Chapter Twelve
Hedge Funds Pigs in Mutual Fund Blankets
The Mutual Fund Beauty Pageant Begins
“I woke up with a pig in a blanket,” laments Martin Mull in his sad song of the same name. How often have your authors felt this same way, at least when reviewing our monthly brokerage statements. The underlying cause is often the same as well: “I drank enough ’til she looked good to me” Mull sings—only in our case, we were drinking Wall Street Kool-Aid. It can happen to anyone. But thanks to this Little Book, it won’t have to happen to you.
In this chapter, we are going to review some of the mutual funds that have crashed into the alternative space, running the hedge fund strategies we described in Chapters 10 and 11 inside the cozy cocoon of a mutual fund wrapper. We will list some notable ones here, sorted by hedge fund strategy, and then in the next chapter we will give you our picks. That doesn’t mean you can snooze through this chapter, though—your picks probably will be better than ours.
In theory, long/short managers have had an easy job recently. All they had to do was go short in 2008 and then go long in March 2009 and they would have made a killing. That one trade would have put them on the cover of Rolling Stone. The rest of the time they could have (indeed, should have) played golf. This trick was so simple that no one could do it. Almost all long/short funds lost money over this period.
We hate to keep quoting ourselves, but as we mentioned in Chapter 10, long/short funds are perhaps the most similar to conventional equity funds, in that they rely on individual managers’ stock picking and market timing skill. The result is that long-short equity is the most highly populated area of regular mutual funds that are running hedge fund strategies, with about 50 funds from which to choose—so far.
In an effort to give you some flavor of what owning them would be like, Table 12.1 shows their performance during terrible (2008) and great (2009) years for the stock market. Will they stand out over the next few years? We don’t know. Nearly all the funds we examined (about 50) have had negative returns lately. Maybe they will do better going forward; we wish them luck. Those listed in Table 12.1 were the best we found.
Table 12.1 Long/Short Funds—Recent Performance
It also shows their correlation (“r” being the symbol for correlation) to the S&P 500 stock index over this period. Where we are able to present these tables going forward, we will also show the performance of the relevant hedge fund specialty index in the second row of the table. In this case, we are using the DJCS (which here and everywhere and always stands for Dow Jones Credit Suisse) Long/Short Equity Hedge Fund Index.
TFS Market Neutral
TFS Market Neutral (ticker: TFSMX) acts like a long/short fund even though it calls itself market neutral, and that’s why we put it in the long/short category. It has a 0.48 correlation to the S&P 500 from 2007 to 2010. If it were really market neutral, that correlation would be closer to 0.00.
The fund has an offbeat strategy. It invests heavily in market niches like closed-end funds, insider buying, and market order imbalances. It has a high expense ratio, but then it’s not just another closet S&P 500 index fund, either. If you like it, you’ll be unhappy to learn that the fund is closed to new investors as of this writing, although advisors with clients already in the fund can get their new clients in as well.
Robeco Long/Short Equity
The Robeco Long/Short Equity (ticker: BPLEX) fund managed to do about 20 percentage points better than the S&P 500 annually over the past three years at roughly the same level of risk. That level of outperformance is good enough to get everybody’s attention (the fund is also closed to new investors but one day it may open again), but it is unlikely to continue. The manager uses a bottom-up approach, screening stocks on valuation, business fundamentals, and the momentum of fundamentals, and goes long or short accordingly. Their recent outstanding performance is in large part due to their decision to load up on unloved financial stocks in 2009.
Wasatch-1st Source Long/Short
Wasatch-1st Source Long/Short (ticker: FMLSX) brings a stock picking approach to the mid- and large-cap universe, using fundamental and technical analysis to identify companies they believe are over- or undervalued.
Highland Long/Short Equity
Highland Long/Short Equity (ticker: HEOAX) has a broad mandate. They are active stock pickers, looking to buy undervalued stocks and short overvalued ones, like everyone else, only they have done it better lately.
Quaker Akros Absolute Return
Akros (ticker: AARFX) only has about $12 million in assets, which is normally too small for us to recommend since the threshold for self-sustaining profitability in a mutual fund is probably closer to $50 million. A trade-off is that this makes it easy to purchase, since it is part of several mutual fund “no transaction fee” supermarkets at the big brokerages. It generates higher taxable income than most, making it a good candidate for an IRA. It is on Morningstar’s radar and has already gleaned a 4-star review at this early stage of its life. The manager appears to be a value investor who makes his long and short calls based on company fundamentals.
