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Nov. 10, 2010, 2:38 p.m. EST

Here come ‘hedged’ mutual funds

Goldman tells investors to add new breed of fund to portfolios

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By Alistair Barr and Sam Mamudi, MarketWatch

SAN FRANCISCO (MarketWatch) — In the late 1990s, Stephen Roseman had a whiteboard in his office to keep track of all the companies in the nascent video-on-demand sector.

But for all the hype, it would be years before video on demand was widely adopted. These days, according to Roseman, many people can barely remember life without the technology.

This anecdote is how Roseman explains why he left the hedge-fund world to start a mutual fund. While talk of alternative strategies in the form of a mutual fund raged for years without much happening, it’s now beginning to take off and apparently is going to be big.

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Others agree — even investors who have backed hedge funds for years. “We’re at the very early stages of a multitrillion-dollar wave that’s going to wash over the long-only asset-management industry,” said Charles Krusen of Krusen Capital Management, which has invested in hedge-fund giants including Paulson & Co., Moore Capital and D.E. Shaw.

“For the mutual-fund industry, hedged mutual funds provide equity-like returns with less volatility, with additional transparency and regulation,” he added. “We think there’ll be a huge move to these types of funds.”

Roseman, chief executive of New York-based Thesis Fund Management, oversaw about $2 billion in assets at hedge-fund firm Kern Capital Management between 2003 and 2005. Earlier this year, he launched a mutual fund called the Thesis Flexible Fund .

He isn’t the first hedge-fund manager to do this. AQR Capital Management, co-founded by Clifford Asness, raised more than $1 billion in less than a year after launching several mutual funds.

But Roseman reckons he’s at the vanguard of a movement that will see more managers take their trading skills to the retail-investing arena. “It’s not that people don’t want the strategy; it’s that they don’t want the hedge-fund structure,” he said. Watch Roseman talk about Thesis Flexible Fund in MarketWatch video.

Hedge vs. mutual

Hedge funds take short positions — bets on falling prices — as well as long positions that benefit from rising valuations. They can also use borrowed money, or leverage, to magnify returns. They usually lock investor money up for a quarter or more, and some are free to trade any securities or derivatives anywhere in the world.

Stephen Roseman, Thesis Fund Management

The goal is to generate positive returns, irrespective of the direction of the overall market. This is usually all wrapped up in a limited-partnership structure where the manager charges an annual fee of 2% or so and takes about 20% of any profit each year.

That “absolute” return goal contrasts with traditional mutual funds, which try to beat benchmarks such as the S&P 500 Index /zigman2/quotes/210599714/realtime SPX +1.49% .

Hedged mutual funds use some of the tools and strategies common to hedge funds, such as short-selling and some leverage. But they also offer the benefits of mutual funds, such as daily liquidity and lower fees.

Investment bank Goldman Sachs Group Inc. /zigman2/quotes/209237603/composite GS +2.78% , one of the largest hedge-fund managers in the world, advised investors to add this new breed of mutual fund to their portfolios in a late September white paper.

The 2008 financial crisis left many uncertain about whether a traditional mix of equities and bonds can generate enough return, the bank said, noting that investors pulled $234 billion from U.S. stock mutual funds in 2009.

Adding hedged mutual funds to a traditional portfolio of 70% equities and 30% fixed income may generate higher returns with less volatility over time, according to the Goldman white paper.

These types of funds — which Goldman calls nontraditional mutual funds — have been around since the 1980s. But they’ve proliferated in recent years.

Adding hedged mutual funds to a traditional portfolio of 70% equities and 30% fixed income may generate higher returns with less volatility over time, according to Goldman Sachs.

Goldman analyzed flows of money into these types of funds using data from Morningstar /zigman2/quotes/209325896/composite MORN -0.63% , Lipper and Strategic Insight. Morningstar calls them “alternatives,” while Lipper gives them the name “global flexible portfolios.” In Strategic Insight’s world, they’re “strategic income” funds, the bank said.

In 2005, these funds pulled in a net $29.7 billion, or 11% of total long-term mutual-fund flows. In 2009, they took in a net $121 billion, or a quarter of mutual-fund industry flows. In the first half of this year, a net $56.5 billion flowed in, or 27%, Goldman indicated.

“The mutual-fund industry will likely continue to see the emergence of new and innovative strategies,” the bank wrote in the white paper. “As investors gain a better understanding of these strategies, adoption and usage will increase, but currently there remains significant growth potential.”

Warming to the subject

Brad Alford, who invested in hedge funds for more than two decades for institutions including Duke University’s endowment, is a convert to hedged mutual funds.

Alford is now chief investment officer of Alpha Capital Management, which offers managed accounts that invest in several large hedged mutual funds.

His picks include the BlackRock Global Allocation fund /zigman2/quotes/205546109/realtime MALOX +1.20% , Pimco’s All Asset All Authority fund /zigman2/quotes/205609764/realtime PAUIX +0.91%  and Ivy Asset Strategy /zigman2/quotes/200116034/realtime IVAEX +1.56% . “There are so many great mutual funds that look like hedge funds now,” Alford said.

The major difference is that hedged mutual funds are structured under the Investment Company Act of 1940, while hedge funds are usually limited partnerships.

All the Investment Company Act funds have to offer investors the ability to withdraw their money every day — daily liquidity, as Alford and others call it.

In contrast, during the financial crisis, many hedge funds froze redemptions or limited withdrawals in other ways. That surprised and angered some investors, and it’s a big reason why hedged mutual funds are gaining more of a following now, Alford commented.

‘It is just tough to have a portfolio fully invested when you are affected by the daily buy and sell decisions of investors. This is especially the case during periods of market turmoil.’

Richard Gates, TFS Capital

Another benefit is that hedged mutual funds charge lower fees and don’t take a big cut of annual profits like hedge funds. “Clients don’t want to pay the astronomical fees of hedge funds, especially in this low interest-rate environment,” he said.

Lower interest rates have put pressure on the returns of some hedge funds, particularly those that trade in credit markets. That makes the industry’s high fees look even more expensive.

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