Is Your Mutual Fund a Hedge in Disguise?

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By Mark Jewell, AP Personal Finance Writer

BOSTON (AP) — Do you worry more about protecting your money than seeing it grow? If your answer is yes, maybe you should be in hedge funds — or at least try to emulate them.

That may sound preposterous if you regard hedge funds as a speculative realm of the wealthy. But from a strategic standpoint, many of these investing refuges of the rich are more conservative than the average mutual fund.

Many mutual fund companies — including big names like Pimco, Vanguard and Fidelity — are trying to spread the word that average investors can benefit from the often complex strategies that hedge funds pioneered to hedge risk while also enhancing returns.

Until a few years ago, those strategies were mostly limited to hedge funds, which often require clients to have a net worth of at least $1 million. At mutual funds, the same strategies are available to individuals with as little as $2,500 to invest.

There are roadblocks. These alternative strategies can get so complex many investors may lack patience to even understand them. Such strategies can also lag in market rallies, and the costs from frequent trading and the funds' typically high management expenses can offset the protection they offer in lousy markets.

But the safety argument is winning plenty of converts. Nearly 200 mutual funds using alternative strategies or investing in alternative assets have launched over the past five years, according to Cerulli Associates. The industry researcher defines alternative broadly, including hedge fund strategies like arbitrage and leverage, ranging to commodities investing, private real estate and venture capital.

The alternative funds' $144 billion in assets isn't huge, although it's up fivefold since 2003. The total is around 2% of mutual fund assets overall.

Financial planner Cliff Caplan fears conventional approaches will leave his clients exposed the next time the market tumbles. That includes moving heavily into bonds, which took an uncharacteristic hit in 2008's meltdown. So he's recently shifted nearly a quarter of his clients' assets into alternatives.

"I'm adding lots of cushion to portfolios — a lot," says Caplan, president of Neponset Valley Financial Partners in Norwood, Mass.

Caplan says the risk of another meltdown isn't remote, citing the fragile economic recovery and financial regulations he says are still too weak.

"The economy is throwing out so many mixed signals," says Caplan, who has more than three decades in the business. "I have never entered a year with this much uncertainty."

Caplan isn't alone. Cerulli's report says nearly 40 percent of financial advisers plan to increase their clients' allocations to alternative investments. Another recent survey by Cerulli found 76% of asset managers believe the 2008 crash did more to help than hurt the case for alternative investments in the retail market.

Those strategies aren't all about defense — some aim to supercharge returns in rising markets. But those approaches remain restricted mostly to hedge funds. One example is leverage, or investing borrowed money with the goal of earning a greater return than the interest costs from the amount borrowed.

But other defensive strategies are already showing their worth. For example, mutual funds employing long-short strategies fell 15% in 2008 compared with a 37% drop for the Standard & Poor's 500, according to Morningstar. The long-short funds gained less than half as much as the S&P 500 last year, but still ended up with a better cumulative result over two years.

Investing "long" is betting a stock will eventually rise. Combining that traditional approach with a "short" strategy means also trying to take advantage of stocks expected to fall. A short-seller borrows a company's shares from a broker, sells them and then buys them when the stock falls. The short-seller then returns the shares to the lender, pocketing the difference in price.

Shorting is one of the tools at the Forward Tactical Growth Fund (FFTGX). Cloned from a hedge fund when it launched in September, the $300 million mutual fund aims to protect portfolios no matter how markets are behaving, says Ricardo Cortez of Broadmark Asset Management, the stock fund's manager.

But Cortez admits mutual fund investors should check carefully before latching onto any alternative strategy. For example, a manager who has successfully used debt to buy securities at a hedge fund may fail in the mutual fund arena, where restrictions limit use of leverage.

And mutual funds must closely manage cash flow to honor investors' redemptions, unlike hedge funds that often tightly restrict when investors can pull out.

"There are substantial problems some hedge fund managers are going to have in translating their basic strategies into the mutual fund world," Cortez says.

Exotic strategies also can boost costs that erode returns. Alternative funds' typically frequent trading is more likely to trigger taxable capital gains than buy-and-hold funds.

For some general guidance, investors should look at turnover. For example, at Caldwell & Orkin Market Opportunity (COAGX), the turnover ratio is 879% — about 10 times the average for stock mutual funds. The $405 million fund also held 27% of its portfolio in cash at the end of 2009, meaning it would potentially offer a safe haven in a falling market, but lag in a rally. As recently as October, the cash stake was even higher, at 68%.

"To justify owning one of these funds, you and your adviser have to have a lot of conviction that it will be a down market" says Alec Young, an equity strategist with Standard & Poor's. "And you've got to decide that it's crucial to protect your capital."

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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