Schwab Launches ‘Hedged’ Stock Fund

Charles Schwab Corp. on Wednesday opened a stock mutual fund that will partly bet against the market, offering mainstream investors some of the trading techniques employed by wildly popular hedge funds.

Schwab’s move reflects both the sober new attitude toward stocks on Wall Street and the search by the world’s biggest online brokerage for new business amid a continuing trading slump that has crushed its earnings.

The San Francisco-based company said its Schwab Hedged Equity Fund would go “long” and “short,” allowing it to play both sides of the market.

In a short sale, an investor borrows shares and sells them, betting on a falling price. If the bet is correct, the investor can buy back the shares later for less, repay the loan and pocket the price difference.

There are numerous other mutual funds available that use shorting techniques, and wealthy investors have been able to buy into hedge funds that typically go both long and short with stocks and other investments.

But Schwab’s decision is significant because of the firm’s huge mainstream customer base.

In a nod to the growing appeal of hedge funds, Schwab is marketing its new fund as a cheaper, more accessible and better-regulated alternative.

Hedge funds, once the exclusive domain of the ultra-wealthy, often require minimum initial investments of $1 million or more, and they typically charge performance fees of 20% a year if their benchmarks are beaten.

The new Schwab fund, by contrast, requires an initial minimum investment of $25,000 (subsequent investments must be at least $5,000), and will carry an annual expense ratio of 2%, at least for the first year, the firm said.

Hedge fund industry assets have ballooned to an estimated $600 billion as well-heeled investors have sought a way to profit, or at least stay above water, during the long bear market that has devastated share values.

In the first half of this year, the average hedge fund’s performance was flat, while the average U.S. stock fund lost 10%, according to Van Hedge Fund Advisors International in Nashville.

Ron Begley, executive vice president at Van Hedge Fund Advisors, said that “mutual funds have had three years of underperformance,” while many hedge funds have preserved investors’ capital or posted gains, helped by their ability to profit from falling share prices.

“This has not been lost on the brokerages,” Begley said.

Some analysts say there is a risk that the small investor is being allowed into the hedge-fund boom--directly or indirectly--at what might prove to be the peak of the funds’ popularity.

Although the idea of being able to profit in any kind of stock market holds broad appeal these days, the task may be trickier than it appears, analysts warn. Shorting can be an extremely risky strategy.

Some so-called market neutral funds that go long and short, such as AXA Rosenberg Value Market Neutral and Phoenix-Euclid Market Neutral, have posted big gains this year, according to a new report from Standard & Poor’s. But other mutual funds that employ shorting strategies have generated mixed results.

Schwab is touting its fund as a way for it to apply its new stock-rating system, which uses mathematical formulas to grade about 3,000 stocks.

“This fund allows us to take advantage of those stocks Schwab rates as ‘under-perform,’ ” said Geri Hom, lead manager of the new fund.

The Hedged Equity Fund will not be market-neutral like several long/short funds already on the market, nor will it be “fully hedged” like the nearly 400 traditional hedge funds, said Schwab spokesman Lance Berg.

Instead, it will hold mainly long positions, with 20% to 25% of assets in shorted stocks. Most long positions will be in stocks rated A or B by Schwab’s formula, while short stakes mainly will be in stocks rated D or F, Hom said.

Mark Constant, an analyst at Lehman Bros., said he expects brokerages to continue blurring the lines between hedge funds and mutual funds.

“Hedge funds are quite trendy right now. Schwab is not the first to offer something like this, nor will it be the last,” Constant said. “It’s funny how nobody at the market peak seemed to care about capital preservation. At the trough, apparently they do.”