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Hedge Funds for Ordinary Folks

By Lewis Braham Anyone who doubts that hedge funds have gone mainstream need only examine Baron Partners Fund. Until last April, only accredited hedge-fund investors -- those with at least $1 million in assets -- could buy the fund. Now that New York-based Baron Funds converted it from a hedge fund into a mutual fund, anyone with $2,000 can get in. "The mutual fund has a different fee structure from the hedge fund, but otherwise it's basically the same fund," says Baron Funds president Morty Schaja.

So why convert? Since the 1997 repeal of the "short-short rule," which restricted mutual-fund managers' ability to short, or bet against, stocks, a growing number of money managers have been opening

long-short, market-neutral, and

arbitrage funds that mimic hedge funds. The 2000-02 bear market accelerated this trend, with assets in funds that hedge in one form or another having grown from $3.8 billion in 1999 to $9.9 billion in 2003.

Given this environment, Schaja felt the fund was ripe for a conversion. "Our traditional customer base for our other mutual funds -- high-net-worth investors with advisers -- are now interested in hedge funds," he says. "But many don't want to put up the money to get into one. The minimum investments are too high. So this is a good alternative."

SKILLED MANEUVERING. Indeed, in many ways hedged mutual funds are better investments than their more glamorous cousins. Management fees vary widely, but they are generally less than those at hedge funds, ranging from 1% on the low end to 3.5% on the high. That compares to a fee of 1% of assets plus 20% of profits in the typical hedge fund.

Mutual funds also are much more heavily regulated than hedge funds, being governed by the Investment Company Act, which makes them less prone to fraud. Plus, most funds allow daily redemptions, while hedge funds typically permit withdrawals only once a quarter. "If a hedge fund's sector is melting down, you're stuck," says Rick Lake, a Greenwich (Conn.) adviser who invests in hedged mutual funds. "But in a mutual fund, you can get out fairly quickly."

Having that trading flexibility has proven advantageous to Lake. "The different investment strategies these funds use tend to work well at different times," he says.

APPLES TO APPLES. For instance, Lake sometimes will invest in the long-short funds run by AXA Rosenberg. These funds' portfolios are always half long, half short, and have a value bias, buying stocks with low expected price-earnings ratios and shorting those with high p-e's. AXA's funds scored big gains in the bear market, but in the current environment, which has favored high-price tech stocks, Lake has reduced his position in these funds and has been leaning more heavily on Needham Growth Fund (NEEGX), which favors tech stocks and can short a maximum of 25% of its portfolio.

While such maneuvering requires skill, it pays off. Since its January, 1999, launch, Lake's hedged mutual-fund portfolio has delivered a 44% cumulative return, vs. a 7.7% loss for the S&P 500-stock index through November, 2003.

As new funds enter the arena, costs have been coming down. Three relative newcomers, Hussman Strategic Growth Fund (HSGFX), ICON Long/Short Fund/I (IOLIX), and Analytic Global Long-Short, as well as Baron's fund, all have expense ratios of less than 1.5%. That compares favorably with Needham Growth, which charges 1.75%, and AXA Rosenberg's long-short funds, all of which charge in excess of 2.5%.

Because strategies vary so widely, though, investors need to make apples-to-apples comparisons. Analytic's global fund, which has a 1.3% expense ratio, can be compared with AXA Rosenberg Global Long/Short Equity (RMSIX), which has an expense ratio of 2.9%. Although Analytic's portfolio isn't always 50% short like AXA's, its short percentage always ranges between 33% and 40% -- close enough, given that it also has a similar global investment strategy.

SELECTION VS. DIRECTION. ICON's and Baron's funds are similar to Needham's in that they short less and infrequently, making them much more exposed to market fluctuations. Hussman's fund is in a league of its own, sometimes completely hedged and sometimes not at all, depending on market conditions.

Smaller management fees are particularly valuable in low-risk/return hedging strategies, such as merger and convertible arbitrage. "Merger arb funds typically earn between 8% and 10% a year," says Lou Stanasolovich, CEO of Legend Financial Advisors in Pittsburgh. "To charge 1% of assets and 20% of profits on that is pretty hideous." So in his clients' portfolios, Stanasolovich uses Merger Fund (MERFX) and Arbitrage Fund (ARBFX), which have expense ratios of 1.3% and 1.9%, respectively. Both funds have beaten the average arb hedge fund's returns in recent years.

Investors have a few ways to fit these funds into their portfolios. With long-short funds, Harin Da Silva of Analytic Global Long-Short Fund recommends a "core-and explore" approach, putting 80% to 90% of stock assets into an index fund and the remainder into a long-short vehicle.

"Normally, if you put money into an active equity strategy, the fund's exposure to the market accounts for 80% to 90% of the return, and stock picking the rest," he says. But by holding short positions, long-short funds reduce their beta -- or exposure to the market's moves -- so that most of their returns stem from stock picking. So a 10% or 20% position in a long-short fund acts as a substitute for the active manager's contribution to returns in a traditional fund. "This way your portfolio is more cost-efficient," Da Silva says. "You are paying active management fees for stock selection, not market direction."

"EVERYTHING THAT MOVES." Funds that employ other kinds of hedging -- such as merger arb and convertible arb -- often behave like a different asset class from stocks or bonds, and will need to be run through an optimizer to see how they fit with a client's overall portfolio. Arb funds have a similar volatility level to bond funds, so they can probably replace a portion of a client's fixed-income portfolio. In some of his accounts, Stanasolovich has a much as 33% allocated to merger arb.

Though mutual funds are rapidly moving into hedged strategies, they still can't touch some areas. "Highly leveraged fixed-income hedge funds are hard to mimic with mutual funds, because of regulatory restrictions on leverage," says Lake. "So are global macro strategies that invest in everything that moves."

Then again, such risky strategies were precisely what caused some of the biggest blow-ups in hedge-fund history, including the infamous Long-Term Capital in 1998. The average investor is probably better off without such volatile fare. Braham is a freelance writer in New York

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