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Funds: Going The Hybrid Route


Why bother with plain old mutual funds if you can qualify for a hedge fund? After all, these private investment pools seem like the ideal way to navigate an era of low returns, since they use sophisticated tools -- off-limits to most mutual funds -- to make money whether stocks rise or fall. But some recent research suggests you may be able to cover much of the same terrain with a handful of mutual funds that mimic hedge fund strategies yet are cheaper and more tax-friendly. That's not to say that these hybrid mutual funds are perfect substitutes. Hedge funds come in more investment styles than their mutual fund look-alikes. Moreover, since hedge funds operate outside the regulatory framework that governs mutual funds, they tend to be more flexible. For example, while mutual funds are permitted to borrow $1 for every $3 they hold in assets, hedge funds can use as much borrowing, or "leverage," as their brokers allow to amplify returns, protect against a stock market decline, or engage in other strategies, says Steven Felsenstein, a partner at law firm Greenberg Traurig in Philadelphia. Some mutual funds are further constrained by self-imposed limits. Consider the Hussman Strategic Growth Fund, which in its prospectus says that it expects never to have a net "short" position, or a big bet on a stock market decline.

BEAR MARKET GAINS

Still, mutual funds that follow hedge fund playbooks share some of the qualities that make hedge funds so attractive. Several, for example, posted gains during the bear market. There's even some evidence that these funds can perform as well as comparable hedge funds. According to a recent study that examined the risk-adjusted returns of 12 hybrid funds between 1998 and 2003, half outperformed the hedge fund indexes they most resemble. "Hybrid mutual funds do offer some return opportunities and characteristics that similar hedge funds provide," says Thomas Schneeweis, director of the Center for International Securities & Derivatives Markets at the University of Massachusetts at Amherst, which published the study.

One advantage hybrid mutual funds have over hedge funds is lower expenses. The hybrids' 1.82% average expense ratio is high for mutual funds but is a bargain for hedge funds, which typically pocket a 1% to 2% management fee plus 20% of the profits, according to the Hennessee Group, a New York adviser to hedge-fund investors. For many, the cost of hedge-fund investing is higher still. That's because in order to get exposure to a diversified portfolio of hedge funds, most individual investors buy into a fund-of-funds. These pass along not only the fees of the hedge funds they invest in, but also tack on an extra 1% in management fees and a 10% cut of the profits for themselves.

Many hedge funds -- mostly in the fund-of-funds category -- also impose hidden tax costs. For example, a fund-of-funds that earns 11% will put an 8.9% return in your pocket after it takes its 1% management fee and 10% cut of the profits. Still, you could easily wind up paying tax on more profit than you receive -- even on the full 11%. Why? A majority of fund-of-funds classify their fees as "miscellaneous itemized deductions" on the K-1 tax forms they distribute. Because of how the tax laws work, "most taxpayers aren't able to use those deductions" to offset their taxable income -- or, in this case, the 11% return, says Robert Gordon, president of Twenty-First Securities, a New York brokerage.

To see why, consider a taxpayer with $500,000 of adjusted gross income and $5,000 in hedge fund-of-fund fees. Since taxpayers can claim only "miscellaneous itemized deductions" that exceed 2% of their adjusted gross income, the first $10,000 of this taxpayer's investment fees can't be used to offset taxable income. As a result, none of the $5,000 in fees paid are eligible for the deduction, and so the taxpayer must pay tax on the fund-of-funds' full 11% profit, despite receiving a gain of only 8.9%. Mutual funds don't have this problem since investors pay tax on the profits that remain after fees are deducted.

Hedge funds can create other tax headaches. If your fund sells a profitable investment, you'll have to pay tax on your gain -- even though you won't receive your share of the profits until you cash out. Mutual fund shareholders, in contrast, can opt to receive an annual check for their portion of any taxable profits.

BIG DIFFERENCES

When picking a hybrid mutual fund, read the prospectus carefully because the funds can vary considerably. Although both the Hussman Strategic Growth Fund (HSGFX) and the Legg Mason Opportunity Trust (LMOPX) can hedge -- or reduce -- their exposure to the market, the Hussman fund sometimes is as much as 100% hedged. (Currently it's at 75%.) In contrast, Legg Mason Opportunity had no hedge in place as of its latest filing on Sept. 30. In the first quarter, short positions comprised 22% of the fund's net assets. Run by star stock picker Bill Miller, the fund also has about 3.1% of its assets in three private partnerships.

Unfortunately, some hybrid funds with strong track records are closed to new investments. Among them: The Calamos Market Neutral (CVSIX) Fund and the Merger Fund (MERFX) -- up an annual average of 8.3% and 4.9%, respectively, over the past five years. But keep checking: Neither rules out reopening if new opportunities arise.

Still, some good opportunities remain, says Rick Lake, a Greenwich (Conn.) adviser who specializes in both hedge and hybrid funds. Among Lake's favorites: the Metropolitan West Strategic Income Fund (MWSTX), a newcomer that invests in a variety of strategies, many in the fixed-income arena. It's up 6.7% over the past year.

Another pick of Lake's is the Gateway Fund (GATEX), which sells call options on its holdings. That way, it pockets income -- albeit in return for giving away some upside potential. It then buys put options with some of the proceeds to protect against a steep sell-off. The fund is up an annual average of 4.36% over the past three years. Other holdings include Legg Mason Opportunity and Hussman Strategic Growth, up an average annual 14.26% and 12.88%, respectively, over the past three years after fees of 1.9% and 1.25%. Why pay more than you have to for hedge-fund returns?

By Anne Tergesen


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