Table 12.2 gives a snapshot of the Upside/Downside Capture of these funds. That is to say, we took a look at how the S&P 500 Index performed over this period, and divided it into up months and down months, of which there were plenty of each. Then we looked at how each fund performed during the up months (Upside Capture) and the down months (Downside Capture), and then at the results combined. What we wanted to see was a high degree of upside capture, a low amount of downside capture, and as high a combined score (which subtracts the downside from the upside) as possible. That is to say, when the market was going up, we wanted these funds to be going up, and then when the market was going down, we also wanted these funds to be going up. Greedy, aren’t we? We felt that this approach was fair because long/short funds are the most similar to conventional mutual funds. We will hold fire on our evaluations until the last chapter, but we put it here in case you want to draw your own conclusions.
Table 12.2 Long/Short Funds—Upside/Downside Capture
Market neutral equity funds evenly balance their long and short holdings, leaving you with a portfolio whose entire return has nothing to do with the performance of the stock market and everything to do with the skill of the manager picking stocks. In theory, these funds would have a correlation to the stock market of zero and a beta of zero. If the manager is skillful or lucky, the fund should have a small positive return and a small standard deviation. For that reason, most of them are benchmarked not to equities but to 3-month Treasury bills. That’s about as conservative as you can get. Market neutral managers try to sterilize their funds from the important dimensions that customarily determine equity performance: size, value, sector, region, currency, and so on.
Table 12.3 shows how some of the leading contenders have stacked up lately. Notice how the hedge funds inside the DJCS Market Neutral Index melted down in the panic of 2008 alongside everything else.
Table 12.3 Market Neutral Equity Funds—Recent Performance
DWS Disciplined Market Neutral
This fund (ticker: DDMIX) ranks the Russell 1000 U.S. stocks along dimensions of price, earnings growth, and market sentiment, and makes offsetting trades to maintain a market-neutral posture while also controlling for the impact of the different market sectors: transportation, utilities, financials, and so on.
JPMorgan Research Market Neutral
This fund (ticker: JMNAX) is quantitatively managed to be market, industry, capitalization, and style neutral, taking long and short stock positions based on fundamental rankings by JPMorgan’s analysts.
Highbridge Statistical Market Neutral Select
This (ticker: HSKAX) is a quantitative fund that takes long and short positions in mid- and large-cap equities to deliver market neutral returns across a variety of investment dimensions. It rises or falls based on its stock selection acumen.
Managers AMG Global Alternatives
When we first heard of this fund, we were hoping that the AMG part of the name referred to the same engineering company that soups up Mercedes Benzes, but there is no relationship. Instead, Managers AMG Global Alternatives (ticker: MGAAX) uses a quantitative tactical asset-allocation strategy across global stock, bond, and currency markets. They take long and short positions across, between, and within these asset classes as they perceive relative value opportunities.
Hussman Strategic Growth
This (ticker: HSGFX) is really a long/short fund with an uninspiring recent record—just one that happens to be better than most other long/short funds. Manager John Hussman is an economist with a proprietary market timing model and a cult-like following. His fund can vary from market neutral up to 150 percent long, and unlike the others, this fund is not market neutral by design. However, his stance is conservative, and he remained market neutral even in the face of the 2009 rally. He posts his economic outlook in weekly missives on the Hussman website (www.hussmanfunds.com).
ProShares RAFI Long/Short
This fund (ticker: RALS) is a new offering from Research Affiliates, and has no track record. We include it because we like its methodology.
This fund simply goes long the 20 percent of U.S. stocks that are cheapest in fundamental valuation, and then shorts the 20 percent that appear to be the most overvalued by the same yardstick, balanced by sector. In this way, the fund is making a bet on the long-term outperformance of value over growth, independent of whether the stock market as a whole is going up or down.
Dedicated short bias funds bet against the market, rain or shine. If you hold half your money in the S&P 500 and half in a short-bias fund, this is like putting one foot on the accelerator and one on the brake, which means that you will go nowhere and just lose money to frictional expenses. That makes these funds a tough gig for long-term, buy-and-hold investments. You accomplish the same result just by having less invested in the market and holding more cash. That makes it hard for these funds to bring much to the hot tub unless you believe the end is coming. Table 12.4 shows the performance of three funds in this space.
