As billions of dollars continue to pour into passively managed index mutual funds, active managers are looking for fresh and unique products to attract investment dollars.
One way they’re doing this is to introduce funds employing hedge fund strategies that have traditionally only been available to high-net-worth investors. These strategies can be potentially aggressive, but, in the hands of a seasoned mutual fund manager, can provide opportunities to outperform on a risk-adjusted basis. In this article, we’ll examine how these strategies can be constructed within a mutual fund and whether or not investors should consider them.
Most mutual funds employ a traditional buy-and-hold strategy, one that typically involves buying securities the manager feels will rise and avoiding those he feels will drop. Hedge funds tend to utilize more complex strategies that can involve the use of leverage, derivatives and shorting to produce additional returns.
At a high level, there are three broad strategies that hedge funds employ outside of traditional buy-and-hold.
Long/short – Instead of just using mostly long positions, a long/short strategy attempts to profit no matter which way the stock moves. The manager can short stocks he feels will drop, adding an additional dimension of fund returns, but one that can come with added risk and cost.
Market-neutral – This strategy looks to pair stocks with identical risk characteristics. The manager buys the one he feels will outperform and shorts the one he feels will underperform. The goal is to produce positive returns from these theoretically risk-free pairings.
Leverage – Managers can use futures contracts to provide extra exposure to securities or markets beyond traditional long or short positions. This can be an especially risky strategy, but one that can deliver outsized returns if done correctly.
Emerging Trends in Hedge Fund Strategies
One of the trends gaining prominence in the hedge fund world is the use of quantitative strategies. Quant investing involves utilizing big data and computer algorithms, instead of humans, to identify opportunities.
There are a couple of reasons why using quant strategies can be valuable. First, they remove emotion from investing decision making. Common behavioral mistakes such as following the herd, choice paralysis and confirmation bias can impact the ability of managers to make investment choices objectively. Computers can act independently of these issues. Second, they’re potentially cheaper. Computers don’t require salaries, health benefits and other costs. High expense ratios are one of the biggest factors driving assets away from actively managed funds. Anything that can lower those fees can make actively managed funds more competitive.
Fund giant BlackRock, in particular, is embracing this trend. The combination of high cost and chronic underperformance that has become a stigma with active funds has driven the iShares fund provider to make widespread changes with its lineup. The company plans on consolidating a number of its actively managed funds and transitioning as much as $30 billion in assets over to quant-focused products. Additionally, it plans on laying off at least 36 employees as part of the move while dropping expense ratios on some affected funds, such as the BlackRock Large Cap Core Fund (MBLRX). If successful, the fund industry may take notice and soon follow suit.
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3 Things for Investors to Consider
Hedge fund investing strategies are often confusing and complex, and therefore won’t necessarily be suitable for everyone. Investors should keep a few points in mind before deciding whether or not to try out one of these funds.
These strategies carry high risk – Betting on stocks going down and adding high degrees of leverage can result in significant losses over short periods of time. The costs of establishing short positions or buying futures contracts can further increase the possibility of underperformance over time.
These strategies might not work – All strategies experience periods of underperformance, and hedge fund strategies are no exception. Morningstar’s multi-alternative category, the group that captures long/short and market-neutral strategies, posted a three-year average annual return of just 1%, compared to a 9% average annual return for the S&P 500.
Investors should do their due diligence – Investing in any fund, stock or other security should always be preceded with a look at how well it aligns with your objective, time frame and risk tolerance.
The Bottom Line
The emergence of quant investing may be the next step in the evolution of actively managed funds in order to address the problems of high cost and underperformance, but these alternative strategies don’t come without risk. The methods used by hedge funds are risky and should likely only be considered by more sophisticated investors or those with higher risk tolerance.
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