Hedge Funds for the Rest of Us

Hedge funds used to occupy a small, obscure part of the investment world. They were out of the public eye; few investors even knew about them. Regulators ignored them, as a matter of law.

Gradually hedge funds became more prominent. A few of the pioneers of the business became billionaires, drawing attention to the business. George Soros received a lot of publicity in the 1990s after winning a big bet against the British pound, a move that British officials lambasted and blamed for the fall of the pound.

Hedge funds really took off after the technology stock bubble burst in 2000. While market indexes declined, many hedge funds held their value or made money. That attracted not only media attention but a flood of money from pension funds, endowments, and other sophisticated investors. It seemed that everyone who did well on the trading desk of a Wall Street firm or who had the confidence of a broker formed a hedge fund and raised tens of millions of dollars to invest. Some hedge funds grew to billions of dollars under management, and some hedge fund owners earned $1 billion and more in a year.

While hedge funds in general did not distinguish themselves in the broad market crash of 2008, they have a reputation for beating the S&P 500 long term and generally have done so in 2009 to date.

The problem for most investors is they cannot invest in hedge funds. By law, a hedge fund can accept only certain investors, known as qualified investors. They also are known as sophisticated investors. These investors are pension funds, endowment funds, foundations, and individuals who meet net worth or income requirements. But there are some safe ways for individual investors to reap the rewards of hedge fund investment strategies.

There is no real definition of a hedge fund, though there used to be. Today, a hedge fund is an investment partnership or pool that is not subject to the regulations that apply to mutual funds, investment advisors, or brokers. Hedge funds are subject to only a few regulations. That is why they can accept only certain types of investors. Those who wrote the securities laws reasoned that these sophisticated investors did not need the protection of the securities regulators and could invest with whatever firm they wanted to.

The original hedge fund was an investment vehicle that took both long and short positions in the stock market. A long position is when an investor buys an investment expecting it to appreciate. A short position is when the investor sells short an investment, expecting it to depreciate. The investor also can use futures or options contracts to take long or short positions in an investment. In other words, a hedge fund actually hedged its investments. It would take a long position expecting an investment to increase but also would take a short position that would profit if the long position did not.

Today the term hedge fund applies to a fund’s legal status rather than its investment strategy. Hedge funds today engage in a wide range of investment strategies. Some have very conservative strategies that aim to earn only a little more than money market interest rates. Other hedge funds employ very risky strategies, even using debt or other forms of leverage that magnify gains or losses.

Hedge funds have several features that attracted institutional investors in recent years.

An important characteristic of a hedge fund is that its investment returns have a low correlation with the major stock and bond market indexes. Correlation is the extent to which an investment rises or falls with an index. Some investors call this “beta.” An investment with a beta of 1.0 to a stock market index rises and falls when the index does and by the same percentage. An investment with a beta of 0.0 to the index has no correlation with it. An investment with a beta of -1.0 moves exactly the opposite of the index.

Correlation is important, because an investor might not want his portfolio’s value to be subject to the ups and downs of the stock market. While the long-term average returns are nice, the investor might not be able to withstand the shorter-term declines of 20% and more, sometimes much more. An endowment or foundation must pay income each year to fund its sponsor. A pension fund must pay pension annuities, and the employer’s annual contribution is based on the current value of the fund. An individual might be paying for retirement or some other expense, and cannot plan well with sharp fluctuations in the portfolio’s value. Each of these investors has good reason to seek an investment that does not have a high correlation with the stock market indexes.

An investment with a high long-term return that does not fit the same pattern as the stock market indexes is a good addition to a portfolio.

Hedge fund investors also like that they can build a diverse portfolio of hedge funds that have low correlations with each other. When some funds are up, others are down. This combination of investments with low correlations to each other also smoothes a portfolio’s returns.

Another advantage of hedge funds is they can be less volatile than the stock indexes. While the stock indexes have wild disparate returns from year to year, a number of hedge funds have much steadier return patterns. This is another way of smoothing the portfolio’s annual changes in value.

Investment returns are another appeal of most hedge funds. The ideal hedge fund has long-term returns that are close to those of the stock indexes but has a low correlation with the index and less volatility than the index.

This is all interesting, but what does it mean for you unless you are a qualified investor? There are ways you can benefit from hedge fund strategies.

A few years ago I set out to build a portfolio of no-load mutual funds that have the same characteristics as hedge funds. The return patterns of the funds would have low correlations with the major stock and bond indexes and also with each other. The funds as a group also would have less volatility than the indexes and would have high long-term returns.

Not too long ago, it would have been impossible to put together such a portfolio. Mutual funds had “long only” portfolios. They did not use unusual strategies, sell short, or hedge. They also did not move from one type of asset to another. In general, traditional mutual funds stuck to one type of investment and strategy, and they did not hedge their investments.

