Making Some Exotic Moves to Get an Edge
Saddled with a sideways stock market, some mutual fund managers are taking a page from the hedge fund industry -- offering clients a range of exotic investment options in hopes of eking out extra returns.
Mainstream mutual funds typically make simple investments in company stocks. In a down or flat market, these funds may offer only a mirror-image performance.
On the fringes, however, a handful of fund companies are striving to outperform the market with such techniques as call options, index futures and arbitrage plays.
These techniques resemble those employed by hedge funds, the secretive investment pools for the wealthy that aim to exploit various market inefficiencies. But there are key differences.
Hedge funds get their name from their use of various strategies to offset, or hedge, investment risks. They are limited to so-called accredited investors such as millionaires and pension funds, and their managers have wide leeway to use complex tools such as derivatives or to short-sell stocks and other assets by betting that their value will decline.
These new mutual funds, by comparison, are open to anyone and as such can be subject to regulatory restrictions, including limits on the amount of short-selling.
“These exotica funds represent a small backwater on Wall Street,” said Michael Porter, senior research analyst at fund tracker Lipper Inc. in New York. “But they have a pretty good proving ground, and if they build worthy performance records they will attract plenty of attention from investors and competing fund companies.”
The mini-trend stems from both the boom in hedge funds, whose assets have mushroomed to an estimated $1 trillion, and the frustrating, post-bubble stock market.
“These funds are pushing the frontier of the mutual fund industry for two reasons,” Porter said.
“People want to graduate from traditional mutual funds but don’t have the wealth to go to hedge funds. And the funds are capitalizing on the feeling that we’re in a low-return environment where you have to find new ways to generate extra income.”
Marco Targeted Return is a good example of one of these new funds. Launched in October, the fund has $5 million in assets and aims to “chip its way to a 12% to 15% annual return” through a series of modest gains, said manager Steven Marco.
Marco, an investment advisor in Atlanta, looks for companies with solid fundamentals and then makes twinned moves -- buying the regular shares while selling “call” options against them to limit his downside risk. It’s a strategy he used for several years with individual clients before launching the fund.
A call option is a contract giving the buyer the right to purchase stock for a set price by a certain date. In exchange for that right, the option buyer pays the seller a premium upfront.
Say XYZ Corp. stock is trading at $41 a share and Marco thinks it may go a bit higher. He would buy XYZ stock for $41 a share and sell call options against it for, say, $3 a share.
The call option includes a “strike price” that is set based on the stock’s recent performance. If the strike price for XYZ is set at $40, the buyer of the option is speculating that the price of the stock will rise above $43 -- anything higher than that amount results in a profit. If XYZ goes to $50 by the end of the term, the option buyer would more than triple his $3 investment.
Marco, meanwhile, makes $2 for every share as long as the stock stays above $40, because he has collected a $3 premium on the $41 share price. The stock has to fall below $38 for him to lose money.
Even if the stock soars above $50, he gets only the $3-per-share premium. Thus, Marco looks for stocks that he expects to go up but not skyrocket.
Banking giant Washington Mutual Inc., for instance, has hovered near $40 for two years, but Marco said he has made an annualized 14% to 15% in the stock by “rolling,” or repeating, his option strategy several times.
“If you think the market is going up 35% a year, you’re probably better off just buying stocks,” Marco said. “But if you think it’s going up 8% or 10%, this strategy makes sense. You get a consistent return that’s much more stable than just buying the Standard & Poor’s 500.”
In the first half ended June 30, Marco Targeted Return gained 2.2%, versus a loss of 1.8% for Morningstar Inc.’s large-cap growth fund category. The S&P; 500 index, by comparison, fell 0.8%.
The fund requires an initial minimum investment of $5,000 and carries an expense ratio of 1.5%.
Another exotic fund, Alpha Hedged Strategies, gives small investors access to a variety of hedge fund strategies in one product. Billed as a “fund of hedge fund managers,” it farms out wedges of the portfolio to 10 hedge fund firms that serve as sub-advisors.
