History has been said to be economics in action. Unfortunately, the action of Main Street investors has usually resembled behavior a bit more like sheep than reasonable investors. Once some magical successful investment method has popularly been identified, Main Street investors tend blindly to follow this new leading investment strategy. More often than not, these investors will end up being financially “sheared.”
It was with this latter perspective in mind that the previous article in the Graziadio Business Review on hedge funds/alternative investments was written. The article defined the various hedge fund strategies and briefly explained their underlying concepts. It showed the rather dramatic historical results in the industry. It also clearly noted the difficulty that Modern Portfolio Theory (MPT) has had in properly quantifying the risk-return trade-off, especially when so many funds were created as well as destroyed over the past fifteen years.
The present article offers an examination of two of the most popular approaches in the field: Fund of Funds and Market-Neutral Securities. In the case of the former, this article is an attempt to be informative while providing a good dose of caution. In the case of the latter, the objective is to show pragmatically how to construct a Market-Neutral Securities hedge fund using mutual funds.
Fund of Funds
Hedge funds, or alternative investments, require considerable commitments of funds. While some hedge funds will now take a $50,000 investment, most require substantially more. They also require significant investigation as well. This investigative work has in part been taken over by consultants who organize their own individual funds of funds. The size of the hedge fund/alternative investments markets has gotten so large that the major investment brokerage houses are now offering these funds of funds themselves.
The fund of funds is yet another type of a hedge fund/alternative investment. This type of fund places resources with managers who, in the opinion of the consultant or brokerage firm that organized the fund of funds, can perform successfully. By definition, a fund of funds reduces risk by diversifying, but such diversification comes at a relatively high cost. Fees will be paid out of all funds, thereby reducing potential rewards. Furthermore, these funds of funds remain unregulated. Some problems associated with hedge funds apply to the fund of funds as well. For example, financial results are often mixed and involve extreme ranges of performance that are inverse to other market results. There is a lack of reliable rank order of outcome probabilities. Performance incentive fees for fund managers attract talent, but they also attract con artists.
Yet the problems do not end there. Fourteen strategies characterize both hedge funds and funds of funds: 1) dedicated short bias; 2) value long/short equity; 3) market neutral equity; 4) market neutral arbitrage; 5) fixed income arbitrage; 6) managed futures; 7) emerging markets; 8) macro; 9) event driven or special situations; 10) market timing; 11) sector specific; 12) opportunistic; 13) aggressive re-growth, and 14) other strategies. Since virtually all funds of funds allow wide latitude in their construction among the fourteen strategies outlined, there can never be any real MPT analysis. The returns and standard deviations of categories (required for MPT analysis) will vary widely depending on the time period selected for analysis. The continuous substitutions and changed percent weight of the money that is invested makes MPT analysis almost a virtual impossibility. The calculated result is further complicated by the instability of the investment manager’s risk-reward profile. This is a problem as well for other constantly changing investment strategies.
Investors in a fund of funds must clearly realize that the historical track record does not mean much, nor should it be relied upon. What an investor is buying is the consultants’ selection of different investment managers who consultants believe should perform based on a review of the managers’ historical experience. However, “survivorship bias” affects that reported historical experience. That is, only those funds that have been successful enough to survive get included in the final calculations. (While this “survivorship bias” also exists in other investment categories, it is particularly acute here because of the extremely high termination rate of hedge funds.) Therefore, the reported results may reflect better financial outcomes than the category actually achieved for many specific styles of funds. The failed funds simply disappear and are not accounted for in the reported results. There is no reason not to believe that some funds of funds will likewise experience substantial losses even though they are diversified.
Fund of Funds of Funds
The foregoing descriptions lead to the next hedge fund product: Fund of Funds of Funds. In this case, a fund is established only to invest in more than one fund of funds. Such a fund is actually not a new idea; the idea has been used with mutual funds for years. However, if one utilizes this type of investment vehicle, one perhaps has a chance of achieving the risk-reward performance exhibited by the Hedge Funds Index. The underlying reason for such potential performance by the Fund of Funds of Funds is due to the large-scale diversification with fund selections made by multiple individuals at three different decision levels. The Hedge Fund Index did show, with a survivorship bias, a 17.7% return and a 9.4% standard deviation, a result that was 129% better than the performance of the S&P 500 over the fifteen-year period ended December 30, 2002.
Alternative Mutual Funds
Fortunately for Main Street, many alternative mutual funds are increasingly being created by Wall Street. The capitalistic market system demands quick response to individual investor needs. Since hedge funds are so popular, clearly these alternative mutual funds are also being developed. These products will also be fully regulated by the Securities and Exchange Commission.
It should also be noted that the SEC is considering regulating hedge funds. For this reason, strategies for alternative mutual funds will be less risky than those of current hedge funds/alternative investments. In general, however, growth of alternative mutual funds is a positive for the average investor who is attempting to utilize the alternative investment philosophy in a proper risk-return tradeoff.
