The Star-Ledger, October 13th, 2002

The Star-Ledger Archive COPYRIGHT © The Star-Ledger 2002

Date: 2002/10/13 Sunday Page: 001 Section: BUSINESS Edition: FINAL Size: 1143 words

Your way in New way to fight volatile markets still isn’t risk-free


For years, hedge funds were an exclusive country club in the Wall Street hierarchy, open only to the rich and famous.

Until now.

Mom-and-pop investors, many of whom have seen their portfolios wiped out by the long bear market, are using a relatively new investment called hedged mutual funds to battle the choppy markets. They act a lot like traditional hedge funds, which for years have aggressively played both sides of the market by shorting stocks, leveraging positions and using options and futures.

And why wouldn’t smaller investors want in? The average hedge fund has blown away the average stock fund during the market downturn, posting a 44 percent gain for the three years ended June 30, according to industry figures. The average stock fund that typically just buys and holds a basket of stocks has lost money over the same period.

The numbers alone have forced investment firms and mutual fund companies to roll out these “poor man’s hedge funds” to stem the exodus of disgusted investors.

These funds not only walk and talk like traditional hedge funds, they do away with many of the obstacles that have kept mainstream retail investors on the sidelines for so long.

For example, investors don’t need a net worth of $1 million to join a hedged mutual fund – a key qualification in traditional hedge funds that also keep membership to a limited number of investors. They also don’t need a huge initial investment or need to worry about getting soaked with fees. The Securities and Exchange Commission also regulates hedged mutual funds, which limits their use of risky leverage and derivatives, or exotic illiquid securities.

These are among the reasons Ron Lake, president of Greenwich, Conn.-based Lake Partners, which invests in hedge funds for institutions and private investors, likes to describe these products as “kinder and gentler hedge funds.”

Today, the universe of regulated hedged mutual funds includes more than 160 funds with combined assets of about $45 billion. That represents a relatively small niche in the $6.4 trillion fund world, but it is a growing segment, Lake said.

The new funds starting popping up after 1997, when Congress repealed the so-called “short-short rule,” making it easier for mutual funds to short securities. Prior the change, mutual funds were not allowed to make more than 30 percent of their gross income from short-term trading or short selling.

Short-term trading meant holding a security less than 90 days. And a short sale is basically a bet that stock prices will fall – a risky trading technique that can be very lucrative in the midst of a bear market when all stocks seem to do is fall.

It was a landmark change for the industry.

“Without the short-side, you are essentially fighting with one hand tied behind your back,” Lake said.


Charles Schwab & Co. joined the ranks of investment firms offering hedged funds last month, a significant move in the eyes of many because of Schwab’s huge mainstream customer base. The world’s biggest online brokerage said its Schwab Hedged Equity Fund would employ some of the trading techniques hedge funds use, meaning it would go both long and short, allowing it to play both sides of the market.

The Schwab fund requires an initial investment of $25,000 (subsequent investments must be at least $5,000) and will carry an annual expense ratio of 2 percent, at least for the first year, the firm said. That initial outlay is more than most hedged mutual funds, which run between $500 and $25,000, Lake said.

There can be other benefits to hedged mutual funds beyond the lower buy-in costs.

For example, hedge funds managers traditionally take a 20 percent cut on any trading profit – a reward known as an incentive fee. That fee is on top of the annual management fee of 1 to 2 percent. Securities law forbids mutual funds from charging this type of an incentive fee, Lake said.

Hedged mutual funds also are more liquid than hedge funds, meaning investors can sell or buy shares on a daily basis, instead of once a month or once a year.

“For folks that want to get access to these types of trading strategies, but are new to the area, hedged mutual funds are much more user-friendly than regular hedge funds,” Lake said. “It’s a more accessible alternative to alternative investments.”

Because hedge funds are unregulated and under no obligation to report their assets or returns to the SEC, there is no definitive data on the number of funds in operation.

But advisers and consultants who work in the field say there are between 6,000 and 8,000 of them, with combined assets probably topping $500 billion. Compare that to five years ago, when the number of hedge funds was closer to 500. Or 10 years ago, when the combined assets are believed to have been around $15 billion.


The mutual fund industry could only ignore the boom so long once the markets started heading south. “Mutual funds are a mature product, so the amount of money going in, the total aggregate amount, is very modest,” said Mark Elzweig, president of Elzweig & Co., a New York-based recruiting firm that specializes in asset management. “Their basic business is not growing, so there is an impetus to transform themselves into broader-based financial services companies, instead of one-product shops.”

Still, not everyone is bullish on the proliferation of hedged mutual funds.

The harshest critics say hedged mutual funds are just marketing ploys, a way for cash-strapped investment firms and fund companies to cash in on investor fears and capitalize on bearish times.

Alexander Haverstick, managing director of Maplewood-based The Palladin Group, a hedge fund that manages over $700 million in assets, wonders if “these companies know how” to run hedged funds.

“The issue,” Haverstick said, “is whether people trained as institutional long-only managers can run these kinds of funds. Hedge funds are hard to institutionalize, because they are not benchmark-driven.

Also, he said, “Large asset managers are in the business of collecting assets. That’s the only way they can stay in business, so if you are T. Rowe Price or Franklin, what do you have to do? You have to stop the hemorrhaging and since you can no longer offer hopes and dreams – you can’t sell greed – you now have to sell fear.”

If nothing else, hedged mutual funds seem to accomplish that much.

“These products appeal to investors’ sense of panic over what’s going on in the last 21/2 years,” said Brian Portnoy, a mutual fund analyst at Morningstar. “This is largely about marketing.

“Hedged mutual funds appeal to people who are running scared today. Right now people are more obsessed with risk than return. They want to believe the hedge fund strategy will hedge the downside risk.”

NOTES: Sam Ali can be reached at sali@starledger.com or (973) 392-4188.