Mutual Fund Education
Introduction to Hedge Fund Strategies in Mutual Fund Investing
David Dierking Jul 25, 2017
If you are wondering whether mutual funds are right for you at all, you should read about why mutual funds, in general, should be a part of your portfolio.
A Primer on Common Hedge Fund Strategies
At a high level, there are three broad strategies that hedge funds employ outside of traditional buy-and-hold.
- Long/short – Instead of just using mostly long positions, a long/short strategy attempts to profit no matter which way the stock moves. The manager can short stocks he feels will drop, adding an additional dimension of fund returns, but one that can come with added risk and cost.
- Market-neutral – This strategy looks to pair stocks with identical risk characteristics. The manager buys the one he feels will outperform and shorts the one he feels will underperform. The goal is to produce positive returns from these theoretically risk-free pairings.
- Leverage – Managers can use futures contracts to provide extra exposure to securities or markets beyond traditional long or short positions. This can be an especially risky strategy, but one that can deliver outsized returns if done correctly.
Emerging Trends in Hedge Fund Strategies
There are a couple of reasons why using quant strategies can be valuable. First, they remove emotion from investing decision making. Common behavioral mistakes such as following the herd, choice paralysis and confirmation bias can impact the ability of managers to make investment choices objectively. Computers can act independently of these issues. Second, they’re potentially cheaper. Computers don’t require salaries, health benefits and other costs. High expense ratios are one of the biggest factors driving assets away from actively managed funds. Anything that can lower those fees can make actively managed funds more competitive.
Fund giant BlackRock, in particular, is embracing this trend. The combination of high cost and chronic underperformance that has become a stigma with active funds has driven the iShares fund provider to make widespread changes with its lineup. The company plans on consolidating a number of its actively managed funds and transitioning as much as $30 billion in assets over to quant-focused products. Additionally, it plans on laying off at least 36 employees as part of the move while dropping expense ratios on some affected funds, such as the BlackRock Large Cap Core Fund (MBLRX). If successful, the fund industry may take notice and soon follow suit.
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3 Things for Investors to Consider
- These strategies carry high risk – Betting on stocks going down and adding high degrees of leverage can result in significant losses over short periods of time. The costs of establishing short positions or buying futures contracts can further increase the possibility of underperformance over time.
- These strategies might not work – All strategies experience periods of underperformance, and hedge fund strategies are no exception. Morningstar’s multi-alternative category, the group that captures long/short and market-neutral strategies, posted a three-year average annual return of just 1%, compared to a 9% average annual return for the S&P 500.
- Investors should do their due diligence – Investing in any fund, stock or other security should always be preceded with a look at how well it aligns with your objective, time frame and risk tolerance.
The Bottom Line
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