More Funds Are Hedging Their Bets

Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative practices like short-selling that typically increase the risk of investment loss. Mutual funds, on the other hand, have traditionally been long-only vehicles designed for retail investors less inclined to pursue sophisticated financial strategies.

The final major difference between the two is fees. Hedge funds typically charge an asset management fee of 1% to 2% of the assets, plus a "performance fee" of 20% of a hedge fund's profit. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating larger returns. Meanwhile, mutual fund investors don't have to forfeit a portion of their gains even to the most successful manager and the average domestic equity mutual fund carries an expense ratio in the 1% to 3% range.

Bridging The Gap

With regulatory, strategy and fee disparities so wide, it's unsurprising that each side has been hesitant to bridge the gap. But mutual fund managers like Lee Schultheis of the (ALPHX Quote)Alpha Hedged Strategies Fund say that retail demand for products that do not have a strong risk exposure to the direction of interest rates or equity markets is creating opportunities for both sides.

Schultheis' tiny $17 million no-load mutual fund allocates assets among a group of specialized hedge fund managers that employ long/short equity hedging techniques including convertible bond, merger and fixed income arbitrage. In order to meet regulatory approval, Schultheis does not invest directly in hedge funds like a hedge fund of funds. Instead, he has sub-advisors manage funds according to their style in separate accounts.

A basic hypothetical example of a long/short strategy would be if a manager buys shares of Coca Cola(KO Quote) and shorts shares of Pepsi(PBG Quote). The result is that the market risk is offset because extraneous factors like rising interest rates and energy costs would hit both companies equally. Nevertheless, managerial risk increases because the manager better be correct in his choice of cola company stocks.

Hedge Fund Hybrids Mutual Funds Using Hedge Fund Strategies
Fund/Index	Ticker	YTD %	Annual Returns %			Expense Ratio %
			2003	2002	2001
Schwab Hedged Equity	SWHEX	2.9	22.9	-	-	2.4
Alpha Hedged Strategies	ALPHX	2.1	3.2	-	-	4.0
Merger Fund	MERFX	1.6	11.0	-5.7	2.0	1.4
Needham Growth Fund	NEEGX	0.3	47.3	-28.3	12.2	1.8
AIM Opportunities	ASCOX	-0.1	39.2	-24.8	-9.3	1.3
Calamos Market Neutral	CVSIX	-0.7	9.4	6.6	8.3	1.5
Arbitrage Fund	ARBFX	-1.3	15.2	9.3	8.7	2.0
Rock Canyon Top Flight	TOPFX	-1.4	52.8	-	-	2.5
S&P 500	-	1.2	28.2	-21.5	-11.8	-
Source: Morningstar (Annual returns through 5/26/04)