Text b. The long and the short of it

Mutual funds are borrowing hedge funds’ techniques – and their fees

For many asset-management firms, hedge funds have long been like a maddening little brother: small, cocky, subject to fewer rules and, yes, the apple of everyone’s eye. Family resemblances, however, will out. Mutual funds, while more tightly regulated than their boisterous siblings, are acquiring hedge funds and adopting some of their behaviour, such as the use of leverage, short-selling (betting on a price falling) and derivatives.

Ironically, they are doing this after a period in which hedge funds have struggled to beat pedestrian index-trackers. And lately some index-fund managers have been fighting a fee-cutting war. So is the aping of hedge funds just a wheeze to justify higher fees, or will clients, such as pension funds, benefit?

This week, Schroeders, a British institution born in tha era of Admiral nelson, became the latest old-style fund manager to embrace the saucier end of the investment market. It agreed to buy NewFinance Capital, a London fund of hedge funds founded just four years ago, for up to $142m. The price was not considered steep by the market. Indeed, it was on a par with last year’s acquisition by America’s Legg Mason of Permal, a French fund of hedge funds: with a downpayment of 4800m, that was the largest takeover so far.

Next week Morningstar, an American company that tracks the performance of mutual funds, will create a new category for regulated institutions that invest in both long and short positions, a favourite hedge-fund style. Dan McNeela, an analyst with the firm, says that at first it will consist of two dozen funds $7.6 billion under management. “It’s a very smallpercentage of mutual funds that do any shorting at all, but it’s definitely becoming more common”.

Other big fund managers, including State Street Advisors and Goldman Sachs asset Management, have also devised ways to spice up the returns of even their most passive-sounding funds, by overlaying short-selling techniques on long-only portfolios. the idea baffles many pension-fund trustees, brought up on simpler choices such as equities versus bonds. But its championships claim it can raise their chances of beating their benchmarks, without much increasing risk.

Although it can still give regulators the willies, especially when combined with derivatives and gearing, short-selling is steadily gaining respectability. In America, mutual funds can sell short with some restrictions, for instance on leverage. In the European Union, recent changes in regulation allow fund managers to take short positions by using derivative instruments, such as contracts for difference and credit default swaps, rather than through underlying shares or bonds.

State Street and Goldman and Sachs are developing funds that will enable them to short-sell exposure to companies they do not like in an index, rather than just underweighting them, as they do now. It is a common complaint of long-only funds that they can only underweight shares by at most their share of the benchmark. At the end of last year, only 49 stocks in the S$R 500 accounted for more than 0.5% of the index’s total capitalization and therefore could be underweigheted by more than half a percentage point. Bigger stocks tend to be underweighted more often than smaller ones. This breeds inefficiency and concentrated risk.

State Street says it is trying to “loosen the handcuffs”. But neither it nor Goldman Sachs is planning a short-selling spree. Both institutions would limit short-selling to around 30% of a global portfolio, while keeping 130% long-only. they say the strategy offers a slice of outperformance, or “alpha” in hedge-fund-speak, on top of a benchmark or “beta” product. “Currently, if we really don’t like a stock we can’t do much about it, and we regard that as leaving alpha on the table”, says Lloyd Reynolds of Goldman Sachs Asset Management. “With the addition of shorting, we can underweight it more”.

Results have been unspectacular. a State street fund that started using the technique in Australia last year has beaten its benchmark, but by less than it had hoped. Mr McNeela at Morningstar says the funds it will include in its “long/short” category have performed disappointingly. He puts this down to their higher fees and to the difficulties of beating a rising market.

Some traditional asset managers seem to believe they are entitled to charge hedge fund-like fees to manage hedge fund-like products. Others, such as State Street and Goldman Sachs, are developing more nuanced fee structures. They charge like a hedge fund only when they beat their benchmark. That is generating interest among pension-fund clients, some of whom are eager for innovation and lucrative ideas. Only once the fund Managers have proved their worth can they charge what they want.