Mutual Funds Using Hedge Fund Strategies ~ market folly

Thursday, May 14, 2009

Mutual Funds Using Hedge Fund Strategies

Typically, most vanilla mutual funds don't short stocks. They are usually long-only funds aimed at matching or beating certain benchmarks. But, over the past few years, we've seen an evolution in the arena of money management and actively managed portfolios. Case in point: We've just learned that $14 billion Turner Investment Partners is launching the Turner Spectrum Fund which aims to earn similar returns as hedge funds by employing those strategies. The fund will have two share classes: an Institutional class charging a 1.95% fee (minimum investment of $100,000) and a Retail class which will charge a 2.2% fee with a $2500 minimum. However, unlike hedge funds, these mutual funds will not charge a performance fee. (Hedge funds typically charge a flat management fee of around 2% and then a performance based fee of 20% of all profits).

Essentially, Turner is relying on their managers to create six other long-short equity strategies including: market-neutral, a financial sector, a healthcare sector, and other sector strategies. It will be interesting to monitor their progress and their performance. They've launched these funds as a way to capitalize on those investors hesitant to invest in hedge funds themselves given how the Bernie Madoff saga has scarred the industry. Keep in mind that this is not a new development on the scene. Instead, they are merely taking the ball and running with it.

Both Legg Mason and AQR Capital have mutual funds using similar hedge fund-like strategies. Also, there are many individual mutual fund managers that are shorting stocks in their mutual fund portfolios. One of the most well-known would have to be Ken Heebner, of CGM Funds. Heebner runs a very active book, turning over the portfolio numerous time within each year. And, his use of shorting definitely draws him closer to a long/short equity hedge fund strategy. He correctly shorted Washington Mutual among others in the turmoil of 2008. However, his small short portfolio was not enough to stave off massive losses in his longs. After having a rampantly successful year in 2007, Heebner came crashing down in 2008. His CGMFX mutual fund was down over 48%. Even though he was using hedge fund-like strategies, he could not avoid losses either. Interestingly enough, we've also noted that Heebner himself will be starting a hedge fund, Wayfarer Capital.

Another example of possible flaws in these hedge fund vehicles came to light when we highlighted QAI, a hedge fund strategy exchange traded fund (etf). We had numerous criticisms of that vehicle and questioned it's ability to truly replicate hedge fund performance. Instead of operating like an individual hedge fund, it seems to be more like a hedge fund of funds that combines various strategies into one collective portfolio. We'll have to check out the fine details of the Turner Spectrum Fund as well.

As a whole, the rough market of 2008 has definitely highlighted the benefits of being truly hedged to downside risk. As such, there's definitely demand from investors for vehicles that can protect them from losses and generate returns in any market. But, the aforementioned mutual funds and ETFs aren't necessarily "hedged vehicles," but rather vehicles seeking hedge fund returns. And, in 2008, hedge funds as a whole didn't perform that well, as they too suffered losses. Well, that is, except for a select few (as we highlighted in our 2008 full year hedge fund performance numbers).

Another major problem here is that they won't be able to truly replicate hedge fund strategies to their fullest extent. And, they aren't really even trying to replicate the strategies as much as they are trying to replicate just the returns. This is mainly due to the limitations and restrictions of the only vehicles they can really provide to investors: mutual funds and exchange traded funds. Sure, they are shorting like a hedge fund would. But, are they using options, bonds, notes and other means to take advantage of unique situations? Are they trading currencies or commodities? Are they turning activist on management teams to institute change? Are they running quantitative algorithms with proven performance? Surely they cannot be that precise. And, they won't be. Their goal of 'earning returns like hedge funds' is so broad and vague that it's pretty much open for interpretation. In the end, it doesn't seem like it matters how they get to the end result. As long as they 'generate returns like hedge funds,' they'll deem the vehicle a success.

While these hedge fund replication vehicles mean well, they are far from perfect. They may prove us wrong and come directly in line with hedge fund benchmarks and performance metrics. But, only time will tell and that's why we intend to monitor them. As is often the case with Wall Street, investments can be marketed differently than what they truly are. And, right now, it seems like the phrase 'hedge fund-like returns' is all the rage. Obviously a distinction will have to be made between the terminology of 'using hedge fund strategies' versus 'aiming for hedge fund returns.' The catchphrase of 'using hedge fund strategies' would more likely attempt to replicate their actual portfolios. 'Aiming for hedge fund returns,' on the other hand, is vague and implies that they will invest however they please, as long as they match the numbers they are attempting to duplicate. In the end, these vehicles are not nor will they ever be truly like hedge funds. But, given the bad year hedge funds had and the overall crazy environment, maybe that's not such a bad thing.

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