It’s not just a rich man’s game. Although only high-net-worth U.S. investors can buy stakes in hedge funds, any individual with as little as $1,000 can buy shares in mutual funds that use two basic hedge fund maneuvers: shorting stocks and buying and selling options.
Financial Research Corp., a Boston-based consulting firm, estimates that 42 funds now utilize these techniques. Assets among the 42 funds have been growing, reaching $8.4 billion at the end of 2003, up from $5.4 billion in 2002 and $2.6 billion at year-end 1998. As of April 31 assets were up slightly, to $8.6 billion.
“It’s a niche market,” says David Haywood, director of alternative investments at FRC. “Yet we have seen a tremendous amount of interest in these types of products.”
Overall returns have been solid. One sizzling performer: the CGM Focus Fund, with $732 million in assets. It sells short, does not use options and, thanks to shrewd stock picking, has generated an average annual return of 24.4 percent over the five years ended May 31.
“The mutual fund format makes hedging techniques attractive to investors,” says Harindra de Silva, president of Analytic Investors, a Los Angelesbased adviser with $4.7 billion in assets under management and two funds, with a total of $48 million, that mimic hedge funds. “You get transparency, and you know it gets priced in an unbiased way.”
Financial advisers and brokers market these mutual funds as an appropriate vehicle for realizing gains uncorrelated with the broader equity market. But they can be a tough sell to the average retail investor.
“Retail investors have not been ready for the premise that is underlying these hedgelike mutual funds: You invest uncorrelated to the market and gain some,” says Avi Nachmany, director of research at Strategic Insight, a New York research firm.
The biggest funds in the category include Westchester Capital Management’s Merger Fund, with $1.8 billion in assets. By arbitraging M&A stocks, the fund has notched an average annual return of 7 percent over the five years ended May 31. That bested the 1.5 percent return for the Standard & Poor’s 500 index over that period but trailed the 9.6 percent average annual return of Hedge Fund Research’s fund-weighted composite index.
Other leading players include $1.6 billion-in-assets Gateway Fund, which sells indexed call options and buys indexed puts but does not short; it has returned an average annual 3.4 percent over the past five years. FMI Focus Fund, with $1.2 billion under management, goes long-short on small- and midcap stocks and uses leverage and options; it recorded an annualized gain of 14.6 percent over the five years ended May 31. One Group Investments created its Market Neutral Fund last year after financial advisers asked for a long-short product to sell to their clients. With $775 million in assets, the fund has returned 2 percent through May of this year, versus 1 percent for the S&P 500.
Management fees for mutual funds that hedge run about 125 basis points, compared with 80 basis points for the average equity fund. Minimum investments range from $1,000 to $5,000. Unlike hedge funds, however, these funds do not claim any share of the returns they generate. Hedge fund managers typically charge 100-basis-point management fees and take 20 percent of any portfolio gains. To invest in a hedge fund requires a net worth of at least $1 million or an income of more than $200,000 for each of the past two years.
Until 1997 mutual funds were restricted in their use of hedging techniques by the so-called short-short rule. A provision of the Internal Revenue Code dating to 1936, this rule stated that a mutual fund that generated more than 30 percent of its gross income from gains on short-term positions had to pay ordinary income taxes on all of its gains. As a result, most mutual funds avoided relying on hedging techniques to boost returns for fear of triggering a tax hit. The rule was repealed by Congress with the Taxpayer Relief Act of 1997, clearing the way for this new class of mutual funds.
But as the bull market was roaring in the late 1990s, absolute-return or market-neutral strategies seemed unnecessary to many mutual fund investors, who were making a killing in equities. Then, of course, the bubble popped.
“Back in the ‘90s, investors were not concerned about the downside, because there was very little of it,” says Robert Straus, manager of Icon Funds’ Covered Call Fund, which has $33 million in assets. “Now there is clearly more sensitivity to the volatility and inherent risk in owning equities. It’s natural to see demand for more hedge-oriented funds.”
Greenwood Village, Coloradobased Icon, which has $2.8 billion in assets under management, created its Long/Short Fund in October 2002. Assets had hit $16 million as of May 31.
In last year’s bull run, less than 1 percent of Icon’s Long/Short Fund positions were shorts; the portfolio returned 38 percent. As of April 30 about 14 percent of the positions were shorts and the fund had generated a 6 percent return year-to-date, easily outpacing the S&P’s slight loss of 0.42 percent.
“It’s beneficial to have these products in sideways and downward markets,” says J.C. Waller, the fund’s portfolio manager.
Laudus Rosenberg Value Long/Short Equity Fund, a market-neutral fund with $148 million in assets, typically goes long one stock and shorts another in the same industry sector. “We want to be truly market neutral,” says William Ricks, chief investment officer of $42 billion-in-assets Axa Rosenberg Investment Management, an Orinda, Californiabased subadviser to the Laudus Rosenberg Funds. “We want to have the ability to make money no matter what the market does.”
In 2001 the fund clobbered the S&P by 24 percentage points; it did even better in 2002, when it beat the index by 50 percentage points. Last year, though, with the S&P up 28.7 percent, the fund trailed by 35 percentage points, taking a 6.3 percent loss. Over the past five years, the fund beat the S&P by an average of 8 percentage points a year.
ProFunds UltraBear ProFund, an index fund, uses short swaps and S&P 500 exchange-traded funds to mimic twice the inverse return of the index. In 2002 the $117 million-in-assets fund gained 38.1 percent; last year it lost 44 percent. Not every investor can stomach such volatility, of course. Still, suggests William Seale, chief investment officer at Bethesda, Marylandbased ProFunds, which oversees $6 billion in assets, “an investor can use the UltraBear fund to hedge a portfolio of other mutual funds.”
In addition to shorting stocks, mutual funds may also sell covered call options. The Icon Covered Call Fund writes calls against at least 80 percent of its portfolio at any time. Icon managers make industry bets, selling what they see as overpriced sectors and buying undervalued ones.
Since its debut in October 2002, Icon Covered Call has yet to prove itself. The fund slightly trailed the S&P last year with a 27 percent return and lagged the index by 0.9 percentage points as of mid-June. This is because it has underweighted the strongly performing energy sector and received lower premiums from the market for selling options.
Many funds selling covered calls are no longer seeing the high premiums they enjoyed in early 2003, before the market rebounded. Premiums are related to the level of the volatility index of the Chicago Board Options Exchange. The VIX, which is based on real-time S&P 500 index options prices and reflects investor expectations of stock market volatility over the next 30 days, hit an eight-year low of 12.89 in April. It climbed above 20 in early May, signaling heightened investor expectations of market volatility and, arguably, higher premiums to come.
Some funds, such as Analytic Investors’ Defensive Equity Fund, short stocks but also use covered call options to bring their portfolios’ beta down to 0.3 in bear markets and 0.5 in bull markets. (A fund with a beta of 1 will generate the same return as the overall market.) Although gains are limited relative to the market, so are losses, and that approach makes the most sense over the long term, says Analytic Investors’ de Silva.
It’s hard to quarrel with Analytic’s results: Over the past five years, the Defensive Equity Fund has outperformed the S&P 500 by an average of 400 basis points annually. That’s a performance that both the rich and the not-so-rich investor can appreciate.
