When Is a Mutual Fund Like a Hedge Fund?

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.