Tuesday, August 4, 2009

WSJ: Mutual Funds Try "Hedge" Approach in Effort to Trim Stock Losses

Well, it appears I was ahead of my time - as we began the site in late summer 2007, we were hoping to exploit a completely under served niche in the mutual fund world upon our eventual birth. Keep in mind that time was an era of butterflies, unicorns, and green shoots (before green shoots were fashionable). So absolute return strategies were not exactly in vogue - nor were they during the roaring bull of 83 to 99 where holding cash was wrong, throwing darts at the stock market generated nice returns, and everyone was pretty darn smart. However, with markets down 30-40% since summer 2007 and mutual funds, in general failing investors miserably the past decade [Feb 5, 2009: Mutual Funds Have a Tough Decade] it appears my "movement" is gaining fans. Unfortunately with 130 some "hedged" mutual fund offerings now, and 60ish of recent vintagee (versus of many thousands of 'long only' of course) they are siphoning off future clientele! Bah.

  • For years, hedge funds have been a gated community for investors. Limited to millionaires and institutional investors, the investment vehicles boasted fancy, complex strategies often designed to protect against market losses, charged lofty fees and imposed lock-up periods for the privilege.
  • Some hedge funds fell short last year, tarnishing the allure of these exclusive portfolios and leading some hedge-fund managers to liquidate their funds. Still, while the broad market fell 39% in 2008, the average hedge fund lost just 20%. And that has made mutual-fund investors and companies more interested in hedge-like offerings for the average Joe.
  • Almost half of the 132 hedge-like mutual funds on the market have been launched since 2006, according to investment-research company Morningstar Inc.
  • Some sell stocks short—that is, they sell borrowed shares, in hopes of buying them back at a lower price—and use the proceeds to add leverage to a traditional portfolio. Others use arbitrage, trying to profit from a price difference between similar securities. Some deal exclusively in complex options, while others just try to ape the returns of the broader universe of hedge funds.
  • Many strategies come into play, but the pitch for most is aimed squarely at investors spooked by the crash: They tout the potential to make money regardless of what the stock market does.
  • The funds have $41.3 billion in assets, and investors have invested more money every year for the past three years, according to Morningstar. That includes 2008, when shareholders sold more than $100 billion of shares in their stock funds.
  • “These are strategies that should have been offered to retail investors a long time ago,” says Nadia Papagiannis, an analyst who covers alternative asset classes for the firm. (Morningstar)
  • Still, few suggest these new strategies will be a panacea. Though less expensive than true hedge funds, they tend to be more expensive than a regular stock fund. The average “long-short” fund, for example, which both buys stocks and sells others short, charges more than 2% a year, or 50% more than a typical stock fund.
The article than goes into 3 main strategies (1) Market Neutral (2) Long-Short and (3) Arbitrage. I'd describe my strategy [Investment Strategy] mostly long-short (with a touch of market neutral), so we'll just bring in that section from the WSJ piece.

Here is how the first 2 strategies have done of late, with the caveat that there are a limited amount of funds practicing each with wide variance in how they actually implement the strategy.... i.e. I run a high turnover, aggressive strategy whereas another long-short might be fully invested with little turnover. In theory arbitrage should be the lowest risk, lowest potential return, with market neutral in the middle, and long-short really in the hands of the manager (most risk, most reward)
  • Market Neutral: Over the 12 months through July, the average return for market-neutral funds was a negative 2.5%, according to fund tracker Lipper Inc., with individual fund returns ranging from a 13% gain to a 22% loss. (large discrepancy from best to worst)
  • Long-Short: The average long-short fund returned a negative 20% over the past year, according to Lipper. Results ranged from a 26% gain to a 43% loss. (notice the HUGE discrepancy from highest to lowers in this group - some 70%!)
More about the Long-Short below...
  • Long-short funds also buy—or go long on—stocks they like, and short other stocks. But they generally try to outperform the market, not reduce the effects of its volatility. That means more risk.
  • For instance, long-short funds known as “130-30” funds short stocks valued at about 30% of fund assets, and use the cash to buy other stocks, which allows them to invest about 130% of the portfolio’s value in the market. (Combining those long and short exposures, such funds on a net basis are 100% invested in stocks.)
  • Other long-short funds stay flexible on their target balance between bullish and bearish calls. In other words, one of the two positions, long or short, can be as much as 50 percentage points larger than the other. When the managers think the markets will rise, they’ll hold more long positions relative to the stocks they’ve sold short; when they think the markets will tumble, they’ll do the reverse. (parallel to our strategy)
  • A long-short strategy only works if the manager’s stock picks, in both directions, are accurate. But there’s added risk here: If the stocks that the fund shorts go up instead of down, the potential for loss on the short positions is unlimited. (true, but only if you allow it to be and don't have risk controls in place)

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