While often controversial, the fact is that some of the best investments have been hedge funds. And though your typical retail investor in stocks or a 401k can’t share in a pure hedge fund strategy, there are mutual fund investments that allow regular folks to invest the same way.
First, let’s look at the power of hedge fund investing. Consider Renaissance Technologies. A world-renowned mathematician, James Simons, started the firm in the early 1980s. He realized there were many investment opportunities in using sophisticated computer algorithms. So he launched the Medallion Fund in 1988. The result has been stunning. Over the past two decades, the fund has averaged 35% annual returns. (This is after subtracting fees of over 40%).
So how can you get into a hedge fund? It’s not easy. There are usually large minimum investments – which can easily be over $1 million. Although, the top funds are often closed to new investors.
However, there are a variety of mutual funds that mimic hedge fund strategies. For example, some will involve structuring a long-short portfolio. Basically, the mutual fund will buy undervalued stocks and short those that are overvalued (to “short” means make money when a security falls). Over time, this should produce fairly stable returns — and help protect a portfolio when there are big breaks on the downside, such as what happened during the 2008 financial crisis.
Another common strategy is convertible arbitrage. This involves finding gaps in values between convertible bonds and the underlying securities that they convert into. It’s complicated stuff but can result in nice profits.
Now, let’s take a look at three mutual funds that follow hedge fund stratagies:
Calamos Market Neutral Income (CVSIX)
John Calamos is one of the foremost experts in convertible investments. He got interested in the topic while serving in the Air Force during Vietnam. Ironically enough, he was looking for ways to improve risk management. In 1977, Calamos started his firm and he has since amassed a fortune of over $2.7 billion (he’s ranked 258 on the Forbes list).
Since 1990, Calamos has managed the Calamos Market Neutral Income fund (MUTF: CVSIX). It not only pursues a convertible arbitrage strategy but also covered call writing. This means getting income by creating stock options, which can be a lucrative approach when markets are volatile.
The Market Neutral fund has $2.2 billion in assets and a reasonable expense ratio of 1.15%. The returns were 3.41% over the past five years and 4.24% over the past decade.
Wasatch Long/Short (FMLSX)
The sweet-spot for the Wasatch Long/Short (MUTF: FMLSX) fund is on mid to large cap companies (the minimum market capitalization is $100 million). There are also investments in fixed income securities.
To find gaps in pricing, the Wasatch fund uses just about every approach to valuation. There is macro analysis to get a sense of the overall economic environment. Next, Wasatch uses fundamental analysis — such as discounted cash flows — on companies. The fund will even use technical analysis to get further confirmation on a trade.
Yes, it’s a lot of work — but it works. The fund, which has $457.3 million in assets, posted a 17.89% return last year. As for the past five years, the average return came to 6.85%. The expense ratio is 1.34%.
Highland Long/Short Equity (HEOZX)
The Highland Long/Short Equity (HEOZX) mutual fund, which manages $405.6 million in assets, buys and shorts securities of mostly domestic companies. At the same, there is use of derivatives, like futures and stock options, as well as borrowed money to juice the portfolio.
Some of the top long positions include Apple (NASDAQ: AAPL), Kansas City Southern (NYSE: KSU), Cognizant Technologies (NASDAQ: CTSH) and Tempur-Pedic (NYSE: TPX). As for the shorts? The main ones include the SPDR S&P MidCap 400 ETF (NYSE: MDY), The Hershey Company (NYSE: HSY), Jos A. Bank Clothiers (NASDAQ: JSOB), Arris Group (NASDAQ: ARRS) and Synaptics (NASDAQ: SYNA).
The Highland fund tends to outperform the market in down months. Consider that this was the case 19 of 21 months when the S&P was in negative territory. In fact, this means that there is relatively low correlation — which should provide diversification.
However, the expense ratio is not cheap, coming to 1.89%.