Closed-door schemes, lax regulation, opaque operations, meltdowns and outsized profits are a few things that the media often emphasize when covering hedge funds. But those reports differ markedly from the goals of a growing group of market-neutral mutual funds that have distilled the essence of hedge fund investing into a more regulated, liquid and accessible format.
The number of funds in Lipper's market-neutral category that are available to retail investors has grown from 10 three years ago to 23 today, while assets have more than doubled from $959 million to $2.2 billion. Funds in this category employ portfolio strategies that are designed to generate consistent returns in both up and down markets by selecting positions with a total net market exposure of zero. They typically use leverage, sell short and employ other nontraditional investment methods to bring hedge-fund-style investing to the masses.
Launched in September 2002, the $393 million Alpha Hedged Strategies Fund is among the oldest and largest of these offerings.  To minimize equity market correlation and volatility, it employs a stew of 15 such alternative strategies as: distressed securities; earnings revision long/short equity; momentum long/short equity; REIT long/short equity; deep discount value long/short equity; international long/short equity; health-care and biotech long/short equity; global long/short equity; equity options overlay; merger arbitrage; fixed-income arbitrage; and convertible bond arbitrage.
True to its mission, the fund has successfully delivered competitive returns with significantly less volatility than, and a low correlation to, the broad stock market averages.  Since its inception, its correlation to the S&P 500 is 0.29 and its beta is .09. The annualized standard deviation is 4.67%, compared with 14% for the index.
"We target a return that is 4% to 6% above that of a riskless Treasury bill," says Chief Investment Officer Lee Schultheis, who manages the fund with Michael Portnoy and Mark Tonucci. "That is significantly better than the mid-single-digit returns the fixed-income markets have delivered." From its 2002 inception through the first quarter of this year, the fund has delivered an average annualized return of 7.36%, compared with 4.44% for the Lehman Brothers Aggregate Bond Index, 2.72% for the 90-day Treasury bill and 15.22% for the S&P 500 index. Its best quarter ended in December 2004 with a total return of 6.76%, and its worst ended in June 2003 with a 1% loss.
A report earlier this year on hedge funds and hedge-fund-like mutual funds by Lipper Analytical Senior Research Analyst Andrew Clark underscores the diversification benefits of those investments, especially when stock or bond markets are falling. "For many of the hedge funds and hedge-fund-like mutual funds in our study, having them in a portfolio improves diversification and, in all cases, does not add to existing risk. The possibility exists that the addition of a hedge fund or hedge-fund-like mutual fund would actually reduce the risk in a portfolio," he concludes.
Schultheis says that financial advisors account for about 90% of his fund's assets. Many of them use it as a fixed-income substitute because of its low volatility characteristics, low correlation to the stock and bond markets and attractive returns. "Most advisors we are working with introduce the fund into the portfolios of more mature clients who have accumulated wealth but are becoming more concerned about protecting principal," he says. "Their focus has shifted from maximum compound growth to increasing consistency and predictability of returns, risk-adjusted returns and decreasing the portfolio's exposure to market and interest-rate risk."
The biggest obstacle in marketing the fund has been its complex strategy, which some financial advisors find extremely difficult to explain to clients. Its 3.99% operating expenses, which are more than three times that of the average domestic stock fund and ten times higher than a low-cost bond index fund, also have met with resistance. Schultheis says the fund pays a higher fee to its hedge fund subadvisors than would be typical in the open-end mutual fund, because of the complexity of running long/short portfolios and other strategies. Even though expenses are much higher than they would be in the average mutual fund, they are lower than the double-layered 500- to 800-basis-point bite an investor would incur with a typical hedge fund of funds, he contends.
The fund is also much more transparent and liquid than a hedge fund of funds. Net asset values are updated daily, and mutual fund accounting and custodianship help prevent mispricing. There is no lockup period. It offers daily liquidity and investment minimums as low as $2,500. It is open to everyone, not just accredited investors.
