The stock market is back in bull territory and you want to get in on the action, but you are also (quite reasonably) concerned about longer term trends in this very unstable economic climate. Is there a way to mitigate the risks inherent in unhedged long equity positions, available even to investors who lack the financial means to avail themselves of sophisticated (and expensive) hedge funds and the like? The answer is yes: there is a growing breadth and depth of mutual funds – available to institutional and retail investors alike – that offer exposure to the types of strategies long employed by hedge funds: long-short, market neutral, merger arbitrage and buy-write just to name a few. We broadly term these “multi-strategy”. In practice investing in one of these funds is no different than that for any mutual fund: they trade the same way, they come in a variety of load, no-load and institutional share classes, and have similar fee structures. However it is important for investors to understand the very important ways in which these funds differ from both traditional stock funds and from bond funds.
Traditionally bonds are the safe haven where investors go to build some risk protection into their portfolios – bonds typically exhibit much lower levels of volatility than stocks by traditional risk metrics such as standard deviation (a measure of absolute variance around an expected outcome) or beta (a measure of an individual asset’s risk against the market as a whole). Investors looking for both some upside potential and downside protection might consider the well-established class of balanced mutual funds, for example. But in today’s investment climate bonds might not be for everyone – there is a strong argument to make that interest rates may have nowhere to go but up over an extended time horizon. This is where multi-strategy equity funds can offer an intelligent risk mitigation alternative.
Perhaps the most well-known of these alternative strategies and one of the more easily understandable is long-short equity. A long-short strategy typically involves looking simultaneously for stocks that are undervalued (where you want to take a long position in anticipation of it rising) and others that are overvalued, i.e. you expect it to fall in the near future and thus enter into a short position. One popular form of long-short is known as statistical arbitrage: quantifying lots of historical trading and valuation data for pairs of stocks within the same industry and taking offsetting long and short positions – for example one could go long Ford and short Toyota, hoping to profit when the market corrects identified discrepancies in their trading prices relative to fundamental value.
Many of these strategies revolve around the general concept of arbitrage. Arbitrage traders look for small fluctuations in an asset’s price from its implied value and seek to “lock in” the profit before the market catches on – this is often called “arbitraging away” the price-value opportunity. For example Merger Arbitrage Fund (MERFX) is a mutual fund whose core strategy is spotting arbitrage opportunities between companies on either side of a merger – again taking offsetting long and short positions. Convertible bond arbitrage involves identifying value asymmetries between a company’s common stock prices and the prices implied by the price at which that company’s convertible bonds are trading.
In evaluating the attractiveness and suitability of one or more of these mutual funds, investors need to pay attention to certain criteria. Short selling and other hedging techniques such as the use of options, futures, swaps and other derivative securities require particular skill sets from the managers different from those employed in the process of long-only stock valuation. Pay close attention to the manager’s track record and how long the management team has been in business. Funds in this category that have been in operation for more than 15 years include Merger (MERFX), Gateway (GATEX), Caldwell & Orkin Market Opportunity (COAGX) and Calamos Market Neutral (CVSIX), among others. You will probably find that in some years these funds underperform their long-only counterparts (especially during strong bull runs) but that they consistently exhibit lower volatility.
That brings us back to the issue raised at the beginning of this piece. You want some equity upside, you want to sleep better at night knowing you have some downside protection, and you aren’t thrilled about the near-term prospects for bonds. For these objectives and concerns it is worth spending some time to get to know this class of mutual fund better.
