The mutual fund industry sems to scrambling to find a new way to entice individual investors. With fewer and fewer investors buying into the active managers claim of stock picking skill, we are now faced with a variety of "absolute return", "long short" or go anywhere funds sold as a way to get access to active managers able to spin gold out of yarn : positive returns whatever the market conditions with less volatility to boot.
The WSJ reports today on another wrinkle to this group of
products the hedge fund like mutual fund which the article notes perform this ambitious feat:(my bolds and comments in blue)
Hedged mutual funds provide stock-like returns with less volatility. Moreover, they provide more transparency and regulation than hedge funds. "We think there'll be a huge move to these types of funds," Mr. Krusen said.
Hedge funds take short positions, bets on falling prices, as well as long positions that benefit from rising valuations. They also can use borrowed money, or leverage, to magnify returns. They usually lock investor money up for a quarter or more, and some are free to trade any securities or derivatives anywhere in the world.
The goal is to generate positive returns, irrespective of the direction of the overall market. This is usually all wrapped up in a limited-partnership structure in which the manager charges an annual fee of 2% or so and takes about 20% of profits each year.
Traditional mutual funds typically take long-only positions and try to beat benchmarks, such as the S&P 500-stock index. The average net expense ratio of mutual funds is about 1.3%, according to Morningstar. Mutual funds don't take any cuts of profits. In contrast, the Flexible Fund's net expense ratio is 3%, according to Morningstar.
It's not hard to understand why this structure might appeal to managers like AQR management that previously only managed hedge funds. Hedge funds typically charge "2 managementand 20% of profits " But if the fund suffers large losses the 20% can only be charged once the fund recovers to the "high water " mark. So with a 30% loss a hedge fund manager would have to recover 42% before beginning to collect the performance fee. This structure led many hedge fund managers to simply close their funds return the money to investors....and start fresh with a new fund. It doesnt take a quant PhD to do the math that 3% annual fee from retail investors would likely be a better trade than "2 and 20" in a hedge fund, particularly when institutional investors have been pushing back for lower fees.
As for whether the strategy makes sense at all, I see no logical reason to assume active managers would be more successful using more complex strategies in the toolbox of these funds than other types of active managers.
Furthermore the structure presents some additional risks. Hedge funds often have "lockup" periods which have the disadvantage of not allowing easy liquidity for investors who also must give several weeks prior notice even before liquidating at the end of the lockup period. There is some merit to the claim by hedge fund managers that such a structure protects them from having to liquidate positions in difficult markets when "hot money" runs to the exits. Even with the structure as it exists such flows can occur leading to liquidations that can cascade into further losses in a panicked market, leading to large losses for those that are invested with a long term horizon. For that very reason sophisticated hedge fund managers such as Yale Endowment insist that their investments with a hedge fund manager be held separately. That way if positions in the fund need to be liquidated to meet redemptions, Yale's positions need not be sold off.
But consider the mutual fund structure for these high risk leveraged strategiies. While the transparency and daily liquidity have benefits the likelihood of hot money flows is extremely high. We know retail investors chase the market. One can only imagine what would happen if a hedge fund type mutual fund reported a one month loss of 20% money would flow out of the fund and positions would be liquidated most likely at extremely distressed values punishing the long term investors. And the reverse would pose a danger as well: money would flow into hot funds, and the managers would be encouraged to put more money into existing positions at less attractive prices or to scramble to invest the money in ways to keep up the returns (and the inflows) taking more and more risk. If there was a virtue to hedge funds in being able to take longer term positions because investors would be committed for extended periods it would all be gone with the mutual fund structure the pressure for short term performance would be intense and the positions and trades wouldbe highly influenced by flows in and out of the funds.
Of course none of this keeps Wall Street from pushing these new untested products playing on investors fears and the well known behvioral finance behavior of "recency" drawing long term conclusions with a disproportionate weight on recent events" From the article:
Investment bank Goldman Sachs Group Inc., one of the largest hedge-fund managers in the world, advised investors to add this new breed of mutual fund to their portfolios in a September report. The 2008 financial crisis left many uncertain about whether a traditional mix of stocks and bonds can generate enough return, the bank said.
Ironically of course a simple portfolio invested 65% in the US total bond market and 35% in the US stock market would have grown 28.9% since the beginning of 2009. Maybe the new new thing will become a simple globally diversified low cost portfolio of index instruments despite the lack of wall street advocating this approach. Particularly when this performance is viewed as a major achievement:
Barrons website
Report: Hedge Funds Running Neck-To-Neck With S&P 500
Posted by Murray ColemanAs noted earlier by a previous study, hedge fund assets keep rising and investors keep putting more new money into managers’ hands.Maybe the smart money is not in the flows described above but among the bifg flows into etfs.shown in the graph at the top of the page.
As long as returns are relatively positive, that’s likely to be the case for awhile longer.
In October, the trend we’ve been seeing of improving hedge fund performance continued. As a whole, hedge funds gained 2% in the month, according to the Barclay Hedge Fund Index compiled by BarclayHedge.
After back-to-back gains in the past two months, the index this year was up 7.24% — nearly matching the 7.84% return of the S&P 500 benchmark.
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