- inverse, and
- tender offers, and
- leveraged buyouts.
Hedging Your Portfolio With Mutual Funds
by John Markese
Its difficult these days to avoid reading about hedge funds, whether the headline is calling for more hedge fund regulation, trumpeting stellar hedge fund performance or sounding the alarm about a hedge funds fraud.
Hedge funds have an exotic allure for many investors, but also a mysterious, unsettling side and investors have to jump through the right hoops in order to get in.
Mutual funds, in contrast, have a more comfortable and accessible structure for all investors—there are no lock-up periods, most do not have high minimum investments, typically their fee structures are not expensive, and there are no investor income and net worth tests. Mutual funds also come with a readily available, transparent history of performance for analysis and comparisons.
But are there any mutual funds that also have that siren song of hedge funds?
It turns out some mutual funds dotheir tactics and strategies mirror those of hedge funds, but they are encased in a familiar mutual fund structure.
Mutual funds that have hedge fund traits may have a place in your portfolio, some providing increased risk reduction through diversification and sometimes outright, real hedging.
Despite the term hedge in their name, many hedge funds do not hedge risks with offsetting investments. In fact, some actually place big investment bets that are totally unhedged. Other hedge funds use hedging strategies and other techniques that are designed to reduce risk.
These differences in risk approach are mirrored in the mutual funds that follow hedge fund strategies. There are three types of hedge fund strategies that are used by these mutual funds:
Long-Short Mutual Funds
These funds take long positions in stocks they feel are undervalued, and borrow shares and sell short stocks they feel are overvalued. The hope is that the shorted shares will decline in price, and they can cover the short position by buying back and returning the borrowed shares, thereby making a profit on the price decline.
A long-short mutual fund does best when its long stock positions rise and its short stock positions fallalthough there is no guarantee, of course, that this will happen. Not all long-short mutual funds are alike, however, when it comes to risk. Some long-short funds employ a strategy that is termed market neutral whereby long and short stock positions are matched to emphasize returns from stock selection while minimizing the returns from broad market movementsa low-risk approach. Other long-short mutual funds will weight long and short positions based upon forecasts of market movement, a high-risk approach.
One risk measure that is useful in capturing the risk characteristics of any fund, but is particularly useful to distinguish between risk-neutral and more aggressive long-short funds, is beta. Beta is a measure of market riskhow volatile an investment is relative to the overall stock market. The beta of the overall stock market is 1.00 and a mutual fund with a beta of 2.00 would indicate that the fund has twice the volatility and risk of the market. Betas can also be negative. For example, a mutual fund with a 1.00 beta is just as volatile as the overall stock market, but the funds returns move opposite to the markets returns.
Aggressive long-short mutual funds would be expected to have betas that were positive and greater than 1.00.
Market-neutral, long-short funds would be expected to have betas near zero or even slightly negative, providing significant potential portfolio diversification benefits.
Inverse Mutual Funds
Inverse funds live up to their category name by moving in the opposite direction as the underlying stock index they are designed to track.
By using short selling and derivatives, such as futures and options contracts, inverse mutual funds go up when the underlying index falls, and fall when the index rises. The only question is the magnitude of relative inverse return movement, and that is answered, again, by looking at a funds beta.
Beta is calculated against the Standard and Poors 500 index, so an inverse fund investing in the S&P 500 would be expected to have a beta of 1.00. An inverse fund investing in a more volatile index than the S&P 500the NASDAQ 100, for examplewould carry a greater negative beta than 1.00. And some inverse funds double the inverse return through derivatives and leverage. A double inverse S&P 500 mutual fund would have a beta close to 2.00.
These inverse funds, often termed bear funds, offer the ability to create a true hedge or make a diversified investment to match a bear market expectation. If you have an investment in a mutual fund that tracks the S&P 500 and you are concerned that the market will decline in the short term but you do not want to liquidate your investment, then a simple hedge would be to invest equal dollars in an inverse S&P 500 fund.
If you choose to invest in a double inverse S&P 500 fund, you would need to invest only half the dollars that you have invested long in the S&P 500 mutual fund as a hedge, because the double inverse fund has a beta of 2.00it will lose twice the amount of a standard index fund when the index rises and will gain twice the return of the index when the index declines. However, while this hedge is in place your expected return is negative due to the expense ratios of the regular and inverse index funds. A regular index fund might have an annual expense ratio of around 0.25%, but inverse index fundsbecause of their more complex constructionmay have expense ratios closer to 1.50% annually. If the inverse fund doesnt invest in an index but simply shorts stocks, the expense ratio could approach twice the inverse index fund expense ratio.
Because expenses are incurred with the hedge and returns are perfectly offset, it makes no sense to hedge for other than short-term periods. In the long term, the hedge would be a guaranteed negative return equal to the combined expense ratios.
Merger-Arbitrage Mutual Funds
Merger-arbitrage mutual funds target the stock of firms in announced situations that include:
Normally, the risk of investing in these situations is that the activity is not completed, leaving the merger-arbitrage mutual fund holding stock that was previously valued on the basis of a closed deal.
In all, these arbitrage situations are not generally sensitive to overall market movements and the majority are accomplished. The risk, as measured by beta, for the merger-arbitrage funds is usually relatively low and not highly correlated with the market, providing portfolio diversification benefits.
Table 1 provides performance and related data on mutual funds, grouped by approach, that have characteristics of hedge funds or can be used to create hedge fund situations.
Annual rates of return over five years are worth a look to develop an intuitive feel for the behavior of a fund over different market environments.
Comparison of year-by-year returns to a market benchmark gives added information, and at the bottom of Table 1 return statistics for the S&P 500 are provided.