Table 12.4 Dedicated Short Bias Funds—Recent Performance
Federated Prudent Bear
The Prudent Bear fund (ticker: BEARX) tries to minimize damage during bull markets by going long on undervalued stocks. In addition to shorting the stock market, the fund can hold cash and Treasury bonds and gold.
Grizzly Short
This bear market fund shorts the domestic stock indexes as well as particular large-cap stocks that appear to be most vulnerable to correction. It may be more convenient for solo retail investors since it can be bought without a sales load.
Comstock Capital Value
Comstock Capital Value (ticker: DRCVX) does not call itself a bear market fund, but it had a correlation of –.93 to the S&P 500 for the past three years. The fund follows a value-oriented strategy, and while it has had a bearish orientation lately, that could switch quickly if the manager’s view changes.
Global Macro is a very broad class of hedge funds that pretty much can do anything they like. The “global” part means they can do it anywhere.
Recently, Global Macro hedge funds have not fared well, as illustrated by famous macro manager Stanley Druckenmiller’s exit from the business after a disappointing 2009 and 2010. Table 12.5 shows some of the mutual funds that try to work this territory.
Table 12.5 Global Macro—Recent Performance
PowerShares DB G10 Currency Harvest
Powershares DB G10 Currency Harvest (ticker: DBV) passively executes the “carry trade.” It goes long and short 3-month currency futures to capture the spreads among the different developed-market currencies. Specifically, it goes long the three highest-yielding currencies and sells the three lowest-yielding currencies, usually levering the difference times two. The gimmick behind the carry trade is that higher-yielding currencies have historically tended to maintain their exchange rate against lower-yielding currencies, giving investors a free ride (but with notable exceptions along the way).
Marketfield
Marketfield (ticker: MFLDX) expresses its macro views primarily through equities and long exposure. This means it doesn’t “hedge” as much as some other funds in its peer group. As you can see from Table 12.5, it was down 13 percent in 2008 but climbed 31 percent in 2009.
Eaton Vance Global Macro Absolute Return
Eaton Vance Global Macro (ticker: EAGMX) employs the macro toolkit in the bond market, with reasonable expenses and good performance. This is a fund that would do better if housed in your IRA, as it generates a lot of income taxed at ordinary rates (or at least it has recently). The fund is closed to new investors but Eaton Vance has launched a very similar new fund (ticker: EGRAX) that may prove of interest.
Mars Hill Global Relative Value
Mars Hill (ticker: GRV) is a new exchange-traded fund and does not track any particular index. The managers confine themselves to taking long and short positions using a country’s exchange-traded funds. In that respect, it is more like a long/short fund. However, its global focus and country versus country smackdown also gives it the flavor of global macro.
IQ Hedge Macro Tracker
The IQ Hedge Macro Tracker (ticker: MCRO) is a hedge fund replicant that targets the Dow Jones Credit Suisse Global Macro and Emerging Market indexes, weighted 50-50. They do an ongoing regression analysis to determine which combination of conventional exchange-traded funds would have most closely tracked this hybrid of the two hedge fund indexes. The fund is not following any particular hedge fund strategy, just looking into a rear-view mirror and simulating what fund managers in these two areas have been doing lately. Research by Hasanhodzic and Lo suggests that global macro is a style amenable to this approach; emerging markets, less so.
Here are some funds that package managed futures for the rest of us. We could not get specific tax information for these funds, but we suspect that their high turnover might make them good candidates for tax-deferred accounts. Nearly all these funds are new (Rydex being the exception), so we don’t have a table of data to present on their recent performance. Depending on which index you follow, managed futures were up between 13 and 18 percent in 2008, a year when commodities and stocks fell 37 percent. Moreover, managed futures have been up more than 10 percent during each of the five worst quarters for the stock market since 1985. That, plus their low correlation to stocks, bonds, and commodities, puts this alternative asset class on your short list.
Direxion Commodity Trends Strategy
The Commodity Trends Strategy Fund (ticker: DXCTX) tracks the performance of the Standard & Poor’s S&P Diversified Trends Commodity Trends Indicator. This index offers exposure to 16 commodity markets in 6 sectors and holds them long or short according to the price trends in relation to a 7-month moving average, rebalanced monthly.