Many Main Street investors desire reduced risk. Such concern naturally leads to use of the concept of diversification. The objective is to find asset classes that provide good returns when stock returns are weak. In other words, investors want to find investment opportunities that are poorly correlated with the S&P 500, i.e., investments that do not change value at the same time and in the same direction as the S&P 500. Using as a benchmark the S&P 500 (which by definition has a beta of +1.00), an investor must seek investment opportunities featuring a low or negative beta.
Click here for Table 1, which provides a list of examples of specific currently available [open] mutual funds. This list of funds is not a recommended list. It is a partial list provided only for the reader’s conceptual use. No investment advice is implied or suggested in this article.)
A Synthetic Hedge Portfolio: A Market-Neutral Securities Portfolio on Demand
The second most prevalent hedge fund/alternative investment is the market-neutral securities portfolio. This concept has created a great deal of interest due to its long-term favorable risk/reward results. The Sharpe Ratio (a measure of risk vs. return) of this style of hedging was 2.9 compared to the S&P 500 Ratio at 0.7 for the same fifteen-year period ending December 31, 2002. This figure is 414% of the S&P 500 Sharpe Ratio. (The Sharpe Ratio is calculated by taking the total return of the investment minus the risk-free rate divided by the standard deviation of the investment. This is a well-recognized investment risk-reward statistic.) Furthermore, this market-neutral securities category exceeded the relative performance ranking of any other category under the hedge fund review presented in the previous Graziadio Business Review article already cited. This market-neutral securities category requires any investor to examine it closely.
Any Main Street investor can construct a market-neutral securities portfolio “on-demand” that best reflects that investor’s view of risk and return at the moment. Construction of such a portfolio is best accomplished through the use of beta (market risk) with the assumption of proportionate dollar investment. Let us say that the investor is highly concerned about the possible occurrence of a 9-11 type of event, yet s/he does not want to be out of the market just in case such an event does not occur. Since the objective of a market-neutral securities portfolio is to reduce the beta of the investment portfolio, this reduction can be accomplished by weighting the selected investments.
The selection of the alternative investments (mutual funds) is a task unto itself. However, as an example, let us construct this synthetic market-neutral portfolio from two of the higher rated mutual funds: Fidelity Low-Price (FLPSX) and The Prudent Bear (BEARX). Let us assume that the investor wants an equally weighted portfolio consisting of the two funds to create a portfolio beta of exactly zero — or to be market neutral. For purposes of the illustration only, the investor has selected the past three years as being indicative of what s/he anticipates for the market over the next three years. (In actuality, this scenario would be very unlikely at this time.) The portfolio beta of zero (risk to the market) with total dollars invested equal to the weights and the three-year historical returns would be as follows:
Table 2: Author’s Example of a Synthetic Market-Neutral Portfolio
|Fund||Weight||Beta x. Weight||Return x Weight|
|Fidelity LP||.6825||0.71 x .6825 = 0.48||15.84 x .6825 = 10.81%|
|Prudent Bear||.3175||-1.52 x .3175 = -0.48||25.97 x .3175 = 8.25%|
|Compare with Vanguard S&P 500 return for this period of -0.22%|
These funds have been taken from the list of alternative investment mutual funds chosen by the author
found in Table 1 located at the end of this article.
The above example of a 29.28% spread was constructed using ex-post betas (after the investment), not ex-ante betas (before the investment). Consequently, there is a bias in the above answer. However, the concept is valid, and an investor interested in a zero beta portfolio could adjust the funds on a regular weekly/monthly basis to approximate the above results. Even so, the above spread would be narrower under real time investment management, and in most cases, there would be costs associated with the constant adjustment.
If an investor had been perceptive enough to know that he or she wanted a market-neutral securities portfolio under this financial environment and had selected these two funds to accomplish this task, such an investment as that described would have resulted in a zero beta and a very positive return! Such an investment is the classical example of the concept of hedging, along with great portfolio selection, as demonstrated by the alphas or excess return not accounted for in the beta.
However, a word of caution is in order. One must recognize that short funds such as The Prudent Bear do much better relative to the S&P in down markets. For example, if the same weights were applied to the previous same two funds for the twelve months just ended (in October, 2003), the results would have been 17.18% as calculated from statistics provided in Table 1 below. This result contrasts with the Vanguard S&P 500 return of 24.23%. One would then have a negative spread of 7.05%, but with a beta of zero. A market-neutral investor must clearly understand the high probability of absolute under performance of such a portfolio in a clear market advance such as has been the case over the past nine months.
Of course, the more active investor can weight these funds differently from their betas. Indeed, one could use some form of a market timing model (such as the Bond Confidence Index or Value Line’s Asset Allocation Model) to modify the weights. Use of a market timing model is what some market-neutral securities funds do today. More than one fund has decided to have “flexibility” in its weightings (more longs than shorts) since the stock market has had extraordinary positive returns since the beginning of the war in Iraq.
