Posted by JR on November 06, 2009 at 15:53:23:
In Reply to: As far as I know mutual funds cannot use leverage posted by Fundmentals on November 06, 2009 at 15:22:06:
modern mutual funds can and do leverage. examples would be 130/30 and its relatives as well as yours truly ARBFX. if you add their short and long exposures (around $642mm) and divide by their NAV the same day ($440mm) (all as of 9/30), you get your typical so called "reg-T" leverage of just under 1.50 to 1. You're right, hedge funds used 6/8 to 1 before crisis, and about 2.50-3 to 1 today. But it is really the same strategy.
i myself look at something more stable, such as this or hussman, but unfortunately, i lack you discipline, attention to details and time available to create a personal portfolio that would be right for me. my goal is to me more like you in investing -- when i grow up! -:)
: You have valid points in that some hedge funds can and do use the merger arbitrage strategy but without leverage the arbitrage strategy makes very little sense to a hedge fund. Mutual funds are not allowed to use leverage (as in borrowing money to take positions) as far as I know. These funds hedge in the literal sense of the word but don't use leverage which protects downside.
: You are also correct that a black swan will also affect these funds. But the lack of leverage makes them as different as day and night in behavior (albeit both on the upside and on the downside). They can also sit on cash rather than having to be fully invested.
: These funds have been around through at least two market crashes and while they reflect the crashes in their behavior you will see the volatility to be extremely low even through those crashes. In addition, they don't participate much in the normal volatility of the market indices like these 100-200 point daily swings and so very good for the nervous or conservative lazy investors.
: I used "exotic" because the words merger and arbitrage can conjure up some complex strategy that will likely blow up in someone's face as happened to many hedge funds. On the contrary these are extremely sedate funds that will likely make anyone but the most patient bored with them in the short-term.
: But you raise a good point that I did not address which is what the role of these funds is in a portfolio.
: In my particular taxable portfolio, these are part of my risk-managed returns pot with capital preservation/downside protection as one necessary goal. Same goal as an absolute return fund but there is no reasonable mutual fund that can do this on its own.
: So I select funds to diversify across multiple active management strategies that will contribute to this as a whole. I have diversified with long/short, permanent and conservative/moderate allocation funds in this pot. This is the best approximation I can do to realize an absolute return portfolio using available no-load mutual funds. In a continuing bull market, they will do much better than just bond funds but through bear markets and crashes, it will limit the downside drawdown and do much better than the typical static allocation (which is in a different pot in my portfolio).
: : : : this is EXACTLY how "exotic" (why the choice of word?) hedge funds called "merger arb" make money! it also includes shorting the acquirer and being long the target and wait for the prices to "merge". you only loose money when the deal is canceled (which actually happens a lot in downturn.) : : i don't think the true hedge fund would touch this deal though. : : the fund you invested in seem similar (may be with the slightly lower leverage). from their website, as of 9/30 they were $434mm long and $207mm short, with $11mm in cash. a hedge fund would have a bit more leverage and a different fee structure, such as 1.5% management fee and 15% performance fee with a high watermark (they only collect perf fees if their investors make money). your fund seems to just have 1.88% mgnt fee. : : i agree that in a steady market, this is a very good strategy. soros's merger arb guys hadn't lost money in 17 years before they left and set up their own boutique. all worked well with steady gains until 2008. a couple of billions are gone now. : : just another decent strategy, but not remedy for the black swan. : : : : The linked article on the Buffett takeover of Burlington Northern shows how these funds (or funds also using this strategy) make money. : : : A slow recovery with a raising market is a good environment for a lot of takeovers and mergers as the winners gobble up losers of the recession as organic growth is limited. : : : These funds are not to be confused with some exotic hedge-fund arbitrage strategy and will not be very flashy but will reduce the volatility of a portfolio (like bond funds) with potential for equity like gains.
: : : I recently added some allocation to ARBFX and MERFX in my conservative taxable portfolio as low volatility, reasonably (but not entirely) major market uncorrelated funds.