Elements S&P CTI
If you are looking for a managed futures fund that tracks the S&P Diversified Trends Commodity index, you can get it cheaper by using the Elements S&P CTI exchange-traded note (ticker: LSC) with its 0.75 percent expense ratio versus 1.93 percent for the Direxion fund above. The exchange traded note format would make for better tax treatment inside a taxable account (at least, unless the IRS rules otherwise). This is not an insignificant benefit, since managed futures funds can be tax-intensive. The downside is counterparty risk with its issuer, the Swedish Export Credit Corporation.
Rydex|SGI Managed Futures Strategy
The Rydex fund (ticker: RYMTX) tracks the S&P Diversified Trends Indicator, which is just like the Commodity Trends Indicator used in both funds above except that in addition to commodities, half the index is weighted to financial futures—primarily currencies from developed and emerging markets as well as U.S. T-bonds and T-notes. It is more expensive than those offerings but offers broader diversification.
Arrow Managed Futures Trend Fund
The Arrow Managed Futures Trend Fund (ticker: MFTFX) attempts to capture price trends in commodities, currencies, and interest rates, but tracks the Trader Vic’s index instead. This does not refer to the swank 1960s restaurant famous for its rum drinks with paper umbrellas, but rather an index developed by commodity trader Victor Sperandeo.
Mutualhedge Frontier Legends
Mutualhedge’s (ticker: MHFAX) approach is to do due diligence and select five diversified Commodity Trading Advisors to run the money. The fund will rise and fall with the CTA selections it makes. In the unlikely event that the CTAs succeed in squelching competition from the other mutual funds on this list, as they would love to do, this fund will be the only game in town (until someone opens another one).
ASG Managed Futures Strategy
AlphaSimplex Managed Futures (ticker: AMFAX) does not license any index, but uses its own trend-following formula to capture the managed futures beta. It is managed to maintain a target standard deviation of 15 percent. It holds long and short positions in futures and forward contracts in the areas of global equity, global bonds, commodities, currencies, and interest rates.
AQR Managed Futures Strategy
AQR Managed Futures (ticker: AQMNX) also does not license any index, but uses its own proprietary trend-following model. AQR’s Cliff Asness wrote his doctoral dissertation on momentum investing. This fund invests in a portfolio of futures and futures-related contracts using more than 100 instruments across four major asset classes: commodities, currencies, fixed income, and equities.
As discussed in Chapter 11, you may recall that a convertible bond is an ordinary bond bundled with a call option on the company’s stock, which gives the investor the right to convert the bond into shares of the stock in the happy event that the stock price goes up enough. Convertible arbitrage hedge fund managers buy these bonds at a discount when they are issued, supplying the company with badly needed capital. Then they hedge out the interest rate risk of the bond and short the underlying stock. This covers their bet while they wait for the bond to mature, at which point it is redeemed at its full face value.
There are only a few mutual funds that practice this technique (so far), and they are all hybrid offerings that combine convertible arbitrage with other approaches. Here is one—we’ll get to some others later. Table 12.6 shows its recent returns.
Table 12.6 Convertible Arbitrage—Recent Performance
Calamos Market Neutral Income
This fund (ticker: CVSIX) combines convertible arbitrage with a “covered call” strategy. Just as we were not crazy about the “buy/write” funds, which seemed to produce the same returns as a stock plus cash portfolio, we are not big fans of covered call funds, either. These funds buy a stock portfolio and then sell call options on the stocks for extra cash. This leaves us with a portfolio that has nearly all of the downside of the stock market with only part of the upside, since if the stock market goes up, the stocks will be called away. The convertible bond and covered call portfolios are not mutually hedging, because when the stock market is down the convertible bonds can also suffer.
In other words, this looks like a convertible bond arbitrage fund with a stock portfolio attached. While John Calamos is a highly-regarded convertible manager, our preference is to find funds that leave us to dial in the stock market exposure we want.
Fixed-income arbitrage attempts to exploit small mispricings in the bond market. Table 12.7 shows how some of their mutual fund cousins have performed recently. As you can see, there has not been exactly a Who-concert-like stampede of fund managers to get into this area.
Table 12.7 Fixed-Income Arbitrage—Recent Performance
Forward Long/Short Credit Analysis
Forward Long/Short Credit Analysis (ticker: FLSRX) is a relatively new fund that invests primarily in higher-yield municipal bonds and hedges out the interest rate risk by shorting Treasuries of the same maturity. It also takes long and short positions using corporate bonds within the same industry.
