Hedge Funds have been getting a lot of press lately. The mutual fund scandals have forced the SEC to come up with new ways to oversee this growing industry. Regardless of whether tighter supervision is good or bad, in most cases, hedge funds are still reserved for the ultra wealthy. What many people do not realize is that many public mutual funds follow hedge fund like strategies, meaning even someone with $2,000 can get in the act. This article will discuss some of the strategies available to individual investors and how they can use them in their investment portfolio.
Long/short buy stocks of companies they think will increase in value and sell short those they believe will decrease in value. Selling short means selling shares of a stock you don't own and replacing it later. Suppose that XYZ Company is trading for $50 a share and I am convinced it will go down in value. I can borrow 100 shares from my brokerage firm and sell them, pocketing $5,000 ($50 x 100 shares). Now lets suppose XYZ declines to $40 a share, I now buy back the 100 shares for $4,000 ($40 x 100) and keep my $1,000 profit. Funds that pursue this type of strategy don't really care whether the market is up or down. Theoretically, when the market is up the stocks it is buying will be up, when the market is down, the stocks that it is shorting will be up. Of course, there is no guarantee that they will be successful in buying good stocks and shorting bad ones.
Let's say that XYZ Company announces that is buying ABC Company for $50 a share and that the deal will be completed in 3 months. What price will ABC stock now sell for? Because of the risk of the deal falling through and the time value of money, the stock will usually sell for something less than the purchase price. Merger arbitrage funds take advantage of these mis-pricings, buying the stock of ABC for say $47/share and selling it later on for the purchase price of $50. Like the long/short funds, merger arbitrage funds don't care what direction the market is going. The risk they take is that the deals they invest in won't go through.
Tactical Asset Allocation
Unlike most mutual funds that just buy one type of investment, tactical asset allocation funds have the freedom to invest in anything, anywhere in the world. In these funds you are relying on the skill of the fund manager(s) to be able to find the best values anywhere in the world.
These funds invest in commodities like oil, wheat, pork, etc instead of buying stocks and bonds. They tend to do well in a high inflation environment when the prices of commodities are rising. Just like some of the other funds, commodity funds don't care which direction the stock market is going.
Putting it All Together
Some hedge fund like mutual funds can be quite volatile so I don't recommend that you just buy one. Our research has shown that if you put mutual funds like these in a portfolio with more traditional investments you can create a portfolio that has less risk. This is because these types of investments don't move in lockstep with the stock or bond market, or each other. When U.S. stocks were down from 2000- 2002 commodity funds, long/short funds and merger funds tended to be up. Of course, past performance doesn't predict future results.