This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Mutual Funds That Hedge Aren't Hedge Funds

Stocks in this article: MORN

NEW YORK ( TheStreet) -- Many companies have been introducing mutual funds that sell short and use other techniques pioneered by hedge funds. If you own a hedge fund, should you dump it and switch to the new mutual funds?

Probably not. On average, hedge funds have been outpacing the competing mutual funds. From the beginning of 2003 through the end of June this year, the Morningstar (MORN) 1000 Hedge Fund Index returned 7.8% annually, compared with 5.5% for long-short mutual funds, and 4.2% for the S&P 500.

Of course, hedge funds and mutual funds are very different vehicles. Hedge funds are aimed at wealthy individuals and institutions with millions to invest, while mutual funds are designed for the average joe. But these days, it is worth comparing hedge and mutual funds because the distinctions between the two are blurring. Some hedge funds are aiming to attract minimum investments of $100,000. Many of the new long-short mutual funds are being sold to institutions.

One of the most important differences between hedge and mutual funds is the amount of risk they can take. Hedge funds have outperformed partly because they take more risk, says Nadia Papagiannis, a Morningstar analyst who follows alternative investments.

Under federal rules, mutual funds can only use a limited amount of short selling and leverage. Hedge funds are largely free to do whatever they want. As a result, many hedge funds borrow heavily. The leverage magnifies returns -- and increases risk. "Hedge funds gain more in up markets -- and they lose more in down markets," Papagiannis says.

During the market collapse of 2008, the hedge funds tracked by Morningstar lost 22%, lagging long-short mutual funds, which lost only 15%. But when the markets rebounded last year, hedge funds led the way, returning 20% for the year compared with a gain of 11% for long-short funds. Both hedge funds and mutual funds are less volatile than the S&P 500, which dropped 37% in 2008 and gained 27% last year.

Besides using leverage, hedge funds also increase returns -- and risk levels -- by investing in illiquid securities. These include private equity, which doesn't trade on public exchanges, and bonds that rarely trade. Because the securities are difficult to buy and sell, many investors shy away from them. That depresses prices and gives hedge funds opportunities to obtain outsized returns. Mutual funds are prohibited from buying illiquid securities.

1 of 2

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!

Markets

DOW 18,053.71 +23.50 0.13%
S&P 500 2,088.77 +6.89 0.33%
NASDAQ 4,806.8590 +33.3870 0.70%

Brokerage Partners

Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs