Dec. 22, 2003 — Anyone who doubts that hedge funds have gone mainstream need only examine Baron Partners Fund for proof to the contrary. Last year only accredited hedge fund investors, those with at least $1 million in assets, could buy the fund. But this April New York-based Baron Funds converted it from a hedge fund into a mutual fund. Now anyone with $2000 can get in. “The mutual fund has a different fee structure from the hedge fund, but otherwise it’s basically the same fund,” says Baron Funds president Morty Schaja.

So why convert? Since the 1997 repeal of the “short-short rule,” which restricted mutual fund managers’ ability to short, or bet against, stocks, there has been a growing number of money managers opening long-short, market neutral and arbitrage funds that mimic hedge funds. The 2000-2002 bear market accelerated this trend, assets in funds that hedge in one form or another having grown from $3.8 billion in 1999 to $9.9 billion in 2003. Given this environment, Schaja felt the fund was ripe for a conversion. “Our traditional customer base for our other mutual funds, high net worth investors with advisers, are now interested in hedge funds,” he says. “But many don’t want to put up the money to get into one. The minimum investments are too high. So this is a good alternative.”

Indeed, in many ways hedged mutual funds are better investments than their more glamorous cousins. Management fees vary widely, but are generally less than hedge funds, ranging from 1% on the low end to 3.5% on the high. That compares to a fee of 1% of assets plus 20% of profits in the typical hedge fund. Mutual funds also are much more heavily regulated than hedge funds, being governed by the Investment Company Act, which makes them less prone to fraud. Plus, most funds allow daily redemptions, while hedge funds typically permit withdrawals only once a quarter. “If a hedge fund’s sector is melting down, you’re stuck,” says Rick Lake, a Greenwich, Conn.-based adviser who invests in hedged mutual funds. “But in a mutual fund, you can get out fairly quickly.”

Having that trading flexibility has proven advantageous to Lake. “The different investment strategies these funds use tend to work well at different times,” he says. So the ability to shuffle between them is useful. For instance, Lake sometimes will invest in the long-short funds run by AXA Rosenberg. These funds’ portfolios are always half long, half short, and have a value bias, buying stocks with low expected p/e ratios and shorting those with high ones. AXA’s funds scored big gains in the bear market, but in the current environment, which has favored high-priced tech stocks, Lake has reduced his position in these funds and has been leaning more heavily on Needham Growth Fund (NEEGX), a fund that favors tech stocks and can short a maximum of 25% of its portfolio. Such maneuvering requires skill, but it pays off. Since its January 1999 launch, Lake’s hedged mutual fund portfolio has delivered a 44% cumulative return versus a 7.7% loss for the S&P 500 through this November.

As new funds enter the arena, costs have been coming down. Three relative newcomers, Hussman Strategic Growth Fund (HSGFX), ICON Long/Short Fund/I (IOLIX), and Analytic Global Long-Short, as well as Baron’s fund, all have expense ratios less than 1.5%. That compares favorably with Needham Growth, which charges 1.75% and AXA Rosenberg’s long-short funds, all of which charge in excess of 2.5%. But because strategies vary so widely, investors need to make apples-to-apples comparisons. Analytic’s global fund, which has a 1.3% expense ratio can rightly be compared with AXA Rosenberg: Global Long/Short Equity/Inv (RMSIX), which has a 2.9% one, because it has a global focus and always has at least a third of its portfolio short. ICON’s and Baron’s funds are similar to Needham’s in that they short less and infrequently, making them much more exposed to market fluctuations. Hussman’s fund is in a league of its own, sometimes completely hedged and sometimes not, depending on market conditions.

Smaller management fees are particularly valuable in low-risk/return hedging strategies such as merger and convertible arbitrage. “Merger arb funds typically earn between 8% and 10% a year,” says Lou Stanasolovich, CEO of Legend Financial Advisors in Pittsburgh. “To charge 1% of assets and 20% of profits on that is pretty hideous.” So in his client’s portfolios, Stanosolivich uses Merger Fund (MERFX) and Arbitrage Fund (ARBFX), which have expense ratios of 1.3% and 1.9% respectively. Both funds have beaten the average arb hedge fund’s returns in recent years.

But how does an adviser fit one of these funds in a portfolio? With long-short funds, Harin Da Silva of Analytic Global Long-Short Fund recommends a “core-and explore” approach, putting 80% to 90% of stock assets into an index fund, but the remainder into a long-short vehicle. “Normally, if you put money into an active equity strategy, the fund’s exposure to the market accounts for 80% to 90% of the return, and stock picking the rest,” he says. But by holding short positions, long-short funds reduce their beta–or exposure to the market’s moves–so that most of their returns stem from stock picking. So a 10% or 20% position in a long-short fund acts as a substitute for the active manager’s contribution to returns in a traditional fund. “This way your portfolio is more cost efficient,” Da Silva says. “You are paying active management fees for stock selection, not market direction.”

Funds that employ other kinds of hedging–merger arb, convertible arb, etc.–often behave like a different asset class from stocks or bonds and will need to be run through an optimizer to see how they fit with a client’s overall portfolio. Arb funds have a similar volatility level to bond funds, so they can probably replace a portion of a client’s fixed income portfolio. In some of his accounts, Stanosolovich has a much as 33% allocated to merger arb.

Though mutual funds are rapidly moving into hedged strategies, there are still some areas they can’t touch. “Highly leveraged fixed income hedge funds are hard to mimic with mutual funds, because of regulatory restrictions on leverage,” says Lake. “So are global macro strategies that invest in everything that moves.” Then again, such risky strategies were precisely what caused some of the biggest blow-ups in hedge fund history, including the infamous Long-Term Capital in 1998. Such volatile fare the average investor is better off without.