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Beware Mutual Funds Using Hedge Fund Strategies

With hundreds of mutual funds that use hedge fund strategies being rushed to market, there are bound to be some real dogs.

After a decade of low stock market returns and high volatility, investors are clamoring for products that seek to profit regardless of the market environment. Mutual fund companies are doing their best to fill the void with products that employ hedge fund strategies.

The $2 trillion private hedge fund industry has always carried a certain allure, with its exclusivity and promises of low risk and double-digit returns no matter whether markets go up or down. Because there are so many hedge funds with so many strategies, the term “hedge fund” itself is somewhat meaningless. However, all have a common goal of achieving positive returns whether markets are up or down.

Of course, the last several years have taken some of the shine off of hedge funds, with several prominent blowups, as well as insider trading accusations. Mutual funds address some of investors’ issues with private hedge funds because they are required to offer greater transparency and are also limited in how their portfolios may be constructed. There are restrictions, for example, on how much borrowing they can employ to boost returns.

At Palisades Hudson, we believe that there can be a place for hedge fund strategies in a diversified investment portfolio. Having said that, we do not recommend diving into the deep end with hedge funds. We believe that stocks are still the best investment for long-term growth and inflation protection. Hedge funds instead can be used as portfolio diversifiers to dampen volatility and boost long-term returns.

We recently analyzed the universe of mutual funds offering hedge fund strategies (also classified as “alternative” funds by Morningstar). That universe is made up of more than 600 mutual funds and exchange-traded funds, collectively managing more than $100 billion. After studying this group, we decided to add a mutual fund that employs merger arbitrage (a strategy that takes advantage of discounts in a targeted company’s stock before the merger is completed) for clients with moderate risk tolerances in the near future. However, we also noticed red flags connected with most of these new funds.

When considering whether hedge fund strategies have a place in your portfolio, be sure to watch for the following signs that caution is in order:

Lack of meaningful track record. This was the issue that came up most frequently when we looked at funds. About two-thirds of alternative funds did not exist in 2008, and two-fifths did not exist as recently as 2010. If you are evaluating a fund, it is extremely helpful to know how it performed during previous market cycles to get some kind of idea of the manager’s skill, as well as of the risks involved. While mutual funds may be able to offer you a track record that predates the fund’s official launch, beware of “back-tested” hypothetical results. You should not have to guess how a fund would have performed over the past three or five years. You should know its performance for a fact.

High expenses. While mutual funds are likely to be less expensive than private hedge funds, which typically charge a 2 percent annual fee plus 20 percent of profits, it is still important to consider whether fees will put a substantial dent in your portfolio’s return. About one-third of alternative funds have annual expense ratios above 1.5 percent, with certain funds charging upward of 2, 3 or 4 percent annually. While there are good reasons for expenses for a hedge fund strategy being higher than those for a passive index fund (such as paying for manager expertise and the costs involved in actively trading securities), you should be conscious of the extra value the manager will have to add to justify the higher expenses. For a fund charging 4 percent annually, can the manager really add an extra 4 percent of value each year as a result of his or her expertise? That’s not a bet we’re interested in making.

A “black box” strategy. Just as with any other investment, it is important to understand exactly what you are investing in. Several funds employ proprietary models and use “quant” strategies to invest across all markets, including stocks, bonds, currencies, commodities, derivatives, etc. Investment decisions may not be based on economic or valuation fundamentals, but rather on market patterns, momentum or the result of whatever the fund managers’ algorithms spit out. Since these investments are mutual funds, the fund managers are required to disclose their holdings periodically, and they’ll likely offer their investors guidance on why the fund is positioned the way it is. But these funds are prone to blowups. For example, one fund we came across plummeted 15 percent over the summer because of some bets that went awry, including a bet against the Swiss franc. If you don’t understand the strategy the fund employs, look elsewhere.

A strategy that is inconsistent with your investment philosophy. At Palisades Hudson, we believe that certain stock markets are highly efficient, including the market for large U.S. companies. We simply don’t believe that an investor can use publicly available information for a company such as Microsoft or General Electric, for example, and discover some secret that other investors (including the army of Wall Street analysts) haven’t found. In addition, while investors can get lucky and outperform broad market indices such as the S&P 500 for the short term, outperforming over the long term is nearly impossible. Rather than even try, we use index funds to maintain exposure to U.S. large-company stocks. When considering hedge funds, we have a fundamental disagreement with any fund that focuses on actively buying or selling U.S. large-company stocks. We’re more interested in hedge funds that focus on less efficient markets, such as U.S. small-company stocks or emerging markets stocks. You shouldn’t compromise your beliefs for a fund that has done well over the short term. Over the long term, it’s likely that such a fund will return to earth.

Funds managed by “the smartest man in the room.” Numerous hedge funds are ultimately managed by one person (regrettably, almost always a man). These funds often market their managers as investment rock stars, presenting them as a draw as large as or larger than the fund itself. There are two major risks with investing in this type of fund. First, there is the risk that something will happen to the rock-star manager. Maybe he retires; maybe he gets hit by a bus. Either way, if he departs and you don’t find out about it for a few months (or years), you’ll have owned a very different product than what you thought you were getting. The second risk is that the manager turns out to not be as smart as you had hoped. As previously mentioned, numerous investors can outperform the markets over the short term. But no one man is smarter than the market. Even if such a man existed, ask yourself if you believe he’d spend his time managing other people’s money in a mutual fund for an annual fee of 1 or 2 percent, rather than looking for more lucrative opportunities.

Poor historical returns. We don’t recommend focusing on returns too heavily when evaluating mutual funds. Other data, such as expenses, manager experience, portfolio diversification, and volume of trading and turnover, can be much more useful for predicting future performance. Having said that, there are some funds that fail to make money, period. Even if you agree with a fund’s strategy and think it could make a worthwhile addition to your portfolio, don’t forget to peek at the returns. Ask yourself whether you’d have the discipline to hold onto a fund that failed to deliver positive returns, not only in the bear market of 2008, but also during the upswings of 2009 and 2010. Losing money each of the last three years would be hard, no matter how you approach investing. Several funds fit this profile (including products from heavyweights such as Vanguard and J.P. Morgan). Think twice about investing in one of them.

We found that after eliminating all of the funds with red flags, there’s not much left for investors. But there’s good news: Time will pass, and new funds will develop track records. Eventually, it will become clear which funds can fulfill their promises of making money in all environments, and which cannot. In addition, we expect more funds to launch in the coming years, with attractive strategies that have a place in a diversified portfolio.

One other thought: With interest rates still at or near all-time lows, simply holding bonds may not be the best way to lower your portfolio’s volatility going forward. When interest rates rise, bond prices will fall, hurting bond investors’ portfolios, especially those with exposure to intermediate- and long-term bonds. Replacing some bond exposure with low-risk hedge fund strategies may make a lot of sense for certain investors.

The explosion of new mutual fund products that offer hedge fund strategies is good for investors overall. At the very least, it adds another tool for investors seeking diversification. However, watch out for red flags, and do your research before investing. Just as with any other mutual fund investment (whether it uses a hedge fund strategy or not), if you can find a fund that has a meaningful track record, low expenses and a strategy you believe in, you likely have discovered an investment that belongs in your portfolio.

Vice President and Chief Investment Officer Paul Jacobs, of our Atlanta office, is the author of Chapter 20, “Giving Back,” in our firm’s most recent book, The High Achiever’s Guide To Wealth. He also contributed several chapters to the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.