The rules regarding hedge fund investing are very strict and they restrict investors with a small asset base from participating in the lucrative returns that come with the asset class. However, there are mutual funds currently employing strategies typically seen in hedge funds. The construction of this portfolio strategy is similar to that of a “fund of funds” hedge fund approach, which invests in different hedge funds that use various investment strategies. The approach of purchasing many “hedge-fund” mutual funds, gives the investor diversity which combats the potential risks that come with investing in individual management firms and potential fund-related risks.
The back-test of an approach utilizing the “hedge fund” mutual funds shows comparable returns to that of overall equity markets—with much less volatility. The portfolio appears to be a great hedge against market downturns because the strategies used in the majority of the funds are long-short, which involves going long one stock and selling an equal amount of a comparable stock. These positions are “market neutral,” meaning that the market and industry risk is taken out of the equation. In some funds, there are other strategies employed, such as distressed debt investing, merger arbitrage, convertible arbitrage, and other hedge fund strategies.
The back-tested portfolio made eight equally weighted investments on January 1, 2003. The portfolio started with a value of $80,000 and made $10,000 investments into each mutual fund. The mutual funds used in this analysis are listed below:
As of Tuesday, May 29, 2007, the portfolio has the following composition, assuming all dividends were reinvested into those funds:
The next chart displays the since inception performance of this “hedge fund” mutual fund portfolio:
Although the portfolio underperformed the S&P 500 by a total about 13% over the 4 ½ year time period, it still had a total return of 58.92% with much lower volatility than the index. The portfolio underperforms the S&P 500 in times of strong bullish sentiment, while it outperforms the index in times of a downturn. This type of performance occurs because the strategies employed by these mutual funds involve making “hedged” positions, where the ideas are to protect capital and to generate alpha.
The next chart shows how the portfolio strategy performed over the past three years, May 27, 2004 to May 28, 2007, when the market was not increasing at a tremendous rate, but instead at a consistent 10% rate per year.
An investor should expect the performance of the portfolio over the above time period to be typical over the long-term, since the market usually does not see huge increases in one year, as was seen in 2003. The portfolio does have some correlation to the equity market, as shown in the small downdraws, but the losses are not as magnified, giving this portfolio a lower beta to the S&P 500 (less than 1.0). The maximum downdraw experienced during the entire life of the portfolio was less than 5%, which is comparable to downdraws seen with bonds and fixed income. The portfolio strategy has similar performance to convertible bonds, but has less volatility and less correlation to the overall market movement.
This portfolio strategy does not include performance experienced during a bear market, because the majority of these funds were not around as early as 2000. However, an assumption can be made taking into account the past performance since January 1, 2003, in which the market experienced a large decline; that assumption is that the portfolio strategy would continue to preserve capital in a long-term market decline.
You can view the real-time performance of this portfolio strategy at http://stockalicious.com/stock_journal/785. Here an investor can view the correlation and beta to the overall market, and they can view the real-time chart of the strategy versus the major stock indices.
This analysis does not take into account taxes, commissions, fund expenses, and sales charges. If you have any questions please comment below.
