Index February 2004 QTD YTD Description
S&P 500 Index* 1.22% 2.97% 2.97% Large-cap stocks
DJIA* 0.91% 1.24% 1.24% Large-cap stocks
Nasdaq Comp.* -1.76% 1.32% 1.32% Large-cap tech stocks
Russell 1000 Growth 0.64% 2.69% 2.69% Large-cap growth stocks
Russell 1000 Value 2.14% 3.94% 3.94% Large-cap value stocks
Russell 2000 Growth -0.15% 5.09% 5.09% Small-cap growth stocks
Russell 2000 Value 1.94% 5.46% 5.46% Small-cap value stocks
MSCI EAFE 2.33% 3.78% 3.78% Europe, Australasia & Far East Index
Lehman Aggregate 1.08% 1.90% 1.90% U.S. Government Bonds
Lehman High Yield -0.25% 1.65% 1.65% High-yield corporate bonds
Carr CTA Index 3.42% 4.42% 4.42% Managed futures
3-month Treasury Bill . . 0.15%
Estimates as of February 29, 2004. *Return numbers do not include dividends.

In the esoteric world of alternative investments, arbitrage managers are charged with the responsibility of hedging out the risk of a select basket of financial instruments. The risks are typically hedged in such a way that only a teeny sliver of the original risk remains. As a result, the only way for arbitrageurs to make a decent return is to leverage up their positions. The current environment of low interest rates and low market volatility is quite conducive to this type of gearing.

This period of relatively easy credit has spawned a new beast, the leveraged hedged fund of funds (FoF). A fund of funds may use a number of borrowing facilities to invest in a portfolio of other funds, with the net result being an interdependent web of investments, all purchased with borrowings. This structure is not without risk; a relatively small loss at the hedge fund level could potentially result in a catastrophic loss higher up the chain. There are far greater systemic implications if the web were to unravel due to losses in a particular strategy, such as convertible arbitrage.

With the combination of steady returns and low interest rates, it is not hard to fathom why fund-of-funds managers might find other uses for leverage. In the absence of difficult periods, the temptation to enhance returns using outright gearing increases. This is especially true if competitive forces require managers to produce higher returns, and if unleveraged funds are lagging.

The most judicious use of borrowing is to increase the diversification of the portfolio, and thus reduce its volatility. The intention–to produce a more steady return through large-scale diversification than would have been possible without the use of borrowed funds–is honorable. But in most cases, funds of funds are leveraged simply to increase absolute returns.

Investors seeking returns in the mid-teens from a fund of funds have two choices: either selecting a leveraged FoF, or one that uses managers who are not strictly arbitrage players. Although this second group of FoFs may have more volatility during benign market periods than their leveraged counterparts, so-called directional FoFs take much different risks than arb-centric funds, and thus have the potential to add valuable diversification.

Directional hedge fund strategies include global macro, managed futures, and even long-short equity if the manager takes a view on the market. These styles are particularly adept at profiting during the worst possible times for traditional investments, a valuable characteristic that should give investors another reason to consider them.

My take is that including a directional FoF in a portfolio that consists of one or more leveraged FoFs makes a lot sense, although the benefits of such an approach may only be realized when stock prices are heading south and pandemonium is running high.