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Buying a Fund? Don’t Just Aim for a Fast Buck

Dreyfus Strategic Aggressive Investing Fund was the most successful mutual fund in the second quarter, up 42.5% in a period when the Dow Jones industrial average rose less than 6%. Strategic Investing’s edge was that it used options and stock-index futures to achieve a very large portion of its gains.

And Howard Stein, chairman of Dreyfus Corp., the $33-billion (assets) parent company of Strategic Investment and more than two dozen other funds, thinks that’s the start of a trend. Dreyfus has just brought out another fund, called Capital Value, that is authorized to use options and futures to hedge against losses in the stock and bond markets.

What’s going on? Does Stein, a veteran of more than three decades in the mutual fund business, think stocks and bonds are about to go into a tailspin? Not necessarily, but he’s certain that markets will continue to be volatile, that we’ll see more days when bond prices move sharply and stocks gyrate wildly.

As Stein sees it, allowing fund managers to hedge with options and futures at such times gives ordinary investors the same flexibility that the big investing institutions enjoy.

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He has a point. Markets are volatile, and if professional investors gain from use of new investment mechanisms, there is no reason the mutual fund business can’t bring the same capability to its 26 million individual investors.

But there are other points for those individual investors to keep in mind, among them that the transaction costs of futures and options trading increase fund expenses at a time when mutual fund fees and expenses are already going up.

Some Lucky Moves

More important than cost, however, is the necessity that investors take the time to understand just what hedging and futures trading is and is not.

The extravagant gains of the second quarter’s hottest fund, for example, came not from hedging stocks for safety but from highly risky futures trading. Stanley Druckenmiller, who manages Dreyfus Strategic Investing, points out that the market rose or fell by 5% or more seven times during the quarter and that his gains came from betting right every time. “It was extraordinary and lucky--and unlikely to be repeated,” says Druckenmiller candidly.

And investors should also understand that hedging limits potential gains.

To illustrate, let’s examine a hypothetical option. When a fund sells a call option, it obligates itself to sell the underlying stock at a certain price to the option buyer.

If the stock should then decline, the option will expire unexercised--as the buyer won’t pay more than the stock’s new market price--and the premium paid for the option becomes the property of the fund.

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The profit on the option thus offsets to some extent the decline in the stock, which is how the hedge works. But don’t lose sight of the fact that the stock declined. At best it’s a break-even situation and, of course, the fund might have been ahead of the game if it sold the stock before it declined.

Won’t Stop Practice

On the other hand, if the stock in that situation appreciated in value, and the option were exercised, you would have a gain from the option fee but have forgone the potential gain in the underlying security.

Complex? Surely. But that’s no reason to forbid it, says Kathryn McGrath, the Securities and Exchange Commission’s director of investment management.

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“The SEC could say the funds cannot do these things,” says McGrath, “but that is unacceptable. It would stop people from making investments they might want to make.”

So the SEC requires full disclosure of the risks and costs in the fund prospectus, and tries--not always successfully--to prevent fund advertising from becoming misleading.

Many mutual funds have begun adding hidden sales charges--sometimes you find yourself paying 3% of your investment when you sell a fund--or taking advertising and sales promotion expenses out of the investors’ capital, under a clause in SEC regulation called 12b-1. As a result, annual expenses, aside from any sales commissions, are getting up to 1.5% of fund assets--meaning the funds take $1.50 a year out of every $100 you invest.

What can you do about that? Read the prospectus and comparison shop. “I’m amazed,” says Stanley Egener, president of Neuberger & Berman Fund Management, “that people will shop for weeks for a refrigerator or a car, but put $20,000 into an investment without a second thought.”

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And what can worried investors do about markets that are getting unstable and may soon decline after rising for five straight years?

First, think about it. Realize that the real reason for investing in a mutual fund or anything else is to preserve capital. And the best funds for doing that, say the annual fund rankings published by both Forbes and Money magazines, are those that perform well in down markets as well as up. There are two dozen such funds on those lists, which measure performance over 10 years.

But none of the funds on those lists use futures or options. Maybe it takes more than trendiness.


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