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February 27, 2006
Mutual funds adopt hedge fund tactics
Pressured by weak stock-market returns and greater competition for investors' money, a growing number of mutual funds are making use of investment strategies typically found in riskier hedge funds.
A number of major mutual-fund companies, including Allianz Global Investors, Julius Baer Holding AG's GAM subsidiary, and Alliance Capital Management's AllianceBernstein, have recently asked fund shareholders for permission to change the rules governing how they can invest to include a range of hedge-fund-like investment strategies.
Some of the new techniques being adopted include making complex derivative trades, investing with borrowed money and short selling. (Short selling involves selling borrowed shares in order to profit from an expected price decline.) Even some conservative U.S. government bond funds are adding risk with more derivative strategies.
Other fund companies, such as OppenheimerFunds and Principal Global Investors LLC, whose policies already permitted more flexible investments for some of their funds, are increasingly making use of these kinds of hedging techniques.
The hedge-fund industry, which has grown dramatically in recent years, has outperformed many conventional investments. Hedge funds, lightly regulated investment pools designed for institutions and wealthy individuals, gained nearly 8 percent annually in the five years ending Dec. 31, although performance has faltered recently, according to Hedge Fund Research Inc. The S&P 500-stock index, by comparison, gained just 0.5 percent a year in the same period, and the average diversified U.S. stock fund gained just over 2 percent annually.
Some companies are launching mutual funds specifically designed to mimic hedge funds, including offerings from Janus Capital Group Inc. and American Century Investments, and the funds' names make it clear that they are pursuing hedging strategies. But some analysts and financial advisers caution that when traditional mutual funds adopt alternative investment strategies, it could bring added risk and higher fees. Some advisers also fear that mutual funds may be rushing into a hot strategy just as hedge funds' performance is beginning to cool.
Allianz Global, for example, has asked shareholders of several of its funds to eliminate restrictions on owning illiquid securities, or securities that are thinly traded. But the company has warned that this could boost trading costs. Allianz spokesman Phil Neugebauer says the board felt the changes would benefit shareholders by giving fund managers a broader range of investment options.
Funds' proposals for loosening investment rules have generally won shareholder approval. But many investors may be unaware that their mutual fund plans to adopt new investment strategies.
The biggest changes are coming in traditional stock funds, a number of which are now shorting stocks for the first time and using complicated derivatives. These are financial contracts whose value is based on -- or derived from -- some underlying stock, currency, commodity or other investment.
Some mutual funds have long used basic derivatives, such as stock-index futures, but a growing number are now expanding into more exotic types. Oppenheimer shareholders last month approved plans to allow several of the company's funds to trade derivative contracts tied to the price of commodities or currencies. "The changes were made to eliminate outdated policies," says an Oppenheimer spokeswoman.
Allianz Global has a proposal before shareholders that would eliminate restrictions on buying stocks with borrowed money at 20 of its funds, which hold a combined $14 billion in assets. And MainStay Investments, owned by New York Life Investment Management LLC, this month proposed changes that would let its funds buy and sell real estate and expand their borrowing capability.
The new investment guidelines give the funds added tools to boost returns at a time when the industry is facing tough competition from other investment vehicles. Exchange-traded funds, which resemble mutual funds but trade like stocks throughout the day, have proven a popular low-cost alternative for investors. Higher short-term interest rates -- many savings accounts currently yield as much as 4 percent -- have made even holding cash a competitive threat to many mutual funds.
It's too early to say whether the new strategies are boosting performance.
More mutual funds are adding hedge-fund-like strategies.
Some techniques:
• Short selling, or selling borrowed shares to profit from a price decline.
• Buying securities on margin, or with borrowed money.
• Using more complex derivatives, or financial contracts whose value is based on an underlying investment.
SOME FUNDS THAT USE HEDGE STRATEGIES:
• AllianceBernstein: Proposing changes to some funds.
• Allianz Global: Proposing changes to some funds.
• Ariel Capital: New rules allow short selling and bigger stakes in individual holdings.
• Oppenheimer: Quest Opportunity Value Fund recently started shorting stocks, using alternative strategies.
SOME FUNDS THAT DON'T USE SUCH STRATEGIES:
• Brandywine.
• Dodge & Cox.
• Vanguard.
Posted by su at February 27, 2006 2:27 PM