Hedge On While The Bear Is Rampant!

Carla Johnson, InvestorsOffshore.com, New York

21 March 2001

Hedge funds - for those who are able to invest in them - are continuing to show up as far superior to conventional stock-based mutual funds during the bearish correction going on across most of the world's stock markets.

The Credit Suisse First Boston/Tremont Hedge Fund index easily beat the S&P 500 during February's market decline, posting a return of - 0.6% against the S&P's - 9.2%.

Dedicated short bias hedge funds (ie funds with more than 50% of holdings in short positions) did best of all, with a positive return of 8.3% in February. The CSFB/Tremont index is made up of nine style-driven sub-indices, all of which produced positive performances, except the emerging markets and long/short equity, which were down -2.9% and -2.4% respectively.

Still, there are some stock mutual funds that can do well in bear markets and a ranking system developed by fund tracker Morningstar Inc. can help identify them. Since 1995, the Chicago-based fund research firm has been ranking funds on how they perform during bear markets. Stock funds carrying the highest Morningstar bear rankings gained an average 14 percent during the period, beating an average of 64 percent of their rivals. Funds with the lowest bear-market rank of 10 fell an average of 36 percent.

For example, the $1.44 billion Clipper Fund, which buys stocks trading cheaply and holds bonds or cash if it can't find value in stocks, gained 42 percent over the past year. It carried a Morningstar ``bear ranking'' of 1 in February 2000. In the last year, the fund's strategy kept it completely out of the technology sector.

For most people, though, hedge funds are a more reliable route to bear market profits. Many people have been aware of the promise of hedge funds for a long time, but have not been able to invest in them due to regulatory barriers. For US investors, that changed in 1998, with the repeal of the 'short-short' rule. It said that mutual funds could not derive more than 30 per cent of their gross income from the sale of stocks or securities held for less than three months. In Europe, most countries still prohibit publicly-marketed funds from short-selling, and access to hedge funds has been limited to 'professional'-type investors until very recently.

Apart from access difficulties, hedge funds can evidently be more risky than conventional stock funds. US mutual funds cannot legally be more than three times leveraged, whereas fixed-income arbitrage hedge funds, such as LTCM, used to trade at 20-25 times leverage until 1998, while more conservative long-short equity hedge funds, and macro hedge funds usually leverage up five times.

Another characteristic of hedge funds is that fees tend to be high compared with stock-based funds, although that may change as access broadens out and hedge funds are increasingly seen as an alternative to straight equity funds.

So, as long as the bear market continues, stick to hedge funds. The problem is knowing when to stop!

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