However, the concept behind a truly hedged portfolio (a market-neutral securities portfolio) is that event risk cannot be anticipated. It will occur when it occurs. It makes no difference if the market is moving up, sideways, or down at the time of a given event. If an investor believes that another 9/11-type event will occur, he or she should not try to anticipate it. Instead, the investor must remain at or near a zero beta portfolio at all times. Such caution could be modified in the future if stocks are also scored as to their even-risk beta rather than to the historical market betas. Paul Rabbit, a successful market-neutral hedge fund manager, manages a hedge fund utilizing this concept.
It would appear from all the evidence that hedging via hedged funds is only for the most sophisticated investors who have significant resources and who are willing and able to commit a great deal of time and effort to the selection process. Even the selection of a Fund of Funds does not allow an investor an easy alternative.
Nevertheless, it would also appear that much of what can be accomplished through hedge funds is available, or shortly will become available, through mutual funds, although with obvious limitations. However, the Securities and Exchange Commission will most likely not allow a macro bet on a single event in these funds. For example, the SEC assumes that a stock portfolio is diversified if at the time of its construction, the portfolio contained twenty equally weighted stocks. Such a balance permits just enough prudent diversification without sacrificing potentially high returns.
While the SEC has had a number of problems lately in protecting investors, overall this group has done an outstanding job of protecting investors and maintaining the integrity of the securities markets. Many believe that regulation of the hedge fund industry is also necessary. The SEC has clearly indicated an interest in such regulation for a variety of reasons. The result of any debate will most certainly be a more regulated hedge fund/alternative investment industry. Such regulation would undoubtedly lead to more hedge fund-type mutual funds as well.
This decade will bring yet another round of inventive American financial products to serve the needs of all investors. As always, however, investors must remain cautious of these financial products’ claims of past or future performance!
Table 1: Alternative Investment Mutual Funds
Return to article
|Beta||Alpha||SR||Name and Symbol||3rd qtr 2003||1 year||3 years||5 years||10 years|
|Category: Mixed Alternatives|
|+.053||+1.22||-0.55||Analytic Defensive (ANDEX)||3.21||15.38||-2.90||4.90||9.29|
|+0.71||+23.91||+0.75||Fidelity Low Price (FLPSX)||8.50||31.02||15.84||15.49||15.30|
|+.50||+10.10||+0.24||Leuthold Core (LCORX)||9.11||35.60||5.69||8.77||–|
|+0.18||+1.85||-0.07||Merger Fund (MERFX)||2.56||11.88||2.13||9.01||9.09|
|+0.74||+17.31||+0.38||Meridian Value (MVALX)||5.21||28.87||9.20||20.84||–|
|+0.61||+8.51||+0.01||Primary Trend (PTFDX)||0.25||14.63||2.90||4.52||7.64|
|Category: Hedged Long/Short/Market Neutral|
|-0.54||-3.69||+0.10||AXA Rosenberg L/S (RMNIX)||-3.26||-15.33||10.96||1.43||–|
|-0.11||+8.57||+0.71||Boston partners L/S (BPLEX)||-0.56||0.99||11.64||–||–|
|–||–||–||Schwab Hedged Equity (SWHEX)||2.08||13.10||–||–||–|
|Category: Defined Bias Short|
|1.52||+8.41||+0.56||Prudent Bear (BEARX)||7.38||-12.58||25.97||2.91||–|
|0.00||-0.93||-6.14||Permanent T-Bill (PRTBX)||-0.07||0.18||1.63||2.61||3.25|
|+1.00||-0.07||-0.87||Vanguard Index 500 (VFINX)||2.60||24.23||-10.22||0.97||9.98|
|+1,92||+1.07||-0.79||Vanguard Total Market (VTSMX)||3.60||26.00||-9.60||2.04||9.40|
(1)The performance (result figures to the right) are through the third quarter of 2003, taken from Barron’s and dated October 8, 2003.
(2)Other investment statistics to the left (beta, alpha, and Sharpe Ratio) are from Morningstar for a three-year period ending September 30, 2003.
(3)Beta refers to the sensitivity of the fund to the S&P 500. It is a measurement of risk.
(4)Alpha refers to the excess return from the fund not attributable to the beta.
(5) Sharpe Ratio (SR) refers to the return of the portfolio less the risk free rate divided by the standard deviation of the portfolio.
* This list provides an example of specific currently available (open) mutual funds as listed in Barron’s, October 8, 2003. This is not a recommended list. It is a partial list provided only for the reader’s conceptual use. No investment advice is implied or suggested.
 Darrol J. Stanley, “Hedging Strategies for Uncertain Times: An Overview,” The Graziadio Business Review, 6, Issue 3 (2003).