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Portfolio > Portfolio Construction

When Is a Mutual Fund Like a Hedge Fund?

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When unsophisticated investors hear terms like “hedging strategy,” “short stocks,” or “call options,” they assume that they’re being asked to take risks with their money. Harindra de Silva, who manages the Analytic Defensive Equity Fund (ANDEX), likes to point out that the hedging he uses for the fund’s actively managed portfolio is intended to lower risk. The numbers back up the strategy: Standard & Poor’s gives the fund a low three-year risk ranking and lists its standard deviation as 8.64 versus 15.82 for its peers. Its Sharpe ratio is 0.69, compared to the -0.12 average for other equity large-cap growth funds. S&P gives the Analytic Defensive Equity Fund five-star rankings for its style and category, as well as for the one-, three-, five-, and 10-year periods. Morningstar echoes S&P’s assessment with a low risk rank and five stars across the board.

In many ways the fund behaves like a hedge fund, but can offer a much lower cost of entry–it sports a $2,500 minimum investment for A class shares–and is not strictly limited to accredited investors. With a management fee of only 0.6% and a low overall expense ratio, it also offers lower costs than many mutual funds, not to mention the high fees of most hedge fund managers.

Please tell us about the philosophy behind the Analytic Defensive Equity Fund. The fund’s been around since 1978, but I’ve only been involved since 1996 or early ’97. There are two other people that I manage the fund with–Dennis Bein and Greg McMurran. My role is primarily focused on the research and the portfolio strategy. Dennis and Greg are the chief investment officers for the firm, so they are involved in the actual implementation.

The original objective of the fund, and it’s still the objective today, was to generate equity-market-like returns–10%, 11%, 12% returns in the long run–with substantially less risk. Our objective was to do that by having an actively hedged portfolio. As a mandate, the portfolio has to be substantially hedged. The original strategy was to buy a portfolio of stocks and then hedge it using options.

Is this the same discipline that all the Analytic funds subscribe to? All our strategies are quantitatively driven, and that would be the overriding technique that’s used. Risk management is very much an active part of all our strategies. We specify a risk target, which might be less risk than the S&P, and a beta target, and then we operate very strictly within that regime.

How does the hedging strategy come into play? There are two components. Let’s look at $100 put into the fund. The first thing we do with that $100 is buy $120 worth of stocks. We use a quantitative process in terms of finding attractive stocks. If we didn’t do anything at this point, you’d have a portfolio that has way more volatility than the S&P. So we hedge that portfolio partly by finding securities that we think are unattractive, and we short $20 worth of that stock.

Now you have $120 long and $20 short. You have a little bit of a hedge in your portfolio in that you have something that’s going to protect you in a down market, but you still have $100 of exposure. Then we do something that has always been done with this fund: find over-valued options. We sell call options with an effective value of close to $50. So you start with $100, go up to $120, go minus $20, and then you’re short another minus $50, which brings the overall beta of the strategy down to around 0.5. We’ll vary how much we’re selling–$50, $60, or $70–depending on our view of the market. So there’s a slight variation in the overall hedge, but generally we expect the hedge to be in the range of 0.4, 0.5, so the overall beta on the portfolio will be in the 0.4 to 0.5 range. What the call options do in the flat market is generate a tremendous amount of income for the portfolio.

Are the call options on stocks that are part of the portfolio? Usually we don’t sell individual stock options because we’re buying stocks that we think are attractive, and if you sell call options, you’re never going to get the upside on those stocks. We almost always sell index options on things like the S&P, which is a broad-based index and not very often mispriced, but you can also sell options on the oil index, the gold index, the utility index. Sometimes people think that oil prices are going up and everybody stops buying options on oil stocks, the oil price index options get overpriced, and you can sell these and bring a lot of premium in the portfolio, which helps protect the portfolio in a downturn.

So what is the benchmark you’re using for the portfolio? The S&P 500? The fund is a little bit funny that way. The stated objective of the fund is to provide equity-market-like returns with substantially less risk. Our returns should be like the S&P, but with a lot less risk. We believe that in a sharply rising market, we’re going to lag the S&P because we’re dealing with options. No matter how quickly we roll the hedge up, we’re going to lag. In a falling market we’re going to do better and in a flat market we’re going to do better. In the short run, we use an index of 40% S&P and 60% bills.

What kind of bills? Treasuries. That’s similar to the risk profile of the fund. I ask myself if we’re beating that, because that’s the risk level our clients want. Over the long run, we have to provide S&P-like, or in excess of S&P-like, returns.

Then I guess a lot of it comes down to what stocks you pick in the first place. Right. If you look at this fund there are really three places you’re getting returns from. First, from where the market goes, because the fund has some beta to it; it’s not market neutral. It’s [also] getting returns from selling the call options and our ability to identify overvalued call options, and then the third component is the stock selection. I would venture to say there’s probably more stock selection here than in any mutual fund because of the fact that we go long 120/short 20.

Could you elaborate on what you mean by that? Most people will find the stocks they like and they’ll go long on those, but what they can’t get is the stock selection from going short, which limits the ability to add value through stock selection versus the market index.

So if you think about GM, this year it’s been a great short, but if you’re a long-only fund manager there’s no way you can exploit that information. All you can do is not hold it.