Western Asset Absolute Return Institutional
Western Asset Absolute Return (ticker: WAARX) has no benchmark and a broad mandate that allows it to seek returns from fixed income investments however and wherever it can generate them. Their description of their strategy could scarcely be more generic: “The Fund’s flexible investment strategy enables the managers to seek opportunities for enhancing total returns through investing in a wide variety of fixed-income securities around the world.”
Notice that in both cases the funds have not been market-neutral relative to the S&P 500 Index: They were significantly down in 2008 and significantly up in 2009. One final piece of advice: Fixed-income funds generate a lot of taxable income. Your net returns will be between 1 and 2 percent higher every year if you can park them in an IRA or other tax-qualified account.
Event-driven hedge funds seek securities that are mispriced relative to each other and whose price is expected to converge due to some corporate event. Merger or risk arbitrage is the most common example.
Unlike in the case of Fixed-Income Arbitrage, there are a number of worthwhile funds in this space, as Table 12.8 points out.
Table 12.8 Event-Driven Arbitrage—Recent Performance
Arbitrage Fund
The Arbitrage Fund (ticker: ARBFX) is actively managed in pursuit of the merger arbitrage. The managers attempt to add value by specializing in smaller companies where they hope to find fewer participants and hence more upside. They avoid hostile takeovers, deals where the financing is in question, and those facing significant regulatory hurdles.
Merger Fund
The Merger Fund (ticker: MERFX) is another actively managed merger arbitrage fund. Each proposed deal is examined on its strategic merits, the only question being: Is it likely to close? If they believe it will close, they proceed. This fund may also invest in corporate reorganizations and corporate bonds, but the bread-and-butter of their operations is risk arbitrage.
Gabelli ABC Fund
Gabelli ABC (ticker: GABCX) has a good long-term track record and has the lowest expense ratio in the group, which means more of its returns are passed on to the investor. The main strategy seems to be merger arbitrage, although there is talk of its value and income investing style in the fund literature, so possibly manager Mario Gabelli is running a hybrid. Its numbers make it look a lot like the other merger arbitrage funds, though.
IQ Merger Arbitrage ETF
The IQ Merger Arbitrage (ticker: MNA) is a new exchange-traded fund that pursues a passive, rule-based strategy of buying into all announced mergers that meet its broad criteria. It offers the distilled merger arbitrage beta unlinked to manager performance, and for a low expense ratio. If the fund can’t find enough deals to invest in, it parks its money in short-term bond ETFs. Several caveats, though: They short the deals through inverse index funds and even ultra inverse index funds (which we hate) rather than through the specific stock. Also, daily volume (5,000 shares a day at this writing) and total assets ($30 million) are not as high as we would like. That may change by the time you read this.
AQR Diversified Arbitrage Fund
The new AQR Diversified Arbitrage (ticker: ADANX) is a hybrid convertible arbitrage plus merger arbitrage offering brought to you by the supersmart Goldman Sachs refugees at AQR Capital. It is managed to deliver the beta of these two arbitrage strategies.
Apart from the IQ Hedge Fund Tracker mentioned above (ticker: MCRO)—a hybrid Global Macro/Emerging Markets strategy replicant—there are presently no mutual funds that execute emerging market hedge fund strategies. Emerging market hedge funds have more in common with a conventional emerging market equity fund such as you might buy from Vanguard (ticker: VWO) or iShares (ticker: EEM), which explains why the correlation between the emerging market hedge fund index and the ordinary emerging market index fund is high, on the order of 0.80. The resourceful investor could supplement an emerging markets index fund with a dash of PowerShares Emerging Markets Sovereign Debt (ticker: PCY) or iShares JPMorgan USD Emerging Markets Bond (ticker: EMB) and have this territory pretty well staked out in his conventional portfolio.
The Alternative Reality
In this chapter, we presented mutual funds that are running hedge fund strategies and caught our attention. For every fund we have listed, there are probably 10 others that we either forgot or that didn’t turn our heads. If a fund tweaks your interest, your next stop would be Morningstar.com to glean what you can, followed by a visit to the sponsoring company’s website to read all you can about it.
Having reviewed some of the mutual fund offerings that are crashing into the hedge fund space, in the next chapter we talk about the ones we prefer and how they might be integrated into the rest of your portfolio.