Baron Partners, a long-short mutual fund that was formerly a hedge fund, has only two full years of performance data, so it is difficult to judge how the fund might act in a different market situationa significant bear market, for example. Its standard deviation of 13.0 versus 7.8 for the S&P 500 indicates relatively high volatility, however.
Standard deviation is a measure of variation in fund return from all sources. The higher the standard deviation, the greater the total risk. Beta measures only relative market risk, not total risk, and is most useful as a measure of volatility for well-diversified portfoliosby definition, portfolios that have diversified away all risk but market risk.
Because Baron Partners mutual fund is not a market-neutral long-short fund but an aggressive long-short fund, its beta of 1.24 reflects its higher market risk.
The Rydex Inverse Dynamic S&P 500, a double inverse index fund, is the most volatile of all these hedge-like funds with the highest standard deviation (15.3) and the highest absolute beta (1.95). A glance at its year-to-year annual returns confirms its risk.
In contrast to Baron Partners, the Laudus Rosenberg Value Long Short Equity fund is a long-short fund that is close to market neutral. Its risk measures confirm the funds strategy with a standard deviation of 5.5 and a beta of 0.07.
Hedge funds have high expenses due to the nature of their investment strategies and most of these mutual funds in Table 1 carry on that trait. Even the inverse funds that base their strategies on indexes have far higher expense ratios than those of index funds (which are routinely close to 0.25%). The return figures incorporate expenses, but very high expense ratios are hard to overcome except with higher risk strategies.
For stock mutual funds, expense ratios above 1.50% are considered high. The Leuthold Grizzly Short fund is double that number at 2.94%.
While these funds are usually not thought of as producing significant income yieldincome distributions relative to average net asset valuesome have significant income yield compared to average stock mutual funds. The yield generally is earned on cash positions held from short selling or employing the leverage inherent in options and futures to maintain equivalent stock index positions with remaining funds held in cash accounts generating yield.
Another statistic to keep in mind is the tax-efficiency rating. A tax-efficiency rating of 100% implies the ultimate in efficiency. The lower the number the less efficient and the more the tax consequences.
Many of these hedge-fund look-alikes employ strategies that generate net short-term capital gains that are taxed at ordinary marginal tax rates if not sheltered. The inverse funds will normally be the most tax efficient funds, and the merger-arbitrage and aggressive long-short funds will be the least tax efficient funds.
Funds rated low in tax efficiency are best held in sheltered accounts such as IRAs, 401(k)s, 403(b)s and other such accounts.
Testing the Hedge Fund Waters
If you are tempted by the hedge fund mystique but want the far simpler and more flexible structure of a mutual fund, the funds listed in Table 1 offer a variety of ways to dip your investment toe into the hedge fund waters. Table 2 includes a description of the funds objectives.
Some of these funds will provide diversification and reduce overall portfolio risk. Some funds will offer an opportunity to hedge existing fund holdings or make an investment tuned to a bear market forecast. And some funds will offer high-risk and potentially high-return investment opportunities. But if there was ever a group of funds where a thorough reading of the prospectus was more required before investing, I have yet to see it.
|Hedge Fund Mutual Funds: Their Objectives|
Non-diversified; seeks capital appreciation by investing in long and short positions primarily in U.S. securities; may borrow an amount totaling up to one-third of its assets.
Caldwell & Orkin Market Opportunity
Market-neutral fund that seeks long-term capital growth with short-term focus on capital preservation. Portfolio divided among long and short stock positions, and money market/fixed income securities; may hold up to 60% of net assets in short positions at any time.
ICON Long/Short I
Seeks capital appreciation by investing long in undervalued stocks and short in overvalued stocks.
Laudus Rosenberg Value Long Short Equity Investors
Market-neutral fund that seeks to outperform its 90-day T-bill benchmark by investing long in undervalued small and mid-sized U.S. firms and short in overvalued small and mid-sized U.S. firms.
Seeks capital appreciation through short sales of stocks when overall market valuations are high and through long positions in value-oriented stocks when overall market valuations are low, based on the dividend yield of the S&P 500.
Schwab Hedged Equity Investors
Seeks long-term capital appreciation with lower volatility than the broad market by investing in long and short positions in U.S. stocks with market caps over $1 billion.
Leuthold Grizzly Short
Seeks capital appreciation, principally by selling stocks short; follows a universe of U.S. stocks greater than $1 billion in market cap and with over $6 million in daily share-trading value.
Rydex Inverse OTC (formerly Rydex Arktos Investors)
Seeks to match the inverse of the NASDAQ 100; engages to a significant extent in short sales, stock futures contracts and options on futures contracts and stock indexes, and may enter into swap agreements.
Rydex Inverse Dynamic S&P 500 (formerly Rydex Dynamic Tempest 500)
Seeks to match 200% of the inverse of the S&P 500 index; engages in short sales of securities and investing in leveraged instruments, such as equity index swaps, futures contracts and options on securities, futures contracts, and stock indexes.
Rydex Inverse S&P 500 (formerly Rydex URSA Investors)
Seeks to inversely correlate to the S&P 500; invests to a significant extent in short sales of stocks or futures contracts and in options on securities, futures contracts, and stock indexes and may enter into swap agreements.
Seeks capital growth by engaging in merger arbitrage; invests at least 80% of its net assets in U.S. and foreign stocks that are involved in publicly announced mergers, takeovers, tender offers, leveraged buyouts, spin-offs, liquidations and other corporate reorganizations.
Seeks to achieve attractive total returns in various market conditions without excessive risk of capital loss; invests in value-oriented stocks and convertibles, and U.S. Treasury bills, and uses certain arbitrage strategies.
Seeks capital growth by engaging in merger arbitrage; invests at least 80% of its assets in stocks of companies that are involved in publicly announced mergers, takeovers, tender offers, leveraged buyouts, spin-offs, liquidations and other corporate reorganizations.