Selling Short No Longer a Shortcoming

Short-sellers have been blamed for the Great Crash of 1929 (turns out unfairly) and all kinds of market manipulation in the years since. But, as investors learned in the three-year bear market, it may not be so smart to be un-hedged all the time. Retail investors with money have been able to go to hedge funds, but what of the common investor, those who don't count themselves as accredited investors? Now, it seems, the hedge fund is coming to them.

Short-sellers have been blamed for the Great Crash of 1929 (turns out unfairly) and all kinds of market manipulation in the years since. But, as investors learned in the three-year bear market, it may not be so smart to be un-hedged all the time. Retail investors with money have been able to go to hedge funds, but what of the common investor, those who don't count themselves as accredited investors? Now, it seems, the hedge fund is coming to them.

Hedge funds are going retail: A number of major fund complexes—including American Century, Franklin Templeton and Janus Capital—have introduced, or are in the process of rolling out, new funds that employ investment strategies more commonly found in hedge funds. Previously, these esoteric investment styles were the domain of boutique fund shops like Diamond Hill and Gartmore.

The question is why? Fund companies say they are introducing them in their attempts to win return for investors and also to expand their product lineup. Critics carp that fund companies are offering them to keep from losing assets and talented portfolio managers.

Says Blair Johnson, a spokesperson for Janus: “Our goal is to give advisors and their clients an alternative investment strategy to complement their core strategy.” Its Janus Adviser Long/Short Fund will come to market on March 31 and will be sold only through advisors in three classes: A, C and I shares. The minimum investment will be $10,000, and it will carry an expense ratio of 1.99 percent, that includes a 1.25 management fee plus 12b-1 and dividend interest payments (dividends must be paid on open shorts).

Meanwhile, the American Century Long-Short Equity Fund hit the Street last September with a 2.38 percent expense ratio (138 basis points make up the management fee, while the remaining portion is 12b-1 and dividend interest) and a minimum investment of $2,500.

“We are looking to take advantage of views of stocks we believe will underperform the market,” says Kurt Borgwardt, portfolio manager of the American Century Long-Short Fund. “It offers a better risk-return tradeoff.”

Says Benjamin Poor, senior analyst at Cerulli Associates, “The funds that are launching these funds are all hungry for business.” Reasons for launching these funds run the gamut. A Cerulli survey of money managers shows that 30 percent of the respondents say that hedge fund strategy funds are a natural part of their product development discussions, while 20 percent view it as a way to add return. Another 30 percent was divided equally among a means for manager retention, demand from the field and the risk of hedge funds eroding their client base.

Some analysts believe their motivations have more to do with profitability. “Most mutual funds see it as a way to have a higher-fee product offering,” says Morningstar's Dan McNeela. The average expense ratio for these funds exceed 2 percent, on average, he says, compared with a 1.27 percent expense ratio for the average large-cap mutual fund with a front-end load. Poor agrees. “They’re pretty expensive,” he says, “But those expense ratios should come down as they build up scale.”

The appeal of these funds is their access to hedge fund-like strategies at a lower cost and lower minimums but with the added protection of greater transparency and regulatory oversight, as well as more flexibility with no lock-up periods. Being registered under the Investment Advisers Act of 1940 limits the chances of a storied blowup like Long Term Capital Management or the risk of your fund manager absconding to Brazil with all your money. Mutual funds were prohibited from shorting stocks and bonds up until December 1996 when the SEC repealed the short sale rule.

Perhaps the most popular flavor is the long/short strategy, which Morningstar recently announced as a new category in its style box, providing further proof of an emerging trend. A fund must have at least 20 percent of its assets in short positions in order to qualify for the long/short category. Although there are less than three-dozen of these portfolios industrywide, the funds that use long/short and an array of other hedge-like strategies have seen some meaningful growth. Over the past five years they have reaped $10.5 billion in assets, representing 24 percent annualized growth, according to Cerulli Associates.

“They’re doing it to stay competitive,” says Jeff Joseph, managing director of alternative strategies at Rydex Investments, which has two funds that employ hedge fund strategies, the Rydex Hedged Equity Fund and the Rydex Absolute Return Strategies Fund, which came to market in September 2005 and have amassed nearly $65 million in assets since inception.

There are undoubtedly risks associated with short selling but these long/short portfolios actually have significantly lower risk than a 100 percent long-only portfolio, Joseph says, because they have a shorting component that eliminates a lot of the broader market volatility. “It’s a perception issue,” he says. In addition, he says they’re superior to funds of hedge funds because they don’t tack on a second layer of fees.

So while assets haven’t ballooned and they aren’t poised for substantial growth this year due to the market’s recent good performance, analysts say, these funds are gradually finding their way on to more advisors’ shelves. “They do have legs but they’re not sprinter’s legs,” says Lipper senior analyst Jeff Tjornehoj.

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