This Day On The Street
Continue to site
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

Mutual Funds That Hedge Aren't Hedge Funds

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 - Get Report) 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

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

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
Stocks Under $10

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

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Submit an article to us!
SYM TRADE IT LAST %CHG
MORN $76.86 0.62%
FB $79.05 0.08%
GOOG $539.29 0.26%
TSLA $231.38 2.40%
YHOO $42.19 -0.75%

Markets

DOW 18,127.39 +103.33 0.57%
S&P 500 2,119.51 +11.22 0.53%
NASDAQ 5,040.4270 +35.0360 0.70%

Partners Compare Online Brokers

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs