2007: Year of Hedge/Mutual Fund Convergence?

by: Christopher Holt

We’re only a few weeks into 2007 and there seems to be an inordinate amount of buzz about mutual funds that are able to pursue non-traditional (read: “hedge fund”) mandates.

This article by Murray Coleman of Dow Jones MarketWatch suggests the phenomenal growth of long/short mutual funds in 2006 will continue into ‘07. Says Coleman:

The amount of money going into dedicated long-short mutual-funds has doubled in the past year. By the end of 2006, the category had attracted nearly $6.3 billion in net assets, according to Lipper.


Long/Short or “Long-Then-Short”?

This seems encouraging on the surface. But the rest of this article leaves us a little concerned. The piece continues:

‘In theory, long-short mutual-funds can beat everyone because they go long when the market is bullish and short when the market is bearish,’ (Lipper analyst, Jeff) Tjornehoj said.

This sounds like a market-timing fund, not a typical long/short fund. If mutual fund investors are interested in “hedge” mutual funds simply because they believe hedge fund managers can pick the top of the market, we’re all in trouble.

A Free Lunch?

Another worrisome sign that the hedge-mutual-fund dialogue may be becoming polluted by marketing hype: suggestions that an investor can have downside risk without losing any upside potential. One hedge-mutual fund manager tells Marketwatch:

We’re finding increasing demand from investors who want to gain more protection against downside risks without losing their exposure to stocks,

Yeah, I’m sure you are finding a lot of people lining up for that free lunch.

Balanced Fund Substitute
Ironically, the entree for hedge funds into retail portfolios might be as a substitute for old fashioned (conservative) balanced funds. According to Lipper analyst Jeff Tjornehoj, a portfolio of stocks plus bonds (which are considered to be inversely correlated in the long run) is not that different from a portfolio of stocks plus short-positions-in-stocks (which really do have a negative correlation to stocks in both the short and long run).

'On an absolute return basis, mixing bonds — whose price often moves inversely to stocks during lengthy stretches — with stocks usually winds up underperforming a long-only broad stock fund,’ Tjornehoj said.

‘The trade-off is less volatility than a stock-only fund,’ he added. ‘The promise of a long-short fund is that it’ll mitigate risk while providing better returns than a balanced mutual-fund portfolio.’

We understand Tjornehoj’s general point. But one critical clarification is needed: a long/short fund will mitigate systematic market risk, not idiosyncratic manager risk (or other non-market risks). Overall volatility might actually be higher for a long/short fund than for a long-only fund.

Regulatory Hurdles
If markets go south, this may be the first year where mutual fund managers have had the option of taking an inverse position on the market. Shorting has only been an option for US mutual funds since the late 1990s, so it was slim pickings for bearish mutual fund investors during the last market rout.

Recent growth in this niche is good news for US investors. But Canadians are still forced to freeze to death in the long-only wilderness where mutual funds are still capped at shorting 10% of NAV. However, neither country can employ significant amounts of leverage in their mutual funds.

Analytic Investors’ Harindra de Silva (of Fundamental Law of Active Management and 120/20 fame) makes the point to Marketwatch:

Harindra de Silva, co-manager of Old Mutual Analytic U.S. Long/Short Fund points out that mutual-funds, unlike hedge funds, can’t borrow to create leverage. ‘But mutual-funds can short stocks and use the cash to buy more long positions,’ de Silva said. Last year, Old Mutual Analytic switched from a long-only focus to combining that investing style with short positions.

Regardless of the direction markets take in 2007, this mutual fund market niche will likely grow significantly. The challenge will be for marketers (and the media) to maintain a rational and logical dialogue.