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Hedge Fund Strategies, at Smaller Prices

Date: Monday, January 11, 2010
Author: Conrad de Aenlle, The New York Times

The lure of hedge funds was always their mix of mystery, complexity and exclusivity. In this post-bear-market, post-Madoff world, though, the cachet belongs to investments that are clear, simple and easy to buy and sell.

Acknowledging that their customary aloofness is bad for business when their potential client base is being standoffish, too, many hedge fund providers are making their strategies available to small investors as mutual funds. As little as $1,000, or even less for certain retirement accounts, can buy access to such financial exotica as long-short equity and bond portfolios, merger arbitrage and commodity futures.

This democratization of the hedge fund industry “is the hottest thing in the mutual fund space right now,” said Nadia Papagiannis, an alternative-investment strategist at Morningstar, the fund researcher. The term “alternative” is often used to describe hedge fund strategies, which seldom involve straightforward ownership of stocks or bonds. Morningstar tracks nearly 350 such funds, about half of which were introduced in the last two years. Last year through October, net investment totaled about $10 billion, Ms. Papagiannis said, nearly twice as much as in the record year of 2006.

Many of the funds have yet to establish track records that would indicate whether shareholders have put their money in the right place, but investment advisers find encouragement in the performance histories of some older mutual funds that use alternative strategies. Returns are often uncorrelated with conventional market benchmarks, they say, and that can help reduce portfolio volatility and, therefore, risk.

Most hedge funds are limited partnerships, and, until recently, many firms would have considered it fruitless to offer hedge funds in a mutual fund format. The need to set daily prices and adjust to an asset base that continually fluctuates can make mutual funds unwieldy to manage, especially when using complex trading strategies or dealing in esoteric instruments that can’t be readily bought or sold.

The costs involved in complying with more stringent regulatory requirements can make mutual funds comparatively expensive to operate, too, while the fees they generate can be much lower. Mutual fund shareholders would balk at the 2-and-20 arrangement common among hedge funds — a 2 percent annual management fee plus 20 percent of any gain over the return of an agreed benchmark. Annual fees for mutual funds that use hedge fund strategies generally run between 1 and 2 percent.


FUND providers are making the move because their best clients, including wealthy individuals and institutions like university endowments and charitable foundations, are demanding it.

“Hedge funds are having difficulty raising assets,” said Andrew Rogers, president of Gemini Fund Services of Hauppauge, N.Y., which provides administrative and other functions for fund management companies. “If you can’t sell to your usual customers, you have to do other things.”

Broadmark Asset Management of New York came to that conclusion in 2008 and converted its hedge fund, which uses exchange-traded funds to bet on a rising or falling stock market, into the Broadmark/Forward Tactical Growth mutual fund.

During the turbulent market conditions, shareholders of many hedge funds could not sell as a result of so-called gates, or clauses in the contracts that allowed managers to postpone meeting investor requests to cash out. Ricardo L. Cortez, Broadmark’s president of global distribution, said that prospective investors were reluctant to put themselves in a position where the same thing could happen to them.

Many funds and their shareholders “thought they had very liquid investments, but when push came to shove, people couldn’t get their money out,” Mr. Cortez said. “A lot of investors, as a result, said, ‘If I could get access to your fund with daily liquidity as a mutual fund, I’d be happy to take a look at that.’ We took a look at our strategy and said it would lend itself well to a mutual fund structure.”

Turner Investment Partners of Berwyn, Pa., made the same evaluation and last spring created Turner Spectrum, a mutual fund employing several stock trading strategies used in its hedge funds. Where Broadmark abandoned its hedge fund partnerships altogether, Turner runs both types of vehicles.

“For people coming off the plunge, a mutual fund gives them a feeling that they have control over their assets,” said Matthew Glaser, Spectrum’s lead manager. “With daily liquidity and daily pricing, you can see how your investments are doing.”

So just how are they doing? Long-short funds like Spectrum have underperformed the broad stock market by a fairly wide margin this year, but that’s what is supposed to happen.

These funds buy some stocks and sell others short. (This is what hedge funds did when they were invented decades ago, and it’s where the name comes from.) With limited net exposure to the stock market, they seldom outperform in strong bull markets or lose much in bear markets.

“These types of investments generally offer more stable patterns of returns,” said Louis P. Stanasolovich, president of Legend Financial Advisors in Pittsburgh. “They generate positive or nearly positive returns when the stock market is negative but won’t necessarily do well when the market is up.”

He is a fan of funds using alternative strategies, especially Caldwell & Orkin Market Opportunity and Hussman Strategic Growth, which can take long and short stock positions. Another favorite is Rydex/SGI Managed Futures Strategy, which provides access to commodities and financial derivatives.

These types of funds are considered most useful in concert with other investments. Owning one can reduce the volatility of a broad portfolio without a corresponding reduction in returns, said Ms. Papagiannis, the Morningstar strategist.

A portfolio of index funds, 60 percent in stocks and the rest in bonds, gained 4.06 percent a year during the six years through September, she said. An allocation of 40 percent each to stocks and bonds and 20 percent to the JPMorgan Market Neutral fund, one of the oldest mutual funds using an alternative investment strategy, would have achieved a higher annualized gain, 4.52 percent, with much gentler swings.

Substitute Hussman Strategic Growth for the Morgan fund and the portfolio’s return would have been 4.20 percent a year, also produced with less volatility than the index fund portfolio, Ms. Papagiannis said.

“These are diversification tools, they’re not supposed to be the core holding in a portfolio,” she explained. “They’re supposed to perform when everything else is not, and they’re not supposed to lose much in the meantime. They’re good at protecting wealth, and often the best way to build wealth is not to lose it.”