A hedge fund for mutual fund investors

The other day I mentioned two public companies that offered exposure to hedge fund-like strategies but there are also some mutual funds in this game. The always excellent Fundalarm Annex written by David Snowball, a once-a-month online column about new and overlooked mutual funds, introduced me to one fairly new offering called the Nakoma Absolute Return Fund (Symbol: NARFX). It’s worth a look if you want an investment that’s much less likely to lose money than a stock fund while preserving some exposure to equity gains.

This is a hedge fund’s hedging mutual fund. By that, I mean this is not just an equity fund with a little short-selling on the side. This is a VERY hedge fund-like mutual fund including lots of short-selling, possible use of leverage and derivatives and the ability to go big into cash in times of trouble. According to its most recent portfolio disclosure, more than 40% of the fund’s assets are in short positions. Fees aren’t quite hedge fund-like, but aren’t cheap either with a management fee of almost 2% plus the costs of selling stocks short (paying the dividends, mainly) adding in another half of a percentage point.

The goal is to provide a solid return without the volatility and losses of pure stock market exposure. In an interview Snowball posted on his site, Nakoma co-manager Mark Fedenia argues that passive investing, sticking with low-cost index funds, is just as risky as using an active manager and makes the accurate and insightful quip that the S&P 500 is an actively-managed fund, it’s just a group of stocks picked by McGraw-Hill’s S&P unit (MGH also owns of Businessweek) with low turnover and publicly-disclosed selection criteria. “For what investor is this really the proper portfolio,” he asks. “Over long horizons passively managed portfolios, more often than not, yield positive results, however the ride may be quite volatile. Unanticipated liquidity needs during the investment period make a smooth return pattern desirable.”

As a result, if you go with Nakoma, you’re giving up a lot of upside but also potentially avoiding a lot of downside. For a young investor saving for retirement 30 or 40 years in the future, the zigzags may not matter. For those closer to retirement or in retirement or saving for shorter-term goals, the zigzags can make all the difference.

According to Snowball, the hedge funds previously run by Nakoma’s managers gained 21% from 2000 to 2002 at the same time that the S&P 500 was dropping like a stone and posting a 37% loss. But from 2003 to the present, their hedge fund has gained only 28% over those four years. The ride was a lot smoother than the S&P as the hedge fund had half the volatility though quite a bit lighter on the gains side too. The index is up almost 70% over that period. Some really simple math on that: if you start with $100 and gain 21% and then gain 28%, you have about $155. If you start with $100 and lose 37% and then gain 70%, you have $107. On the other hand, since the previous big bear markets were in the early 1970s and around the Great Depression, that much downside risk seems, at least historically, to be a ways off in the future.

I have to say I was impressed when I looked at the fund’s most recent list of holdings, dated 2/28/2007. Among two dozen short holdings, the fund was all over the subprime bust with positions in Countrywide Financial (CFC), Washington Mutual (WM), FirstFed Financial (FED), Centex (CTX), MDC Holdings (MDC) and even Harley-Davidson (HOG). Those six names are down an average of 8% each in 2007. They’re also down on some tech names like Motorola (MOT), Applied Materials (AMAT) and Semtech (SMTC). There’s also a short position in the iShares Dow Jones US Energy Sector ETF (IYE) — which is UP 17% so that’s not working — and my personal favorite whipping post (or maybe whipping cream post) Starbucks (SBUX), which has lost almost 20% this year. On the long side, the biggest industry bet was on healthcare, including positions in Medimmune (MEDI), up 80% this year thanks to the AstraZeneca takeover, Thermo Fisher Scientific (TMO), up 20% this year, and Hologic (HOLX), up 16%. Then again clunker AMN Healthcare Services (AHS) is down 16% and Mylan Labs (MYL) is off 1%.

Bottom line — the fund is up almost 6% year to date, trailing the S&P 500 by about 3%, a little better than the managers’ historical performance in bull markets.