PREMIUM SEARCH Search by job title, geography and build a list of executive contacts
There is a fundamental disconnect between the mutual-fund industry -- which promises individual investors professional money management at low fees -- and the vast majority of folks who buy funds.
Individual investors typically think that when the market falls or a stock implodes, a fund manager should have the skill to avoid the worst of the losses. In contrast, the fund industry mainly hopes that a manager will outperform a specific sector or benchmark in good times and bad. For example, Oakmark (OAKMX
) earns five stars from Morningstar, even though it's down 13% so far this year. True, that loss puts it in the top 7% of all large value funds, and the fund compares favorably to the Standard & Poor's 500-stock index, down 20% this year. But you can bet that most Oakmark shareholders aren't cheering right now.
"The average investor doesn't really care if their fund outperforms its peers or a benchmark," says Phillip Toews, CEO of money-management firm Toews Corp. "They care about getting some kind of growth above inflation." Toews points out that a money-losing fund is of special concern to retirees, "who can't afford to lose their money."
GENTLER ALTERNATIVE. A tiny niche of the fund industry is attempting to resolve the essential conflict between the fund and investor camps. There's a crop of new funds, known as "long-short" or "market-neutral" funds, that aim to perform well (or at least hold their own) in bull as well as bear markets.
These funds are often modeled on hedge funds, which are largely unregulated, high-fee funds for high-net-worth individuals that typically use a wide array of sophisticated trading strategies. But since the hedged mutual funds are more regulated, they can't magnify their bets using derivatives or hold too many illiquid securities. "They are sort of gentler hedge funds," says Rick Lake, a Greenwich, Conn., investment adviser who specializes in long-short funds.
On Aug. 7, Charles Schwab introduced the Schwab Hedged Equity Fund, the most mainstream of the new entries. This fund will buy stocks that the firm's new proprietary rating system predicts will go up. At the same time, it will sell short (a way to profit from stocks that decline in price) those stocks its rating system predicts will underperform the market. The fund's managers joined Schwab when the firm acquired hedge fund Bunker Capital Management in 2001.
TRUST TO LUCK? In July, 2001, Toews set up two funds that attempt to mimic the S&P 500 and the Nasdaq 100 on the upside, while eliminating much of the risk on the downside. That may sound impossible, but the strategy involves the relatively simple idea of putting on market hedges when the indexes fall blow a certain trendline (he won't say what trendline he uses) and taking them off when stocks climb above it.
So far, the strategy is working well, at least in terms of shielding investors from losses. The no-load Toews Nasdaq-100 Hedged Index Fund (these funds are so tiny they haven't yet been assigned a symbol) has lost 5%, vs. a 25% decline for the Nasdaq 100 Index this year. The Toews S&P 500 Hedged Index Fund has fallen 4%, vs. a 20% decline for the index this year.
The problem with these funds, like the hedge funds on which they're modeled, is that returns are especially tied to the luck or skill of the manager. For example, Franklin U.S. Long-Short (FUSLX
), is flat so far this year and has a three-year average annual return of 27%. But other long-short funds have racked up significant losses. Choice Long Short (CHLAX
) is down 28% in 2002 and Montgomery Global Long-Short (MNGLX
) is down 15%.
ZIG ZAG. Lake uses two successful funds to show how much strategies can differ: Boston Partners Long/Short (BPLEX
) buys stocks it expects to go up and shorts stocks it thinks will go down. It has a three-year average annual gain of 18% (vs. a three-year loss of 12% for the S&P 500) and is down just 2% this year.
Meanwhile, Calamos Market Neutral (CVSIX
), aims to eliminate stock-market risk by owning convertible bonds and shorting the underlying stocks. Returns have been consistently in the high-single and low double-digits since 1995 (five-year returns average 10%) and the fund is up 2% this year.
"These [hedged mutual funds] all behave very differently," says Lake. His fund-of-funds, which he calls "Lasso," for long and short strategic opportunities, is down 8% this year through July, but has gained 27% since it launched in 1999, vs. a loss of 22% in that time for the S&P 500. "We try to match funds that zig with funds that zag and keep down daily volatility," Lake says. He requires a minimum of $100,000 for each managed account and charges an additional 1% a year on top of the funds' fees, which are often quite high (2% or more).
EASIER ENTRY. Investors should consign only a small part of their portfolios to hedging strategies, which by nature are high risk and can backfire. The new hedged mutual funds are untested, and strategies that work well under current market conditions may fail in the future.
Still, frustrated investors who are losing faith in the fund industry may find it encouraging that new funds are debuting that aim to do more than simply outperform the steadily falling indexes. And these new funds generally don't carry the high minimum investments that traditional hedge funds do, making them more accessible to the average investor.
"What the fund industry needs to do is incorporate a broader range of alternative strategies into its product base," says Lake. "If not, it will lose all its investors." Hedged mutual funds may not be the answer, but at least they're a step in the right direction.
Amey Stone is an associate editor of BusinessWeek Online
Get BusinessWeek directly on your desktop with our RSS feeds.
Add BusinessWeek news to your Web site with our headline feed.
Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video.
To subscribe online to BusinessWeek magazine, please click here.
Copyright 2002, by The McGraw-Hill Companies Inc. All rights reserved.
Printer-Friendly Version