An 11th slice is run by Lee W. Schultheis, whose New York-based Alternative Investment Partners launched the fund in September 2002.
To minimize the effect of cash flows in and out of the fund, he keeps that slice in cash and liquid instruments, regularly forwarding money to the sub-advisors for investment.
“We’re on the conservative end of the spectrum,” Schultheis said, noting that he avoids hedge fund managers who make bold bets on, say, the direction of the U.S. dollar.
Sub-advisors to the $116-million fund include Zacks Investment Management, an affiliate of earnings tracker Zacks Investment Research Inc., which uses a “long/short” equity strategy based on analysts’ earnings revisions. Zacks bets on the relative stock performance of similar firms whose profit expectations are rising, compared with those whose projections are flat or falling.
Recently, for instance, the fund was long on mutual fund manager Franklin Resources Inc., which has benefited from a diversified lineup including international and fixed-income funds, and short on Janus Capital Group Inc., which is still smarting from the bursting of the technology stock bubble (although its performance and fund flows have improved lately).
Twin Capital Management runs a portion of the portfolio devoted to “long/short equity momentum.” That strategy favors stocks that are rising over those that are falling. Recently it was long on software maker Adobe Systems Inc., a strong performer in recent years, and short on Intuit Inc. in the same sector.
Despite its unusual nature, Morningstar tags Alpha Hedged Strategies as a “conservative- allocation” fund.
“We’re designed to be market-neutral,” Schultheis said, “and the truth is, you probably will appreciate this fund most in a down market.”
The fund, which requires a minimum initial investment of $10,000, carries an expense ratio of 3.99% -- sky-high by mutual fund standards.
Schultheis contended that similar hedge funds of funds are more costly, charging as much as 7% a year including performance fees (a management incentive off-limits in the mutual fund world).
As with a hedge fund, the costs could be justified if the performance is strong. Alpha Hedged Strategies’ returns have been mixed relative to those of its peers, but the fund has notched gains in 2003, 2004 and this year. In the first half, the fund climbed 0.7%, versus a rise of 0.6% for the conservative-allocation category.
Like Alpha Hedged Strategies, PMFM Tactical Opportunities is a variation on a fund of funds.
The fund’s advisor, PMFM Inc. of Bogart, Ga., is among a growing roster of firms that use exchange-traded funds instead of stocks to build their portfolios. ETFs are baskets of stocks tracking indexes, but unlike index mutual funds they trade throughout the day.
PMFM -- originally known as Personal Mutual Fund Management -- uses ETFs in Tactical Opportunities and its other funds because of their relatively low cost and trading flexibility, said manager Tim Chapman.
“They allow us to easily implement our tactical allocation strategy,” he said.
Tactical Opportunities, which was launched in September and has $13 million in assets, has three core, stable holdings that comprise 80% of the portfolio: ETFs tracking the blue-chip S&P; 500 index, the technology-heavy Nasdaq 100 and the smaller-stock Russell 2,000.
With the remaining 20%, the fund managers use futures contracts to leverage the portfolio to as much as 50% net long or 40% net short on each index. Currently the fund is at its maximum long position, meaning its models point to a near-term bullish move.
Chapman said the firm sticks to mathematical, or quantitative, models and buys ETFs to limit the risk of individual company blow-ups.
“We don’t want to have to do fundamental analysis of individual companies. Our analysis is top-down, macro-level stuff,” he said. “We don’t really care what Oracle’s fundamentals are.”
The fund requires an initial minimum investment of $1,000 and carries an expense ratio of 1.5%.
“What clients are getting is a hedge fund kind of approach at a fraction of what a typical hedge fund charges,” he said. “We’re bringing the hedge fund strategy to the working-class investor.”
Whether the strategy, which Chapman said his firm has used successfully in private accounts for several years, translates to the open-end mutual fund world remains to be seen, however: In the first half, the fund lost 4.7%.
