A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than long-only investment funds, and that, in general, pays a performance fee to its investment manager. A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return. This success has led a relatively new class of mutual funds to mimic hedge funds by adopting alternative strategies. These newer, alternative funds are called “hedge-like mutual funds” or “alternative mutual funds.”
These mutual funds are becoming more popular, as financial advisors and individual investors learn more about why institutional investors often invest in alternative investments or hedge funds. Over the past 10 years, many institutional investors have increasingly shifted the weights of their portfolio to these types of alternative investment vehicles. Since institutional investors have the most sophisticated portfolio optimization and research resources available, their decisions heavily impact the retail market and many follow their lead. A typical investor in a hedge-like mutual fund is someone who has a substantial income – enough to afford the high minimum investment that is often required – and has an appetite for risk that traditional investments do not satisfy.
Part of what attracts investors to hedge-like mutual funds is the prospect of higher returns and the ability to implement alternative strategies without having to be an individual with high net worth. Hedge-like mutual funds allow average-income investors to join the world of alternative investments and diversify their portfolios in a unique way. Additionally, hedge-like mutual funds offer benefits for investors that hedge funds do not, such as more SEC oversight, daily liquidity and smaller fees. Adding a mutual fund to a portfolio that uses a market-neutral or long-short strategy may reduce risk in a way that was not previously available to traditional investors. For example, Morningstar reports that in 2002, the value of the average stock mutual fund fell 22% while long-short mutual funds only dropped 0.3% in value.
Although hedge-like mutual funds are similar in a few ways to hedge funds, there are two important regulation differences.
The SEC regulates mutual funds, making it difficult for mutual funds to adopt hedge-fund strategies. Specifically, there are four federal laws that the SEC imposes on mutual funds: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act of 1940. These laws restrict mutual funds from adopting some of the strategies or investing in some of the asset types used by hedge funds. These can include leveraging or borrowing against the assets in a fund’s portfolio, and it requires mutual funds to register with the SEC and provide daily net asset values. The regulation that the SEC imposes on mutual funds compared to hedge funds have contributed to hedge-like mutual funds underperforming hedge funds because they have less flexibility and are required to have a greater degree of liquidity.
Hedge-Like Mutual Fund Strategies
Hedge-like mutual funds use many different alternative strategies. A popular strategy is the long-short strategy, which buys stocks to hold while selling stocks at the same time. Long positions involve owning securities in which the investor’s portfolio profits if the price of the securities increases, and the portfolio is negatively affected by a fall in the price. Holding short positions is the opposite, where the fund sells borrowed securities which must eventually be bought back and given to the lender. The short position expects the price of the security to fall, and the portfolio suffers if the price increases.
Another hedge-like mutual fund strategy is a market-neutral mutual fund which is equally split between long and short positions. Merger or arbitrage funds use a different strategy of buying stocks in companies that are expected to be taken over in the future. The risk involved in all of these strategies is that these mutual funds attempt to anticipate the market, which could lead to costly exposure to unexpected changes in the market. (For further reading, check out Getting Positive Results With Market-Neutral Funds.)
Conclusion
Hedge-like mutual funds are a unique and largely unexplored corner of the mutual fund industry. Their unique investment perspectives and tools set them apart from other mutual fund offerings, and secure them a long-term position within the industry. (For further reading, take a look at Alternative Assets For Average Investors.)
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