Hedge-fund envy

Date: Monday, March 19, 2007
Author: The Economist

Mutual funds borrow a few ideas from hedge funds

MUTUAL funds are the familiar, unexciting face of stockmarket capitalism, the financial product of choice for millions of investors. But a growing number of mutual-fund managers, including some old hands, are now borrowing investment strategies from the smaller, younger and sharper world of hedge funds.

Even the names of their products are being spiced up: Global Alpha Edge, a new fund offered by State Street Global Advisors sounds like it was dreamt up by a hedge fund. In fact, it is a mutual fund employing a “130/30 strategy” (a blend of long and short positions, betting that certain stocks will rise and a select few will fall) allowed under new European rules.

Todd Trubey of Morningstar, a rating agency, distinguishes three sorts of mutual funds that show hedge-like characteristics. Some funds, which describe themselves as “market-neutral”, aim to make money in bad times as well as good. But it is hard, Mr Trubey says, to wring worthwhile returns from such a strategy without the leverage hedge funds use.

A second, far more ambitious strategy is the “equity long-short” approach. This involves bets on the direction of individual stocks. Shorting stocks—betting they will lose value—is a dicey game that can pay handsomely for some and fail miserably for others.

Other products offer the “fund-of-funds” approach, which combines a number of strategies in a single product. Some invest in a range of hedge funds. In others, mutual-fund managers get access to special accounts set up for them exclusively by hedge-fund managers, offering exposure to some of their strategies without all of their leverage.

Unfortunately for investors, this financial engineering comes at a price. The notoriously juicy fees earned by hedge funds are creeping into the mutual-fund world as well.

Thus far, these racier products account for only a tiny share of the $20 trillion invested in mutual funds (see chart). They were inspired in part by the stockmarket collapse earlier this decade, which did not stop hedge funds showing strong returns. But ironically, they are emulating hedge-fund strategies just when overall returns to that asset class are falling.

Moreover this cross-pollination can go only so far, since the two sorts of funds appeal to different audiences and thus play by different rules. Governments want a tight regulatory leash on mutual funds, which are geared to individual investors, many of them saving for retirement. They must continually disclose information, they face restrictions on borrowing and they must typically hold a relatively liquid mix of assets (although Europe's regulators are beginning to allow freer use of derivatives, for instance). In contrast, hedge funds target institutional investors and the ultra-rich and so are free to invest creatively, change course quickly and leverage their bets heavily. Unlike mutual funds, though, they cannot market themselves to the general public.

Politicians, as well as punters, will determine the success of both kinds of funds. In the European Union, the UCITS III directive (Undertakings for Collective Investment in Transferable Securities) is meant to give mutual funds more freedom to invest. But it is being implemented at different speeds and in different ways in various countries. In France and Spain such funds are widely accepted; in Germany they are much less popular. Meanwhile, in America congressional hearings on both mutual funds and hedge funds are underway, including a proposal to limit access to hedge funds to investors with at least $2.5m to their name. Hedge funds may enjoy great freedom to pursue whatever strategies they like. But they must envy the freedom of mutual funds to chase any customer they choose.