Hedge-like funds can reduce risk

Date: Friday, June 15, 2007
Author: Harriet Johnson Brackey, Chicago Tribune

Individual investors who want something more than a plain-vanilla investing plan are increasingly trying out a new option: mutual funds that use hedging strategies.

While a standard mutual fund looks for companies with good financial performance and waits for those stocks to rise, a hedge-like mutual fund flies into special situations.

It can be aggressive, betting that stocks will fall or trying to pick takeover targets.

The primary goal of hedging one's investment bets is to have positive results whether the market is up or down. When stocks are high, hedge funds may not produce impressive results.

But during big market downturns, analysts say that hedge-like mutual funds can reduce risk.

"When you really want diversification to work, of course, is when the market goes haywire. Not just the usual up and downs," said Andrew Clark, senior research analyst for Lipper Inc., a mutual fund analysis firm.

Investors are pouring lots of money into them. Assets in one of the most popular categories, long-short mutual funds, rose to more than $19 billion by March, a more than fivefold increase from $3.6 billion at the end of 2001, according to Financial Research Corp. of Boston.

By comparison, the assets of all mutual funds increased 1 1/2 times in the same period.

Until recent years, only wealthy people had access to hedge funds.

Those aren't mutual funds at all, but instead are private pools of money with few restraints on what they can invest in.

The Securities and Exchange Commission limits access to investors who have at least $1 million or a high income. The hedge fund can lock up the investors' money for two years or more. And there have been some spectacular failures, such as Amaranth Advisors LLC's collapse and loss of $6 billion in one week last year.

But with the advent of hedge-like mutual funds in recent years, ordinary investors can get into -- and out of -- this growing class of funds.

The best way for individual investors: Use a fund that combines several hedging strategies, called a fund of funds, suggests certified financial planner Jay Shein, head of Compass Financial Group in Deerfield Beach, Fla.

Hedge-like mutual funds trade just like ordinary mutual funds and can have small minimum investments.

"I look at hedge funds both as a risk-reducer and a return-enhancer," Shein said.

Clark recently studied how hedge funds and hedge-like mutual funds performed between January 1994 and December 2006.

The results showed they don't react the same way as stocks and bonds. In other words, they'll zig when the market zags.

In 2002, a terrible year for stocks, the average stock mutual fund lost almost 22 percent of its value, while long-short mutual funds lost only 0.3 percent, according to data from Chicago-based Morningstar Inc.

The most popular hedge-like fund strategies are:

- Long-short funds, which buy stocks to hold at the same time as selling other stocks short. In a short sale, the investors sell borrowed shares, expecting the stock to decline in price so they can buy the shares when they fall.

- Market-neutral, which is equally divided between long and short positions.

- Merger or arbitrage funds, which take positions in stocks of companies that could become takeover targets.

Investors should be careful about a key point: Hedge fund managers charge big fees for their feats. Typical hedge fund managers charge fees of 2 percent a year and take 20 percent of the profits.

That certainly takes a bite out of returns. And that translates to hedge-like mutual funds, as well. Fund of funds tend to have high expenses because of multiple managers.

Another negative: Hedge funds can be volatile, especially when they borrow money to make their bets on the direction of stocks, said Phil Keating of Keating Investment Management in Delray Beach, Fla.

"I don't think that they are a magic solution," he said.

But traditional mutual funds can be volatile, too.

Shein found that putting 20 percent of a stock and bond portfolio into hedge funds boosted returns only slightly, but the portfolio had about half the risk of one invested only in the Standard & Poor's 500.

The hedge fund strategies don't seem to fall as hard or stay down as long as the S&P 500.

"They tend to smooth the ride," Shein said. "I could actually make an argument that the more conservative the investor is, the more he or she should have hedge funds." ---------- Harriet Johnson Brackey is a columnist for the South Florida Sun-Sentinel, a Tribune Co. newspaper.