funds and outright fraud perpetrated by the managers of others that brought them notoriety. It was only natural that average investors became intrigued by the returns but turned off by the horror stories.

Enter the hedge-like mutual fund. These are funds that attempt to create a sort of “best of both worlds” investment product. Let’s take a quick look at what this means. Okay class, let’s see what you remember from parts I and II of this series. What do mutual funds have that hedge funds don’t? Anyone? Anyone? Don’t make me call on someone! Alright, you in the back. Yes, that is correct. Mutual funds have the following benefits that hedge funds don’t:

  • Daily Pricing
  • High Liquidity
  • Transparency
  • Relatively Low Fees
  • Close SEC Oversight
  • Availability to Nearly All Investors
  • Low Minimum Investment Requirements

This sounds like a good thing, does it not? Sophisticated hedge fund strategies with all the benefits that mutual funds provide. But do hedge fund strategies really work under the traditional mutual fund format? The answer is yes, but with limitations. First of all, not all hedge fund strategies can be used by mutual funds, some for practical reasons, and others for legal reasons. On the practical side, strategies that depend heavily on long-term investments in illiquid assets are difficult to use effectively in mutual funds. This is due to the fact that mutual funds are required to be redeemable on a daily basis. On the legal side, hedge fund strategies such as fixed income arbitrage, which rely largely on the use of leverage, may not work as effectively in mutual funds due to the strict limits our federal government imposes on the amount of leverage mutual funds can have. On the other hand there are several hedge fund strategies which work quite well under the mutual fund format. These strategies include market neutral, long/short, absolute return, and commodities futures. But even these strategies might underperform their hedge fund cousins, again, because of liquidity requirements, as fund managers have to be ready to redeem shares on a daily basis. Even so, some investors might consider any underperformance issues as a small price to pay in exchange for the relatively inexpensive access to the sophisticated strategies that these hedge-like funds provide.

How Do Hedge-Like Mutual Funds Differ from “Ordinary Mutual Funds”?

First of all, what do I mean by ordinary mutual funds? When most of us think of a mutual fund, we are thinking about funds that employ “relative return” or “long-only” strategies. These strategies are designed to beat or track an index or a given asset class, such as mid cap growth stocks. Such funds generally move up and down with the performance of their sector. These funds can be actively or passively managed (index funds). Actively managed funds try to beat their benchmark by selecting securities they believe will outperform the market, while index funds seek only to stay even with their benchmark. Actively managed funds have higher fees to compensate the management team, and index funds usually have very low fees. Hedge-like mutual funds fall solidly into the actively-managed category. In fact, some of these funds are the most actively managed funds around. Thus, you can expect to pay higher fees in mutual funds that use hedge-like strategies than you would with traditional actively-managed funds. This is not always the case however. The 5.5 billion dollar Hussman Strategic Growth Fund, which clearly falls into the hedge-like category, charges annual fees of only 1.09%, which is more than an index fund, but fairly average for an actively managed mutual fund.

Why would anyone want to invest in funds that have higher fees than many traditional mutual funds? It may well be worth the extra cost if the fund is adding value to the portfolio. Many of the hedge-like mutual funds pursue a strategy that is less dependant on the performance of the market in general. Some of these funds held up very well in the market meltdown of 2008, but they also may have underperformed in the 2009 recovery. Their proper use in a portfolio may serve to dampen volatility and provide investors with a smoother ride, while still producing reasonable returns. The goal is to provide relatively low correlation with stocks and bonds.

In Part IV, I will discuss another method of entry into the world of hedge funds for average investors, the “fund of funds” fund. (Say that three times fast!)