Hedge Funds Hiding in Mutual Funds

Ann C. Logue | Jan 14, 2008 12:00am EST | Comment

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Hedge funds have been private investment partnerships for two reasons: some fund managers and investors liked the lack of scrutiny, and the SEC restricted the marketing of funds to people who were not considered to be accredited investors (meaning they have a net worth of $1 million or an annual income of $200,000.) Many of the best-performing hedge funds are able to set very high minimum investments, in the millions of dollars, which means that they are closed to even most accredited investors. But just because you can’t get into a hedge fund doesn’t mean you can’t obtain similar strategies through mutual funds.

Hedge funds fall into two broad categories: absolute return and directional. An absolute return fund tries to offer a steady profit no matter what the market does. This return is usually higher than the return on bonds but lower than the return on stocks. It’s designed to be a core part of the portfolio. A directional fund has exposure to the market and it is designed to offer a higher return based on the amount of risk that it takes. (Some directional funds beat the stock market indexes handily.) An index mutual fund would offer a pure directional return, designed to match the market in both risk and return.

Many mutual fund investors are able to mimic an absolute return strategy through good diversification; others look for a directional return through investments in small-cap and technology funds. There are also several mutual funds that try to copy hedge fund strategies explicitly, as well as hedge funds that are structured as closed-end funds rather than private investment partnerships. The bottom line is that there is nothing magical about the private partnership structure; investors can profit from hedge-fund strategies without being in a hedge fund.

Bear funds are designed to make money when the market goes down. These are not the same as funds that hold up well in bad markets; instead, the portfolio managers look at what the market is doing and then do the opposite. These funds often have a huge short component, meaning that the fund managers borrow stock and sell the borrowed shares, hoping to buy the shares back cheap when they go down in price. These funds can be a nice hedge in a diversified portfolio. Two of the many bear funds out there are Prudent Bear (BEARX) and the Grizzly Short Fund (GRZZX). (Yes, mutual funds are allowed to short stocks; the tax laws that once restricted short selling were repealed about a decade ago.)

Long-short funds are designed to generate absolute return by owning (being long) stocks that are expected to go up and shorting stocks that are expected to go down. Many fund managers look at specific industry groups and buy shares in the company with the best prospects and short shares in the company with the worst prospects: think J.C. Penney Company, Inc. (NYSE: JCP) versus Sears Holdings Corporation (Nasdaq: SHLD). This was the traditional hedge fund investing style and several mutual funds follow it, among them Diamond Hill Long-Short (DIAMX) and Templeton Global Long-Short (TLSAX).

Closed-end hedge funds are hedge funds that do not issue more shares, but the shares that are already issued trade freely on stock exchanges, just as do shares in a closed-end mutual fund. Anyone with a brokerage account can buy shares in these funds, which include KKR Private Equity Investors (Amsterdam: KPE.AS) and Greenlight Capital Re (Nasdaq: GLRE). Rumor has it that more will be going public, because the closed-fund structure gives the fund managers a reliable capital base. These are not the same as hedge fund management companies, a few of which are also publicly traded.

And, believe it or not, there are a few open-end hedge fund mutual funds. The manager of the Alpha Hedged Strategies Fund (ALPHX) and the Beta Hedged Strategies Fund (BETAX) allocates money to hedge fund managers. The money is kept in separate accounts, not in the hedge funds themselves, but it is managed in the same way. The assets are priced daily and the leverage is determined by the fund manager.

The downside of all these mutual fund/hedge fund hybrids is that the fees can be a lot higher than with traditional mutual funds. But if you want a piece of the action or are looking for ways to diversify, it might be worth it.