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) 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.

Illiquid holdings presented big problems for hedge funds in 2008. As panicked investors sought to make redemptions, hedge funds were forced to dump their illiquid holdings to raise cash. With few buyers available, the funds were forced to sell at fire-sale prices. That caused enormous losses. As a result, many hedge funds were forced to liquidate. Last year, 3,000 hedge funds disappeared from Morningstar's database, a huge number in an industry that includes about 10,000 funds.

Because they cannot cash in their illiquid holdings easily, hedge funds must limit redemptions by their investors. Funds typically lock up investors for certain periods, such as a month or a year. In contrast, mutual funds are required to allow daily redemptions.

To appreciate how the risks of hedge funds and mutual funds compare, consider a figure known as standard deviation, which measures the amount returns bounce up and down. Investments with higher standard deviations tend to be more volatile. The S&P 500 has a standard deviation of 20.7, which means that the annual returns are usually no more than 20% above or below the average results for the index. The standard deviation for hedge funds is only 8.8, while the figure is 6.3 for long-short mutual funds.

Investors who are shopping for hedge funds and long-short mutual funds should keep a close eye on standard deviation. Investors who can tolerate a higher standard deviation may prefer hedge funds. Cautious investors may pick one of the mutual funds that steer away from illiquid investments and seek to hold down risk.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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