Morningstar Advisor - Spring 2007 - (Page 30)

Spotlight: Hedge Funds In choosing between “lower-quality, low-liquidity hedge funds and liquid, transparent open-ended funds…we’ll take the open-ended fund in all cases” —advisor Kurt Box An investor is able to perform important holdings-based analysis, a privilege rarely afforded with a hedge fund. And the fact that mutual funds provide clearly defined prospectuses and are overseen by a board of directors makes them easier to monitor. Clients might be more comfortable investing in them, too, With hedge funds getting so much media attention recently, Plant, the advisor from Oklahoma, says that they’ve caught the attention of some clients, but they usually back off the idea after discussing it with him. “They’re surprised when I cover all the concerns I have with hedge funds,” Plant says. Instead, he’ll steer these clients into hedge-like mutual funds. But pickings are fairly slim in this newly minted niche. A host of “me-too” asset managers have rushed to market in recent years with new offerings, and many of them are not worth their salt. Fund returns have been lackluster, and fees are not exactly cheap. Worthy options can be found, however. The following funds feature experienced management teams and below-average expense ratios compared with similar funds in their category. What’s more, we think all three can play a diversifier role in a traditional portfolio of bonds and stocks. The Merger Fund MERFX Its veteran manager has cranked out a 10-year annualized return of 7.31% return by sticking to a fairly straightforward merger-arbitrage strategy. It charges a relatively modest expense ratio of 1.36%, giving it a fighting chance against the average hedge-fund peer, which charges 1% management fee along with a 20% performance expense. Diamond Hill Long/Short DIAMX Seasoned managers Ric Dillon and Chuck Bath follow a fairly conventional long/short strategy, buying stocks that appear cheap while shorting those that look expensive. The managers have executed well, using a contrarian tack. They’re in it for the long term, as both managers are large investors in the strategy and firm. Hussman Strategic Growth HSGFX Former economics professor John Hussman plies a flexible strategy. He looks to take advantage of both market sentiment and valuations, routinely using options on indexes to both hedge and leverage. The results have been outstanding, especially in times of market turbulence—exactly what you’d want from a hedge product. The fund has notched a five-year annualized return of 7.83% while exhibiting a low standard deviation of less than 5% and R-Squared of only 25. The fund’s expense ratio is 1.14%, and the minimum investment is $1,000. Advisor Kurt Box, CFP, of Cypress Advisory Services in Houston, is a fan. “We use alternative investments quite heavily because we seek “x” rate of return for our clients, instead of trying to beat some vague benchmark,” he says. “We’ve been using Hussman’s fund for years. It’s not a typical long-short fund, and it’s greatly helped us meet our return goals.” Plant also uses Hussman Strategic Growth as an alternative, in addition to Merger Fund and Schwab Hedged Equity SWHIX. “I use such funds in some clients’ portfolios to reduce downside risk and overall beta,” he says, “with the objective of keeping volatility low and capturing a greater portion of the upside than the downside movement.” The number of good mutual fund alternatives might be limited, but Box says there’s enough available to make individual hedge funds a “less important” option to him and his clients. “With the proliferation of hedge funds, the quality of them has declined significantly,” Box says. “That is not to say that there are not excellent hedge funds out there, but these tend to have extremely high minimums, if they’re not already closed. That leaves us with choosing between lower-quality, low-liquidity hedge funds and liquid, transparent open-ended funds. In that matchup, we’ll take the openended fund in all cases.” Passive Investments: Innovation Encouraging, but Jury Is Still Out Passive hedge-fund investment vehicles are designed to give the investor a less-expensive way to participate in hedge-fund returns. “Investable” indexes are the most traditional and popular of these. Their constitution methodologies tend to vary, but most indexes invest in a large set of hedge funds, asset weighted according to strategy. Like funds of funds, indexes allow the investor to diversify risk and tap into many different 30 Morningstar Advisor Spring 2007

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Morningstar Advisor Spring 2007 Features Departments Letter from Joe Mansueto Get to Know Morningstar’s Fund Managers of the Year Is Your Client a Stock or a Bond? Less Alpha, More Beta Than Meets the Eye Your Mileage May Vary A Clear-Eyed Look at Hedge Funds Lower Risk, Higher Returns, What’s Not to Like? Without Cash and Clout, Advisors and Clients Get Short End of Stick Get the Strategy Minus the Headaches Analyzing Funds of Hedge Funds Not All Hedge Funds Are Created Equal A Fund with a (Long) View Laying Low and Prospering A Menu of Ideas to Fill Five Market Baskets Oil and Gas Gushing with Values Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities What’s New at Morningstar and on the Web You Can’t Always Get What You Want

Morningstar Advisor - Spring 2007

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