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A Tale Of Two Hedges

The hottest topic in investing today is undoubtedly that of hedge funds.  Exciting and enigmatic, hedge funds have become the buzz of nearly every investment symposium or trade show the world over.  But why all the fuss?  Is it because of sub-par equity returns in the past few years?  Or is it due to the purportedly superior risk/reward profiles boasted by hedge funds?  Or is it perhaps their limited access?

Whatever the cause, it is safe to say that hedge funds have earned a permanent place in the financial vocabulary of most investors.  The world of investments is often surrounded by a “stock of the week” mentality, a short-term mindset.  Yet hedge funds are not just a fashionable fad.  In fact, a diversified group of hedge strategies has historically produced equity-like returns, but with substantially less market risk.  In fact, over the past ten years hedge funds have produced similar positive results as the S&P 500 yet at less than half the risk.  It cannot be forgotten that this time period encapsulated one of the greatest domestic large-cap bull markets in history.

While the benefits of hedge strategies may no longer be in question, investors still have difficulty implementing them in their portfolios.  Typically, a hedge fund in a limited partnership format requires investors to be “accredited.”  This means that the individual investor must have a $1 million net worth or earn an annual salary of over $200,000.  To be certain, this is not the profile of the average investor.  This begs the question; how does the average investor use hedge tactics in his or her portfolio?  Perhaps more importantly, if they do find a means of doing so, are they giving up performance to the “accredited” elite?

We contend that the most suitable alternative to limited partnership hedge funds is a mutual fund that uses hedge fund techniques.  These of course are not your run-of-the-mill mutual funds.  Just like their hedge fund limited partnership cousins, they employ strategies like global macro (a hedge fund name for tactical asset allocation) market neutral, long/short equity, announced merger arbitrage and convertible arbitrage, to name a few.  While the jury is still out on long-term performance differences between the two formats, the mutual fund does offer some distinct advantages.  Some of the differences are outlined below:

 

Private Hedge Fund

Mutual Fund (Hedge-like Strategy)

   

Aggressive Use of Leverage

Sometimes

No

Diversified

Often Concentrated

35-100 Positions

Fees

2-3% + 20% Performance

0.80 to 2.50%

Regulation

Little or None

Closely regulated by the SEC

Daily Pricing

Infrequently

Yes

Daily Liquidity

Almost Never

Yes

Transparency

Rare

Yes

It is no secret that many of the most talented portfolio managers have begun a migration toward the hedge funds (limited partnership format) arena.  This will put a premium on talented mutual fund mangers who can implement these hedge type strategies.  However, they do exist and in fact many of these same managers run both types of funds.  By and large, non-accredited investors are better off with these mutual hedge funds in their portfolio than without.  What follows is a comparison between hedge strategy indices, as provided by CSFB Tremont Hedge World, and sample mutual fund performance of funds that are comparable to the strategies employed by the hedge funds (Data per Morningstar as of January 31, 2004).  The results may surprise you. 

Without question, there are biases in these types of examples.  Primarily, the funds selected for comparison are identified as some of the best in their class.  Yet the results are positive enough to warrant consideration.  We continue to believe that investors can use these hedge-like mutual funds to reduce their portfolio risk and increase their long-term performance.

For further information, contact Louis P. Stanasolovich, CFPÔat (412) 635-9210 or e-mail him at legend@legend-financial.com.



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