Wealth

Hedge Fund Returns Without the Headaches

The trick? Invest in a mutual fund in hedge-fund's clothing

By: Virginia Munger Kahn
[ Updated: Sep 11, 2008 - 11:57:55 AM ]

When it comes to cocktail-party chatter, nothing beats boasting about the mega returns generated by your hedge fund. That is, until the next time a hedge-fund manager runs away with investors' money—remember Bayou Capital Management?—or completely implodes, as Amaranth Advisors did in September 2006.

A more efficient, less anxiety-provoking way to get access to the investment strategies followed by hedge funds is to buy a mutual fund in a hedge-fund's clothing. Morningstar, the fund-analysis firm in Chicago, counts nearly 50 funds that follow long/short or market-neutral strategies--common investment approaches followed by hedge funds. Not only will you avoid the high fees, but you'll also know a lot more about what the managers are doing with your money.

These funds charge annual expense ratios of around 2 percent of assets; compare that with the 2 percent of assets plus 20 percent of profits charged by hedge funds. Also setting them apart from real hedge funds: They are required to disclose their holdings every six months and keep investor assets in a third-party institution. These safeguards have not kept mutual funds scandal-free, but it has been a long time since a mutual-fund manager absconded with fund assets and hightailed it off to Bermuda.

Among market-neutral funds, Morningstar analyst Todd Trubey likes the Merger Fund and the Arbitrage Fund. Both follow a straightforward hedge-fund strategy: They capture the spread between the share price of firms about to be acquired and their proposed purchase prices, which is designed to produce consistent returns with a low probability of loss over a three-year period. "Both funds have delivered on that goal," said Trubey. Their annual returns lately have been in the 6 percent range. That's not so exciting when the market is up 16 percent, as it was last year, but it's a home run in a year when the market falls 16 percent.

Another Trubey recommendation is Hussman Strategic Growth, which follows a typical long/short approach. Such funds not only buy stocks in the traditional way (that's the "long" portion of the portfolio), but they also try to make money by short-selling, or betting that certain other stocks will fall in value. The idea is that when the market is going up, the gains of long positions will outpace the likely losses on the short portfolio, and if the market falls, the short positions will help make up for losses on the long side.

The manager, John Hussman, develops an outlook on the overall market and then adjusts the portfolio's net position—long versus short—based on that outlook. While the fund owns individual stocks, the short position is gained by selling broader stock indexes short--"a very traditional hedge-fund strategy," says Trubey.

A higher-octane version of this strategy is Diamond Hill Long-Short. The managers buy stocks they think will go up in value, and short those they think are overpriced and will therefore fall. The fund has returned an average of 12.08 percent a year (through January 12) over the last five years—the best in the long/short category, according to Morningstar. At that rate, investors would double their money in six years.