Even better, my “hedge fund” mutual funds do not have the high expenses of hedge funds. A typical hedge fund charges annual expenses of 2% of assets plus an incentive fee of 20% of all positive returns. That is how hedge fund managers make high incomes. You do not need to earn high returns to earn a high income if you have a lot of assets under management and take 20% of all positive returns.

I put the hedge fund portfolio together in 2001 and back-tested its performance. The performance since has been consistent with the back-testing and the goals. The portfolio returns more than the S&P 500 with less volatility and a low correlation to the index.

The key to a long-term successful portfolio such as this one is to avoid the large losses of the indexes. While 2008 was a rough one for my “hedge fund” portfolio, it was better than for traditional mutual fund investors and for many well-known hedge funds.

The big picture numbers of the portfolio are impressive. The volatility, as measured by standard deviation, is 10.75 over three years, 8.7 over five years and 7.73 over 10 years. In each case, the volatility is about half that of the S&P 500. (All the data are as of June 30, 2009.)

The portfolio also has a low beta, or correlation, with the S&P 500, though that has increased the last few years. Over three years the beta is 0.52, and it is 0.51 over five years. Over 10 years the beta is 0.36.

Returns are excellent. Alpha is the extent to which the returns exceed those of the benchmark. The portfolio consistently delivers alpha over the S&P 500. Over three years, alpha is 3.01 annually, and it is 2.93 over five years. Over 10 years, annual alpha is 5.88.

The financial crisis of 2007 and 2008 increased the standard deviation and beta, because all assets were negatively affected by the market meltdown and credit squeeze, except treasury bonds. I expect over time those numbers for the shorter periods will become closer to those of the 10-year period, as they were before 2008.

One of my goals for any investment is to avoid big losses. We cannot avoid all losses, but we want to avoid those 40% and 50% draw downs to which the market indexes are subject. The hedge fund portfolio has accomplished this.

Over the one-year period, the portfolio lost 9.12%. That is disappointing, but it is much better than the 26.21% loss of the S&P 500. Over three years the portfolio has a positive return of 0.30% annualized, versus an annualized 8.22% loss for the index. Over 10 years we have a 7.26% positive annualized return instead of the 2.22% annualized loss of the S&P 500.

Normally a portfolio that avoids large losses also misses out on bull markets. That is not the case with this portfolio. The highest returning period of the last 10 years was the three months ending with May 2009. The hedge fund portfolio earned 16.27% during this period. That lags the historic returns the S&P 500 earned during the period, but it is a strong return and coupled with the portfolio’s loss reduction qualities puts the portfolio well ahead of the index. The worst three-month period for the portfolio, not surprisingly, was the period ending November 2008 with a 20.63% loss. The worst 12 months ended February 2009 with a 22.78% loss, and the worst three years ended Feb. 2009 with a 4.43% annualized loss. Losses of that magnitude are disappointing, but they are well above the index and what most investors sustained. The portfolio bounces back with the markets.

The hedge fund portfolio is diversified among not only strategies but also different types of assets. As of June 30, 2009, the portfolio was 7.37% in cash, 37.52% in U.S. stocks, 9.22% in non-U.S. stocks, 43.04% in bonds, and 2.85% in other assets.

The funds in the portfolio are carefully selected for several characteristics. They must be no-load and have reasonable expenses. They also must use strategies commonly used by the best hedge funds instead of typical mutual fund strategies. The funds also must have low correlations with each other and with the major indexes.

The hedge fund portfolio is designed as a buy-and-hold portfolio. Changes are made when newer funds prove themselves after a few years or when an existing fund has a major change, such as its management or fee structure. But generally we depend on the fund managers to move their portfolios among different asset classes instead of doing it ourselves.

The portfolio has a wide variety of mutual funds. There are traditional hedge funds, such as Schwab Hedged Equity. There also are “asset allocation” funds such as Hussman Strategic Growth and PIMCO All Asset. There are some unique balanced funds, such as Oakmark Equity and Income, FPA Crescent, and Berwyn Income. The portfolio also has funds that can invest in almost anything but specialize in distressed asset investing. Finally, we have some funds that invest in long only strategies but do so in assets that offer good diversification, such as real estate investment trusts, high yield bonds, and international bonds.

Investors have been damaged by following conventional investment strategies of buying and holding portfolios of long-only mutual funds that invest in many of the same assets. There are opportunities to achieve true diversification and construct portfolios that deliver better returns than the S&P 500 with less volatility and risk. These results can be achieved using select no-load mutual funds that avoid the high fees and lack of liquidity of traditional hedge funds while employing traditional hedge fund strategies.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 07-23-2009 11:41 AM by Bob Carlson