A recent Wall Street Journal article explored the rise in hedge-like mutual funds. These mutual funds are using techniques traditionally used by hedge funds to eke out gains in hard economic times. The rational is that, while the market plunged 39% last year, hedge funds fell a less devastating 20% on average. This is thanks to the unique strategies that work with arbitrage, risks and leverage in ways that plain vanilla stock funds cannot. So, more and more mutual funds are doffing their stodgy neckties and pulling on the flashy boa of hedge funds. (Learn when to take risks in Risk Tolerance Only Tells Half The Story.)
Types of Funds
Hedge-like mutual funds are operating in three ways: arbitrage funds find takeover arbitrage and convertible bond arbitrage to make low risk profits; long/short funds go long on some stocks while shorting others (allowing them to invest over 100% of the fund, thanks to leverage); and market neutral funds that seek to neutralize the effect of market swings on the stocks in their portfolio. These funds offer very different risks and rewards - something they hope investors recognize as a useful tool for diversifying. But their MERs also creep closer to pure hedge funds, cranking up the expectations on them to beat out their pure mutual fund cousins by wide margins to justify the expense.
Unproven Track Record
Because hedge-like mutual funds are relatively new, there isn't a solid track record to judge them by. This, combined with the high MERs, make them a potentially trendy investment vehicle that will simply fail to live up to the hype – time will tell. Right now, however, their growth is good for the market. Since the downturn, speculation has taken a beating in the market through losses and in congress through misplaced blame. More money being put towards closing market gaps means that pricing inefficiencies will be recognized and corrected sooner. This may actually tone down the outsized returns that hedge funds have seen in the past – not a good prospect for the funds getting in now. However, this increased speed in correcting markets will also help guard against long-term stock bubbles by increasing the diversity of opinions flowing through the market. Just like the fashion industry, variety is the lifeblood of finance. (Should the Fed intervene in market bubbles? Read Economic Meltdowns: Let Them Burn Or Stamp Them Out?)