Under our structure, you can bring that value to your clients. There are stocks that are fundamentally unattractive. One of our shorts is eBay, because we think it’s heavily overpriced given the revenue outlook in its industry. So it’s a short position in our portfolio.

I notice that the turnover is a lot higher than that of your peers. Is that a function of the strategy? Yes. Turnover is going to be higher because, if you go back to the example, for every $100 there’s $140 of active stocks in that.

But at the same time your expenses seem to be lower than average. In our case we’re a little bit unusual as a firm in that we don’t use soft dollars at all. Our commission costs tend to be low, and if your commission costs are lower, you should turn over the portfolio more.

In terms of the stocks that you choose, how often are you readjusting the holdings? We take our universe, and if we have a prospect, we develop it according to 70 different characteristics for each stock. That seems like a lot, but even if you look just at the valuation factors, you can’t just look at earnings-to-price or churning earnings-to-price and sales-to-price and cash-flow-to-price. There are all these different metrics, and each different camp–valuation, growth rates, analyst revisions, risk factors–has these different characteristics that we look at.

The weights that we assign to these [characteristics] change over time, based on what’s been working recently. Every day we come up with a new ranking of all the stocks in the universe. Whenever we see that after adjusting for trading costs we can make the portfolio better in terms of its potential reward, we trade the portfolio–generally once or twice a month.

How big is the universe of stocks you’re looking at? We look at the Russell 1000, but most of the portfolio is in S&P 500 stocks.

How many holdings are there likely to be in the portfolio at any one time? The number varies quite a bit. Part of the reason is we’re targeting the overall risk level of the portfolio. If the market is really volatile, then you’ve got to have lots of names in the portfolio to get the same risk level. If the market is not too volatile, you’ve got to have few names, or there’s no way you’re going to get any value added. So the number of names we have is dynamic; the amount of risk we target is constant.

We typically have about 120 long positions. Right now [May 4, 2005], we have 120 long positions and 35 short positions.

When you’re looking for stocks, are you looking at the different sectors, or is it strictly on a company-by-company basis? We are looking at companies, but when we look at them, we tend to look relative to their industries. I think that everyone that looks at stocks tends to do that.

The holdings of the fund tend to be well-known names and really big companies. Could you talk a little bit about some of your holdings and why they’re in the portfolio? In the last quarter, for example, the three largest long positions were Conocophillips, Johnson & Johnson, and JC Penney. Conocophillips we own because relative to other companies in the industry, it’s got a really low sales-to-price [ratio], so it’s a relatively inexpensive company and its earnings estimate revisions have a strong upward trend: those are both fairly important characteristics for us. Johnson & Johnson has high return on assets [ROA], high profitability, very strong price momentum, and it’s very positive relative to other companies in its industry. JC Penney also has positive estimated revisions.

The companies that are kind of opposite to that would be the ones we are shorting. One of our largest short positions was Biogen Idecitic (BIIB), which was very unattractive based on the same sales-to-price measure and low profitability in terms of ROA. There was also a lot of insider selling of that stock, which is something we look at.

Another was PMC Sierra (a provider of high-speed Internet components), which had negative price momentum compared with other companies.

In some ways if you look at the 70 characteristics we use, we think that in this universe it’s hard to get some sort of informational edge over somebody else. But where we think we can add value by looking at all these different characteristics is by getting an inferential edge. You’re basically looking at the same information, but you’re processing that information better. My expertise and the expertise of everybody at the firm is statistical analysis, so we can get a lot more out of the data than anybody else can, or at least, I think we can. At the same time, if you give me the annual report on a company, I don’t know what to do with it. Warren Buffett can look at an annual report and he can actually read it. So different people have a different edge in terms of what they can do with the same information.

Why don’t you talk a little bit about the risk in the fund? How do you define risk? There are two measures of risk we look at for the portfolio. One is the total volatility of the portfolio; our goal is to be substantially less than the S&P. So we’re talking 40%, 50%, 60% of the S&P risk. So if the S&P is around 14, we need to be around 7 to 8.

The second measure of risk is the beta of the portfolio in terms of overall market exposure. We like the beta to be between 0.4 and 0.5.

In terms of the portfolio, where do government securities and cash fit? There may be some government securities in the fund. There’s a little bit of cash in the fund because when you short $20 worth of stock you get some cash into the fund, but we generally don’t carry a large cash component.

Other than the cost of entry, how is Analytic Defensive different from a hedge fund? The cost of entry is a big factor. In terms of the strategies themselves, I don’t see a big difference. We do run these types of strategies on a separate account basis as hedge funds. The fund is a little bit unusual in that if you talk to people on the portfolio management team, the majority of their liquid net worth is in this fund. People sometimes ask, why does this fund exist? This fund exists partly as an investment vehicle for people in the firm. That’s among the reasons the fees and expenses are so controlled. It’s our money.

Who is the investor in this fund? We don’t want people moving in and out. Most of the investors are people who have taken the time to understand the strategy and are comfortable with all the hedging. This is not a hot-dot strategy. It’s going to have good long-run numbers but it will seldom appear at the top of the charts. If you have a 30% year, something strange is going on.

Staff editor Robert F. Keane can be reached at [email protected].


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