|Even a modest positive return during a bear market is enough to pique an investor's interest, which is what brought hedge funds into the limelight in 2000. In a year when the Standard & Poor's 500 index was down 9.1%, the mutual fund class, which saw an average return of 4.85% for the year (according to CSFB/Tremont Hedge Index), attracted a large following. |
Hedge funds are not as popular as growth or value funds, and there is a very good reason for that. If you want to invest in hedge funds, you must have:
1 An annual income of $200,000 for the past two years with a reasonable expectation of maintaining that income level in the future, orIn spite of these limitations, assets invested in hedge funds have increased. The results of a report from TASS Investment Research, an information and research company providing information on hedge funds, can be seen in Figure 1. The amount of assets flowing into hedge funds has been steadily increasing, with a total of $8 billion in new assets invested in 2000 alone.
Hedge funds remain access-ible only to individuals with high net worth. True, there are situations in which you can pool assets with others to invest in a hedge fund or in hedge mutual funds with lower minimum requirements, but they still tend to be restricted to the higher-income group. If you have the wherewithal to invest in hedge funds, by all means, consider them. But what about those of you who don't have sufficient net worth or income, but still want the flexibility in generat-ing returns that hedge funds offer?
Because of the increasing interest in hedge funds, mutual fund companies have started to offer products that resemble hedge funds but do not have some of their strictures.
Hedge funds are unregulated, so managers have the flexibility to short stocks, take advantage of exotic derivatives, trade currencies, and engage in arbitrage. Traditional mutual funds, on the other hand, are subject to strict regulations and prohibited from generating more than 30% of their gains in stocks held for less than three months or sold short. Selling short is when borrowed stock is sold with the hope that it can be repurchased at a lower price in the future. The restriction on selling short prevents mutual funds from performing well during bear markets. In 1997, the short-sale rule was repealed. This action resulted in mutual fund companies offering a type of fund known as market-neutral funds.
Market-neutral funds allocate half their portfolio to long positions and the other half to short positions. The managers of market-neutral funds will invest in undervalued stocks in the hope the funds will go up, and short stocks that are overvalued in the hope they will go down. This suggests that during a bull market, the long positions will do well, and during a bear market, the short positions will outperform. Sounds like a great strategy that can't go wrong, doesn't it? The value of your portfolio goes up whether the markets go up or down, and the portion of your portfolio that is in cash will be invested in money market instruments. If worst comes to worst, you'll at least gain a modest return, if nothing else.
The lack of stellar performance could be due to reasons ranging from poor stockpicking on the managers' part to the high expense ratios associated with these funds. Annual expense ratios range between 2% and 3%, whereas domestic equity mutual funds have expenses that average 1.4%. Another factor to keep in mind is that you can expect these funds to have high turnover because fund managers will be constantly adjusting their portfolios to adapt to changing market conditions. High turnover means high capital-gains taxes. If you still want to take your chances and include market-neutral funds in your portfolio in spite of their poor historical performance, make them part of tax-deferred investment vehicles such as IRAs.
Although market-neutral funds were introduced to reduce the risks associated with investing, their performance has proved otherwise. This, together with higher expenses and turnover, makes them an unattractive investment. If given the choice, I would stay away from them.
Editor Jayanthi Gopalakrishnan can be reached at Jayanthi@Traders.com.
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