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Fund Spy

Should Mutual Funds Act Like Hedge Funds?

Why shorting stocks would lead to market-timing and higher costs.

One of the worst things an investor can do is drive by looking in the rearview mirror. Just ask someone who bought a tech fund in 1999 or a Japan fund in 1990. Attracted by these categories' huge gains in previous years, most investors bought in just in time to see them come crashing down.

Now some regulators and pundits are doing the same thing by calling for mutual funds to act more like hedge funds. SEC Commissioner Roel Campos was recently reported in The Wall Street Journal as urging fund companies to make greater use of hedging strategies, such as shorting stocks, in order to protect individual investors from severe market declines. Other calls have come from industry observers who want to see mutual funds shift their assets out of stocks and into cash when the market goes down.

To be sure, most of us wish we had owned stock funds that moved into cash or shorted stocks about three years ago. But now, after a brutal bear market and with money market yields at record lows, does it really make sense to suggest that there should be more funds that can short stocks or venture into cash?

Short-Sighted
There are two basic problems with shorting stocks. First, stocks go up. Every once in a while a bear market roars through to punish speculation and bring stocks close to reasonable levels. It happened in 1973-1974 and it happened again in 2000-2003. Nonetheless, stocks generally go up, and if you have a lot of your portfolio in short positions, you’ll have a hard time keeping up with inflation.

In addition, shorting stocks is costly. You have to pay any dividends on them, and if you’re using shorts as a hedge you have to do a lot of trading to maintain consistent exposure. Funds that run market-neutral or long-short strategies typically have steep expense ratios and fork over quite a bit in commissions.

Yes, there are a few successful long-short funds, but there are even more with dismal long-term records. For proof of what mistimed long-short calls can do, check out  Strong Discovery’s  record. In 1996, the fund was long U.S. Treasuries and Japanese stocks and short U.S. stocks. All three of those bets flopped, and the fund's annual return lagged the S&P 500 by nearly 22 percentage points in 1996. The fund continued to flail around for years after that, though it appears to have recently righted itself by forswearing market bets and instead using a plain-vanilla growth strategy.

Meanwhile, many of the least successful funds with long-short strategies have been liquidated. For example, Calvert Strategic Growth was launched in 1994 with a bold mandate to go long or short as management saw fit. The fund shot out of the gate, but things quickly went awry. Over its lifetime, the fund produced an 18% cumulative return while the S&P 500 gained 130%. By December 1997, Calvert had merged the fund away. Crabbe Huson Special and Heartland Small Cap Contrarian suffered a similarly wretched fate. Both funds had long positions in small-cap value stocks while they shorted big-cap growth stocks like  AOL Time Warner   during the mid- to late 1990s. The problem was that large-growth stocks did far better than small value over that stretch. Though both funds were run by good stock-pickers, the portfolios’ mismatch of long and short positions crushed their returns. Now those funds are gone.

A number of market-neutral funds have also bitten the dust over the years. Their mistakes weren’t as spectacular as the long-short funds', but when you expect consistent single-digit returns from a fund and it actually loses money, the experience isn’t too pleasant. There are a handful of market-neutral funds with sound strategies, but most use quirky strategies, such as merger arbitrage, that couldn’t be replicated by every big fund shop out there.

Is Cash King?
If shorting stocks is too risky and costly, why not protect investors by upping a fund's cash position? Though pundits have suggested that more funds should raise cash when the going gets tough for stocks, this isn't the answer, either.

Most financial planners do agree that investors should hold a healthy amount of money in Treasury bills or money markets that invest in Treasury bills. The reason is that cash doesn’t lose value, and if some kind of calamity hits you tomorrow, you’ll want to be able to tap those funds.

However, cash in an equity mutual fund is much less helpful. You can’t use a fund that’s 70% stocks and 30% cash as a short-term investment because it’s just too volatile. Furthermore, funds that have attempted to time the market by raising cash have often timed their bets poorly. Check out  Fidelity Magellan’s (FMAGX) record in the mid-1990s for proof.

Another negative is that stock-fund expenses can quickly eat up whatever your fund is earning on its cash holdings. The typical stock fund charges more than 1% in its expense ratio. That means that with T-bills yielding just 1.07% as of last week, a fund manager who holds cash is actually locking in a loss after expenses.

Nearly every fund has to hold some Treasury bills in order to handle redemptions and new investments from shareholders. But beyond that, decisions about cash positions are better left to individual investors or their advisors, who can gain exposure to short-term bonds at much lower cost through low-expense money market funds or direct purchase of T-bills.

Better Ideas
The fund industry already has a group of low-cost funds that usually hold up well when the stock market gets crunched. They’re called bond funds. With the exception of junk-bond funds, most bond funds have held up just fine during the bear market. To be sure, they come with risks, too, but they aren’t the same as the stock market’s risks.

The fund industry could also do its part to make sure investors don't chase performance, and should learn from the mistakes it made in the late 1990s' bull market. During that time, fund companies came out with ever more aggressive funds as investors’ greed overtook common sense. Fund firms could tell themselves that they were up front about the risks involved in these offerings, but they know many investors missed that part of the message. When a super-aggressive fund is taking in $10 for every $1 that goes to the firm’s deep-value fund, alarm bells should go off.

Even in the case of more respectable growth funds, it’s clear that many investors didn’t use them well. The industry’s real challenge isn’t to borrow strategies from hedge funds, it’s to make sure that people make good use of the funds that are already out there. While fund companies provided lots of good educational material, most couldn’t resist the urge to sell based on recent returns. On the one hand, they were telling investors to be diversified and invest for the long haul. On the other, they implied you could make a quick buck by buying funds that had great 12-month returns--a message that was clearly contrary to the first.

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