Is your mutual fund an overpriced long/short hedge fund?

Date: Tuesday, November 20, 2007
Author: Mark Nobel, Advisor.ca

Many investors view hedge funds as overpriced and risky playground for wealthy investors who refuse to settle for "plain vanilla" mutual funds. But hedge funds may actually be a cheaper and less volatile alternative to most equity mutual funds, according to one alternative investment expert.

Speaking at Arrow Hedge Partners' Educational Hedge Fund Summit in Toronto, Chris Holt of Holt Capital Advisors says the actively managed portion of many mutual funds resembles a long/short hedge fund.

However, this actively managed portion, which is considered mostly alpha — returns attributable to the manager, and not the market — is very small.

Holt, who writes extensively about alpha on his popular website, Allaboutalpha.com, says the majority of mutual fund returns are beta, meaning they are heavily dependent on the performance of the market. He argues most of a mutual fund portfolio could be duplicated by an index ETF at a fraction of the cost, since the ETF has a much lower management expense ratio than a traditional long-only mutual fund.

"A mutual fund is a different package of an ETF," Holt says. If you replace the beta portion of the portfolio, he adss, a picture of an embedded hedge fund starts to emerge. After removing the beta, what the mutual fund is left with consists of overweight and underweight positions that resemble a long/short hedge fund.

Regulation deters shorting in most mutual funds, but Holt argues they still tend to use underweighting in a similar fashion to shorts. Much like a short position, underweighting a stock is essentially betting a stock has an inflated market value. The key difference between a mutual fund manager who uses overweight and underweight positions and a long/short hedge fund manager is the cost to the investor.

Holt says the management fee an investor pays should be for alpha, or the manager's skill. In the case of most mutual funds, that portion is represented within the embedded hedge fund. Because the embedded hedge fund is only a tiny fraction of the mutual fund's holdings, after stripping out the beta and replacing it for what it would cost for an ETF, the management fee for that hedge fund could be as high as 10%, based on the proportion to the MER for the overall fund portfolio.

"Alpha is the essence of what you pay for in a mutual fund or a hedge fund," he says. "Why would you want to pay a 2.5% MER for an index-hugging fund?"

Using this logic, Holt says long/short hedge fund fees start to look like a bargain in comparison.

It should be noted that despite the fact you're betting against a stock in both cases, shorting can have a greater risk than underweighting. It's essentially leverage, and like all leverage, it magnifies returns as well as losses. A bad underweight position means a mutual fund misses out on greater performance. A bad short, however, means the hedge fund loses on its bet plus owes money to its prime broker. In some cases, if the short isn't panning out, hedge funds can end up in a liquidity crisis if they don't have the money to cover margin calls.

Arrow, the host of the summit, also invited the managers of some of the underlying funds held in its funds-of-funds to give presentations. Most of the managers made it clear to the audience of primarily retail advisors that their short positions were typically at a minimum. Non-accredited investors can invest in hedge funds that can short as much as 30% of the portfolios, but the vast majority of presenters had short positions of less than 10%, or none at all.

California-based hedge fund manager GPS Partners, which manages a fund in Arrow's U.S. Equity Income Fund, was actually leery of using shorts, since it invests in the emerging U.S. Master Limited Partnership market.

Steven Sugarman, a partner at GPS, says in an emerging market, which tends to have a higher level of volatility, stocks can have prices that are drastically out of whack with their underlying fundamentals, making prudent shorting difficult.

"In emerging markets, you sometimes see dislocations that are illogical," he says. "Leverage kills because dislocations can persist that are unrelated to fundamentals."

Another hedge fund, Elmwood Capital, uses shorts to minimize risk. It shorts one to two inverse correlation ETFs to reduce market volatility exposure.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com