Old Mutual is a veteran in the eclectic, newly recognized long/short category of funds.

By Marla Brill

    Harindra de Silva compares running a mutual fund to making a Caesar salad. "If you take individual ingredients like raw eggs, anchovies and lettuce, it doesn't sound very appealing, but when you mix them together they taste great," says the 46-year-old cooking enthusiast.
    To de Silva, the blend of strategies that go into the Old Mutual Analytic Defensive Equity Fund, including the use of hedges and short selling, create a similarly eclectic yet tasty mix. "I've always had a lot of my own money in this fund," says de Silva, who has been its manager since 1997. "Its dissimilar components end up working well together."
    The ability to hedge and sell short are among the key ingredients that have given Old Mutual Analytic Defensive Equity a unique flavor since it was founded in 1978 by Analytic Investors, a Los Angeles firm known for its expertise in derivative strategies. Despite its pedigree the fund had a minimal following and, after 27 years of operation, began 2005 with a modest $57 million in assets.

    De Silva believes that because it was only available to the public through direct retail sales until recently, sales languished because the average retail investor had trouble understanding its complex strategy. An important part of that strategy involves a 120 long/20 short stance, which means that if someone puts $100 into the fund the manager buys $120 worth of stock on the long side, and then shorts $20 of it. The process magnifies the impact of stock selection, or alpha, while bringing the investor back to $100 of exposure and a beta of 1.
    To whittle the beta down to his targeted level of around 0.5, de Silva, along with co-managers Dennis Bein and Greg McMurran, sells call options on broad-based indexes such as the S&P 500, as well as narrower ones based on sector groups such as oil or gold. "We use calls on indexes rather than individual stocks because we think our holdings have a significant chance of outperforming the market, and we don't want to give up all of that upside," he explains. "Plus, index options have tremendous liquidity, particularly some of the new exchange-traded fund options. So if we want to adjust our positions we can do it less expensively than we could with individual stock options."
    Because it is hedged the fund tends to do best in a flat to choppy market, says de Silva, who believes his mandate is to "achieve market-like returns at substantially less risk." Its performance history shows that in a rising market, returns tend to lag those of the S&P 500 Index, the benchmark from which it draws most of its investment ideas. In 2001, for example, it fell by 2%, but still beat the index by ten percentage points. In 2003, a strong year for the market, it underperformed the index.
    But the fund's fortunes, both in terms of performance and recognition, have been looking up lately. Last year, its 15% total return beat its bogey by a wide margin (although it has lagged the market over the last several months). Now marketed through financial advisors, it has $520 million in assets.

De Silva believes that liberalized attitudes toward hedging have helped the fund gain broader acceptance. "There seems to be a lot more appreciation of the benefits of a strategy that is not entirely dependent on market return," he says. "Most investment managers will buy a stock if they like it, or ignore it if they don't. But it's hard to argue that you should simply buy stocks whose prospects you like, and ignore short-selling opportunities. Removing a long-only constraint adds a lot of value to a portfolio." Recently, for example, a position in Visteon, the auto parts supplier with close links to Ford, helped performance as the stock price fell after the company delayed the release of financial statements and cautioned that it plans to revise financial statements for the past three years. A short position in OfficeMax also paid off when the company reported deeper-than-expected losses as a result of sluggish retail sales.

    If the proliferation of mutual funds that employ hedging strategies is any indication, the investing public seems ready to entertain the notion of playing both sides of the investment fence. In March, Morningstar rolled out five new fund categories, including long/short funds. The group, which once fell into the "conservative allocation" or "moderate allocation" categories, typically buys stocks just like other equity funds, but also short stocks or indexes. To be included in the category, mutual funds must generally have shorts of at least 20% of total net assets. New funds in the genre, including Rydex Absolute Return Strategies Fund and American Century Long-Short Equity Fund, join old timers such as Schwab Hedged Equity, Hussman Strategic Growth, and Laudus Rosenberg Global.
    De Silva says he welcomes the competition. "I think it's a great development and a movement toward the next generation of mutual funds," he says. "Making hedge-fund-like investing available in a mutual fund format provides the benefits of transparency, daily valuation and the safeguard of a custodian."

    Like others in the group, Old Mutual Analytic Defensive Equity has some drawbacks. Frequent buying and selling can boost investors' tax bills. Its strategy can be difficult to understand and explain. And annual expenses, while lower than most other funds in the category, are still a bit higher than those of the average stock fund.

    Still, de Silva believes investors can fit hedge funds into portfolios in a few ways. "An advisor might look at the fund as a complement to a core equity strategy. If you are looking to put 15% to 20% of assets into the alternative portion of an allocation plan, this is the fund to consider." Because the fund also forms its strategy around the S&P 500 Index, people can also think of it as a core holding with a twist, he adds.

What's Hot, What's Not
    A native of Sri Lanka, de Silva honed his quant skills as an engineer for several years before earning his Ph.D. in finance from the University of California. His approach revolves around the notion that investor tastes change, and that capturing value in the market means adapting investment strategies to those changes. That philosophy began to take shape early in his career when he worked as a consultant helping companies select investment managers, an experience that convinced him not to bank on a single investment style. "One of the most frustrating things about the job was picking a manager who had a good track record, only to have his style of investing go out of favor," he says.

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