When stocks plunged in 2000, dispirited fund investors looked enviously at hedge funds. By selling short or investing in mergers, hedge fund owners could make money — even when the S&P 500 collapsed. But hedge funds are far from a perfect solution. Most fund investors can't afford the price of admission, and some of the most successful of hedge fund strategies also require a tolerance for high risk.
Luckily, a group of mutual funds has emerged to give everyday investors the ability to embrace the ethos of hedge funds while avoiding their downsides. About half a dozen appealing choices follow various market-neutral or arbitrage strategies — and all are designed for investors with small wallets and limited tastes for risk.
These funds produce decent returns nearly every year — whether the market is rising or falling. Though mutual funds do not have the freedom to use the enormous leverage that some hedge funds use, they still are strong diversification tools. The best hedged mutual funds post tiny standard deviation scores and low R-squared figures, meaning they don't move with the equity market.
“This is a great way to reduce the volatility of your portfolios,” says Richard Bregman, chief executive officer of MJB Asset Management, a registered investment advisor in New York, who often puts more than 5 percent of client assets into merger mutual funds.
Indeed, merger and arbitrage funds rank among the most consistent choices in this category. Consider Gabelli ABC, which has stayed in the black every year for a decade, while reporting a minuscule standard deviation of about 1. Given that the S&P has a standard deviation of 17, the Gabelli fund promises a much smoother ride. Though it's been closed to new investors, Gabelli plans to reopen the fund in May.
One option available immediately is Enterprise Mergers and Acquisitions, also run by Gabelli. While ABC puts all its money in takeovers, Enterprise puts two-thirds of its assets in announced takeovers and one-third in small stocks that seem like future candidates for takeovers.
Gabelli ABC ranks as one of the tamest equity funds by following a strategy of minimal risk. The fund invests in a stock after an acquisition has been publicly announced. Then the portfolio manager only buys the takeover candidate when the acquisition is being done at a solid premium to the market price of the shares. The aim is to find deals that will give shareholders a small profit with very little risk. (The nightmare hovering over all acquisitions, of course, is that the deal will collapse, dropping the target shares back to their former price or lower.)
To appreciate Gabelli's cautious approach, consider the fund's current holding of Dial Corp., the soap maker being acquired by Henkel Group, a German maker of home care products. After the deal was announced, Dial stock was trading at $28.50, and the Germans pledged to buy it for $28.84. So if the deal closes in late March and the price stays put as expected, Gabelli will earn 34 cents a share, about 1.2 percent, or 7 percent on an annualized basis.
“There is very little risk that the deal won't be completed,” says Paolo Vicinelli, a portfolio manager with Gabelli. “Henkel is a strong buyer that understands the soap market and stands to gain from the acquisition.”
Merger funds can succeed in all kinds of markets because their returns depend on whether deals close — not on the direction of the S&P. But the funds do tend to thrive when there is a healthy volume of mergers. In 2002, the number of mergers collapsed as the economy skidded, and hedge funds competed fiercely for the few remaining deals. That left skimpy rewards for the merger mutual funds. In contrast, 2000 was a superb year for merger funds, since hedge funds had more interest in technology stocks than takeover plays.
“These funds are excellent diversifiers, but you have to realize that they can have hot and cold years,” says Louis Stanasolovich, president of Legend Financial Advisers, a registered investment adviser in Pittsburgh.
A top member of the category, Merger Fund, which has returned 8.7 percent annually for the past five years, occasionally posts uneven results. In 2000, the fund returned 17.6 percent, beating the S&P by 26 percentage points. Then in 2002, Merger Fund lost 5.7 percent, a disappointment for shareholders but still 16 percentage points ahead of the S&P.
Now the merger funds could be poised for a strong period. Merger funds produced solid single-digit returns in 2003, and the volume of deals is rising, which could pave the way for strong performance.
Shifting to Neutral
Like merger portfolios, market neutral funds don't necessarily deliver big results every year. But they can provide unusual diversification. Boston Partners Long/Short Equity boasts an R-Squared of 2 and a beta of -0.08, indicating that the fund marches to its own drummer, rarely locking step with the S&P 500. During the past five years, the fund has returned 10.7 percent annually.
To avoid suffering in downturns, market neutral funds typically take half their assets and buy stocks that seem poised to go up. The other half are used to sell short stocks, a strategy that produces profits when stocks drop. In theory, the funds should do equally well in up and down markets. In fact, many funds favor undervalued stocks, so they tend to do best in value-driven markets. Boston Partners buys undervalued stocks and shorts expensive issues. That explains why the fund returned 25 percent in 2001, a year in which growth stocks plunged and value won the day. In 2003, when growth led the race, the fund lost 2.2 percent.
“Our strategy won't do well during periods when speculative growth stocks dominate the market,” says Paul Healthwood, a product specialist for the Boston Partners fund. “But we believe that value stocks will win over time, and our fund can produce solid results in most markets.”
AXA Rosen Value Long/Short Equity favors undervalued stocks that are likely to produce positive short-term earnings growth. Such stocks were left behind during the bubble environment of 1999 when investors favored companies with scant earnings and high prices. Then in 2001 and 2002, AXA won its revenge, scoring double-digit gains and outdoing the S&P by wide margins.
Kathryn McDonald, an AXA portfolio manager, says the extreme conditions of the bubble years are unlikely to return any time soon. In an environment of more moderate ups and downs, market neutral funds could calmly perform their job, outdoing Treasury bills and providing investors with important diversification.
Funds That Can Thrive When Stocks Collapse
|Fund Name||Ticker||Category||12-Month Return||3-Year Return||5-Year Return||Expense Ratio||Max. Front-End Load||R-Squared||Beta|
| AXA Rosenburg |
| Boston Partners |
| Enterprise |
Mergers and Acq. A
| Gabelli |
| Westchester Cap. |