John HussmanÃs hedging strategy helps his fund flourish in a bear market.
Although hedging strategies have helped Hussman Strategic Growth Fund thrive in a bear market, manager John Hussman's voice takes on an edge when he hears someone call it a "bear market" fund.
"This is emphatically a growth fund. It's not a market neutral fund, and certainly not a bear market fund," says the 40-year-old Hussman. "But we also have an articulated strategy that helps protect capital during unfavorable market conditions. The risk is that the fund may not always track the overall direction of the market."
Since the fund's inception in July 2000, shareholders usually have been rewarded for taking that risk. Hussman's hedging strategy, which uses a combination of put and call options on major indices to dilute the impact of broad market moves in the portfolio, helped the fund gain 5.5% for the 12 months ending March 10, beating the S&P 500 Index by some 35 percentage points. Last year, the fund rose 14.02%, versus a loss of 22% for the index. It gained 14.67% during 2001 and 16.4% from its inception to the end of 2000. It has also been much less volatile than the overall market, and has never experienced a decline in net asset value of more than 7%.
Its mettle has been tested more recently, with the fund having falling nearly 5.5% from its August 2002 peak through mid-March. While that's less than half the drop of most major market indices, it falls well below the level of outperformance that shareholders enjoyed in the past.
Hussman attributes the pullback to the fund's unhedged position of nearly 40% during the initial part of the market decline from its August peak, as well as slight underperformance by portfolio stocks compared with the major indices. In a letter to shareholders, he notes that he avoided companies that performed well over that period-namely debt-heavy media, telecom and financial services companies-because they do not have the financial stability and strong cash flow he's looking for.
The stocks he favors defy easy categorization because Hussman finds labels such as "value" or "growth" misleading. "Rapidly growing companies can be an extraordinary value," he says. "I bought Cisco Systems in 1991 when it had a price-earnings ratio of 35. But for that company at that time, it was a bargain." He typically holds about 100 stocks, with each position accounting for anywhere from 0.5% to 2% of portfolio value.
He also does not restrict the size of companies he buys, and has holdings ranging from yesterday's favorites such as Merck to more adventurous concerns such as Internet bookseller Amazon. Reflecting its eclectic mix, which includes a hefty dose of consumer service and manufacturing companies, Morningstar categorizes Hussman Strategic Growth as a mid-cap blend offering.
The common denominator for fund holdings is that they must have stock prices that appear reasonable in relation to the future stream of earnings, dividends, revenues and cash flow. He also examines financial statement information on capital structure, inventories, book value and other factors that influence financial results.
Despite the fund's bear market bravura and its rapid growth to about $442 million in assets, Hussman remains a fresh face in the world of mutual funds. He began his career in the mid-1980s as an options mathematician for Peters & Co. at the Chicago Board of Trade. He began publishing the Hussman Econometrics newsletter in 1988, and he started managing individual accounts in 1993 while an assistant professor of economics and finance at the University of Michigan, a position he held until 1999. By the time he started the fund in July 2000, he had some $25 million under management, including his own money.
He migrated those accounts into the mutual fund because he saw it as a more efficient way to manage them. With a minimum investment of $1,000 ($500 for IRA accounts), it also opened the door to smaller investors.
Those investors were drawn to the fund, despite Hussman's miniscule marketing budget. The Ellicott City, Md., headquarters offices of Hussman Econometric Advisors remains a hands-on, low-overhead operation, with Hussman maintaining a professional staff of just two assistants who handle accounting, due diligence, research, reporting and administrative tasks.
Morningstar analyst Brian Lund expresses some concerns about the impact rapid growth could have on the fund's ability to produce market-beating returns in the future. "More assets could limit the fund's ability to profit from its stock-picking method, which draws on the relation of market prices and trading volume," he says. "As the fund's purchases exert greater influences on the market, it may become more difficult to exploit inefficiencies." He also has concerns about its short operating history and unpredictable level of market exposure.
Hussman insists that the fund's go-anywhere investment charter, which places no restrictions on market capitalization, gives him plenty of room to operate without bruising performance. He also points out that economies of scale allowed him to lower the expense ratio from 2% to 1.45% last November, about average for a domestic stock fund. The 1.5% redemption fee paid by investors who hold shares for less than six months remains in place to discourage short-term trading.
Given the flexible nature of the fund, concerns about an unpredictable level of market exposure seem unavoidable. The amount of hedging the fund employs changes with Hussman's view of market conditions and stock valuations. To assess market conditions, he looks at "trend uniformity." If trend uniformity is favorable, price trends advance across a wide range of industries and security groups-an indication that investors are willing to assume risk. When both valuations and trend uniformity are unfavorable, as they are now, the fund takes a fully hedged position.
Typically, the fund uses option combinations to hedge. Buying a put option on a stock index, and simultaneously selling short the call option having the same strike price and expiration, creates the same effect as selling short the underlying index. However, the fund can't go to a net short position, so it isn't designed to profit from a market decline. But it can hedge enough to moderate fluctuations in the portfolio. In a fully hedged portfolio, the return is driven by the difference in performance between the stocks the fund owns and the indices he uses for hedging-typically the Russell 2000 Index and the S&P 100 Index.
Today, with the fund fully hedged, the entire value of the stocks in the portfolio is offset by a short sale of equal value in the major market indices used for hedging. So if the market falls by 10%, and the stocks held by the fund fall by 5%, the fund's return would be about 5%. In contrast, if the market falls by 10% and the stocks held by the fund fall by 15%, the fund would experience a loss of about 5%.
The fund's hedging strategies tend to insulate it from short-term market blips, both up and down. Hussman acknowledges that in the initial stages of a market recovery, the fund could lag. "We are willing to defend capital at the risk of underperforming during short-term rallies," he says. "But the strategy does not restrict the fund from performing well during a bull market." When market conditions are more favorable, the fund can take a more aggressive stance by moving to a totally unhedged position, or using leverage.
Such a stance would point to a bull market, something the fund has yet to experience. Hussman says the performance of his individually-managed accounts reflect different investment parameters, and would provide little insight on how his fund might behave in a bull market.
Nor will he reveal whether he intends to reduce or eliminate his use of hedging any time soon. He doesn't try to forecast the market, he says, but simply tailors his approach to prevailing market conditions.
While those conditions make a powerful stock market rebound unlikely, he believes that the S&P 500 Index "remains priced to deliver total returns in the 3% to 5.5% range over the coming decade." He bases that calculation on an average earnings growth rate for the index of 6%, which he contends is more realistic than the figures many investment managers are using today. "Some people apply 15% growth rates to a large number of stocks over a long period of time," he says. "That's just not realistic in an economy that is only growing at a rate of 6% in nominal terms. Historically, it is very unusual for corporate earnings to grow faster than that over the long term.