The mutual fund format also offers more protections on the investment side. Leverage is limited to 50% of net assets, although the fund typically sets the bar at about 20%. All subadvisors are fully disclosed in the fund prospectus and on its Web site, and shareholders have full access to all portfolio details. Illiquid securities, including thinly traded stock, can make up no more than 15% of assets.
Shareholders who like the idea of a hedge fund wrapped in a mutual fund format also get the team's expertise in honing the strategy mix and the ability to access world-class, highly specialized managers who are generally unavailable to the investing public. Portnoy and Tonucci are responsible for reviewing each sub-advisor and its investment process and organization. In the past, Portnoy has crafted specialized investment products, including hedge fund-of-funds offerings, and Tonucci has developed investment products for both institutional and retail distribution at a number of banking and financial institutions.
Schultheis' background emphasizes mutual fund organization and distribution. Before co-founding Alternative Investment Partners in 2002, he was president of Kinetics Funds Distributor and president and managing director of Vista Fund Distributors, the sponsor of Chase Manhattan Bank's Vista Family of Mutual Funds.
After they decide which strategies to emphasize, they assign pieces of the portfolio to 18 outside investment sub-advisors, who manage a hedged portfolio in a separate account for the fund. The list of managers includes some large, well-known names, such as Gabelli Asset Management (for merger arbitrage), Weiss, Peck & Greer (for distressed securities and special situation plays) and Smith Breeden Associates (for fixed-income arbitrage).
It also includes many smaller boutique shops. Carlin Asset Management, a firm with just $16 million in assets under management, handles the deep discount value long/short equity strategy. Hovan Capital Management, with $26 million under management, oversees health-care and biotechnology long/short equity. And tiny Opportunity Research Group, in charge of equity options overlay, has just $2.6 million under its belt.
"In the hedge fund space, most assets go into the top 100 funds even though there are over 9,000 names in the hedge fund world," Schultheis says. "But there are some excellent smaller managers with good pedigrees who are more nimble because they have fewer assets to deploy. Many of them have worked at larger institutions and have gone out and created their own management companies. We know their reputations and can screen them effectively." When a manager closes in on $1 billion under management, the team will consider ratcheting back an allocation if performance starts to lag.
The amount of assets deployed to each investment strategy depends on how Schultheis, Portnoy and Tonucci view its prospects over the next six to 12 months. At just over 19% of assets, distressed securities and special situations is by far the most prominent theme in the portfolio. The approach involves investing long and short in the debt or equity of companies in financial distress. Such securities typically trade at substantial discounts to par value, and may be attractive to investors when managers think a turnaround will materialize. The strategy also may invest in special situations where a corporate event such as a merger, spin-off or other significant action is announced or anticipated. "The U.S. markets are pretty efficient on a day-to-day basis, so this is one of the few opportunities to uncover major mispricing," Schultheis says. Strategies may include selling short stock of a company that is teetering on Chapter 11, or buying debt instruments for less than half of par value with the expectation of getting 60 or 70 cents on the dollar once a distressed company reorganizes its finances.
Concerns about subprime mortgage pools have created some opportunities in the fixed-income area. One of the fund's sub-advisors has shorted securities backed by mortgage pools that are perceived as those with the highest risk, and gone long on the pools with lower foreclosure rates. "We can make out nicely in a hedging situation as long as the market discriminates between superior and inferior securities," he says.
Mergers and acquisitions are also getting a little extra play in the fund. A merger arbitrage strategy is designed to profit from fluctuations in the acquirer's and target company's stock price after an announced merger and acquisition transaction, with a special focus on smaller cash deals with higher relative spreads. The strategy allocates some money to companies identified as trading at a significant discount to their intrinsic or private market values and thus may be attractive acquisition targets. M&A arbitrage looks attractive now because private equity firm have increased the supply of potential targets and helped widen arbitrage spreads, Schultheis notes.