Do-It-Yourself Funds of Funds

The trouble with hedge funds is not necessarily their expense. The real deal breakers for financial advisors with wealthy clients who have sophisticated needs are that hedge funds tend to be illiquid and lack transparency. There are registered hedge funds, but many advisors still find them somewhat opaque.

There is a third way, call it the hybrid strategy. That entails using mutual funds that use hedge fund strategies. Rob Isbitts, president of Emerald Asset Advisors, a registered financial advisor in Weston, Fla., often creates low-beta, absolute-return strategies for clients out of open-ended mutual funds, even if they are wealthy enough to buy into a limited partnership or a fund of funds directly. “I can deliver to the investor a similar experience of a hedge fund of funds in terms of absolute return, but absent many of the headaches of fund of funds,” Isbitts says. “The advantages include lower total cost, much greater liquidity, greater transparency, greater tax-efficiency and more overall flexibility in the process.” He has created basic templates in conservative, moderate and aggressive strategies, customizing them with other securities and funds as suits the client's needs.

A Demand Fulfilled

Isbitts can do so because of the large number of hedge-like mutual funds to choose from. Seeing investors stampede into hedge funds (although that growth slowed in 2005), mutual fund companies have decided to join the crowd. Fund developers have introduced a host of offerings that sell short and use other techniques employed by hedge funds. Make no mistake, hedged mutual funds will never produce the kind of returns that made star hedge fund managers rich and sometimes famous. Still, plenty of hedged mutual funds have shined-particularly during years when it paid to short the markets. Of the 55 hedged funds tracked by Morningstar, 19 have outdone the Standard & Poor's 500-stock index by wide margins during the past five years. Winners include Diamond Hill Focus Long/Short A, which returned 11.6 percent annually, during the past five years, compared to 0.6 percent for the S&P. Laudus Rosenberg Value Long/Short Equity returned 7.9 percent.

Advisors have been using the hedged funds to help get positive, low-correlated returns in recent difficult markets. Most investors should put 10 percent or more of their assets into hedged funds, says Isbitts. The protection does come at a price, says Mike Arone, portfolio manager of SSgA Directional Core Equity, which holds about 30 percent of its assets in short positions. Hedged funds tend to lag in bull markets. “By avoiding big losses in downturns, we aim to outperform long portfolios over a full market cycle,” says Arone.

Perhaps the most important reason to consider hedge funds is for diversification. Most of the mutual funds have relatively low r-squareds, suggesting that they don't rise and fall with the S&P 500. James Market Neutral boasts an r-squared of 17, while Arbitrage, which invests in mergers, has a score of 36. Some of the newest funds track currencies, which have little correlations with stocks and bonds. ProFunds Rising U.S. Dollar goes up with the greenback, and ProFunds Falling U.S. Dollar moves in the opposite direction. “Plenty of institutions hold currencies for diversification, and now individuals can do it conveniently,” says Michael Sapir, chairman of ProFunds.

One of the most diversified of the latest crop of choices is Rydex Absolute Return Strategies. Launched in September, the fund holds six different portfolios, each following a different strategy, including currencies, commodities, short selling and mergers. Rydex charges a total annual expense of 1.7 percent, well below what individual hedge funds or funds of funds charge.

Veteran Hedged Funds

Among the more appealing offerings are merger arbitrage funds, which have long been prized because they can make money in up or down markets. After a takeover has been announced, the shares of the target company's shares typically rise to a bit below the acquisition price. The price doesn't go higher because investors worry that the deal will collapse and shares will drop. The merger arb funds aim to pocket a few dollars by buying shares that sell for less than the takeover price-and then hanging on until the deal is done. One of the top players of the merger game is Arbitrage Fund. In 2002, Arbitrage Fund returned 9.3 percent, a notable achievement in a year when the S&P 500 lost 22.1 percent.

Arbitrage Fund outdoes most competitors because the mutual fund is a small player with only $200 million in assets. That enables portfolio manager John Orrico to participate in tiny deals. “The prices are better on the small deals because they are off the radar screens of the large pools of capital,” says Orrico.

This could be an ideal time to try a merger fund. The number of announced deals has increased dramatically lately. In that environment, the arbs have lots of opportunities to rake in healthy profits. In contrast, the pickings were slim in 2004, and arbs saw only a few takeovers that produced meager profits.

Another common approach used by hedge funds is so-called market neutral. In this style, the manager puts an equal amount of assets in long positions, which aim to profit from rising markets, and shorts, which seek to win when markets drop. If the manager chooses wisely, the market-neutral fund can grind out single-digit returns nearly every year, and the portfolio has little correlation with the market. Laudus Rosenberg Value Long/Short Equity ranks as a top member of the group. Sporting an r-squared of just 19, the fund returned 22.9 percent in the difficult year of 2002.

A quantitative shop, Laudus screens 5,000 mostly small- and mid-cap stocks for valuation and earnings growth prospects. About 10 percent to 20 percent of the group seem very undervalued, and the fund takes long positions there. The fund shorts stocks that seem overpriced. To avoid big mistakes, the portfolio includes about 800 positions; if a few go bad, shareholders will not suffer much. In addition, the fund tries to hold a diversified collection of industries in both its long and short positions. Purists may note that Laudus is not a strictly neutral portfolio because it has a slight bias toward value stocks. The fund concedes the point. “When we rank the stocks, we find more value stocks at the top of the list and more growth names at the bottom,” says Stephen Dean, a Laudus portfolio manager.

While market-neutral funds always have about half their holdings in short positions, long-short funds vary the mix. Analytic Global Long/Short typically has more of its assets long than short. The aim is to make sure that the portfolio's beta is about 0.5, suggesting that the fund will have about half the volatility of the S&P 500. “We want to give shareholders about the same risk levels as a portfolio that is 60 percent in bonds and 40 percent in stocks-but with better returns than a stock-and-bond portfolio,” says Harindra de Silva, a portfolio manager of the fund.

While Analytic stays broadly diversified, Diamond Hill Focus Long/Short is not shy about placing bets. The fund is currently long on energy and short technology. Most often Diamond Hill has been right, producing double-digit returns during the past five years while maintaining a beta of 0.5. Many short-sellers focus on real stinkers-troubled businesses that seem to be headed for bankruptcy. But Diamond Hill sometimes shorts market favorites, companies with growing earnings and sky-high stock prices. Currently the fund is shorting growth stars Panera Bread and Yahoo. “These are great companies, but the valuations are completely unrealistic,” says Ric Dillon, Diamond Hill portfolio manager.

Schwab Hedged Equity always maintains a long bias. For every dollar that goes into long stocks, the fund typically has $0.35 to $0.50 in short positions. The fund relies on the letter-grading system that Schwab developed to help clients pick stocks. Stocks with healthy growth prospects and reasonable ratings are graded A, while shaky performers can be graded F. The fund normally buys the A's and shorts the F's.

Icon Long Short varies its mix considerably. The fund company calculates the intrinsic value of stocks, buying bargains and shorting stocks that are too expensive. Figuring that the market was undervalued by the end of 2002, the fund cut back its short positions to less than 1 percent of holdings and returned 37.8 percent in 2003. The next year, Icon became wary of overvalued technology stocks and shorted 25 percent of the assets, a move that helped the fund outdo the S&P 500 for the year. “This is an opportunistic fund,” says portfolio manager J.C. Waller. “Because we can short, we have the tools to get good returns in good and bad markets.”

Hedged Mutual Funds

Funds that provide diversification and winning performance