A Hedge That Actually Works

Hedge funds have given the word hedge a bad rap. As originally intended, the word refers to an investment made to offset risk. But today the term evokes thoughts of astronomical fees, excessive leverage and a devil-may-care attitude toward risk-taking.

But there is much good to be said of hedges in the original sense. Holding investments that zig when others zag can decrease your portfolio’s volatility significantly. A simple thought experiment illustrates the point: Suppose you had a portfolio of two assets -- Stock A and Bond B. Imagine that Stock A and Bond B are perfectly negatively correlated with each other and are equally volatile (in other words, one’s zigs are the mirror image of the other’s zags).

Further, imagine that Stock A will likely return 10% a year over the long haul and Bond B will likely earn 6% (albeit with plenty of volatility along the way). Thanks to their negative correlation, growth of a portfolio split evenly between the two assets would look like a straight, upward line -- your return would be an unwavering 8%.

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The real world seldom produces such clean results. But investments with low or negative correlations to traditional stocks and bonds are still worth seeking out, provided you’re willing to venture off the well-worn track.

One such strategy, still new in the realm of mutual funds, entails both owning bonds and selling them short (that is, betting on their prices to fall). Two promising funds in this category are Driehaus Active Income (symbol LCMAX) and Forward Long/Short Credit Analysis (FLSRX). Consider the former for a tax-deferred account and the latter for a taxable account. Read on to see why.

The Driehaus fund’s results are impressive. From the time the current management team took over three years ago through August 31, the fund returned 7.6% annualized. That lagged the Barclays Aggregate Bond index by a nose. But the fund did so with close to zero correlation with the bond index and with low volatility.

Those enticing numbers flow from an obscure strategy. Lead manager K.C. Nelson spends most of his time scrutinizing companies’ capital structures -- that is, the range of sources that provide a company’s capital, from senior bonds down to common stock -- looking for a bond here or a stock there that is mispriced relative to the rest of a company’s capital structure. He’ll then use a combination of long positions and short positions (one can short bonds the same way one shorts stocks -- by borrowing the bond from a broker and selling it, with the aim of repurchasing the bond at a lower price later) to bet that a mispricing will eventually reverse. For example, he might purchase a company’s convertible bonds but short its common stock if he felt the convertibles were undervalued. He makes similar trades on the debt of different companies within the same industry -- for example, buying Home Depot bonds but selling short Lowe’s bonds -- if he finds a mispricing. The benefit of such a niche strategy is that it doesn’t depend on the market behaving itself to eke out gains. “We try to make money in every environment,” Nelson says.

Nelson also tries to keep a tight leash on the fund’s volatility. He hedges the fund’s exposure to interest-rate risk by selling short U.S. Treasury bonds. His aim is for the portfolio’s duration -- a measure of interest-rate sensitivity -- to be zero. Under such circumstances, changes in interest rates should not affect the fund’s share price.

Nelson also uses derivatives to create a sort of insurance for the portfolio, so that the fund could profit if the bond market were to suddenly seize up. The tactic seems to work: The fund was roughly flat during the chaotic period between the collapse of Lehman Brothers in September 2008 and the stock market’s bottom in March 2009. One downside is the $25,000 minimum-initial-investment requirement. However, you can buy the fund inside an IRA with just $2,000. The fund yields about 4.5%.

The Forward fund employs a similar approach but focuses on municipal bonds, making this a good choice if you’re investing in a taxable account. The fund has gained an impressive annualized return of 13.7% since its inception in May 2008, beating both the Barclays Aggregate Bond index’s 7.3% annualized return over the period and the Barclays Municipal Bond index’s annualized gain of 7.0%. However, the Forward fund is not as risk-conscious as the Driehaus fund, and Forward’s volatility has so far been on par with what you would expect from a junk-bond fund.

Co-managers Alan Hart and Guy Benstead take a fairly freewheeling approach: Munis, corporates and preferreds are all fair game. They delve into the specific terms of individual bonds and the underlying companies’ finances. They will purchase issues they find attractive and short issues they find unappealing. The fund will typically hold a portfolio of high-yield and investment-grade municipal and corporate bonds, with short positions in U.S. Treasuries and certain corporates.

Benstead will opportunistically adjust the fund’s exposure to interest-rate movements according to his view of the economy (he can sell Treasuries short to reduce the fund’s interest-rate exposure). However, he adds, “we want to make money by getting our credit analysis right. We don’t want to earn the majority of our returns from interest-rate calls.” Forward can also magnify its bets by investing the proceeds of its short sales -- Benstead typically runs the fund with about 150% of assets in long positions and 50% in short positions. The fund, which yields 6.1%, has zero correlation to bonds and little correlation to stocks. Benstead says investors can expect about two-thirds of the fund’s income stream to come from municipal bonds.

Because of the intricacies of short-selling bonds, both funds’ expense ratios appear astronomical -- 2.09% for the Driehaus fund and 3.89% for the Forward fund. The figures are lofty because when a fund shorts a bond, it must make that bond’s interest payments out of its own assets until it closes the short position. Those interest payments show up as part of each fund’s expense ratio, even though overall the short positions are sources of returns for the funds. Management fees total 0.55% for the Driehaus fund and 1.50% for the Forward fund; the latter also charges an annual 12b-1 fee of 0.25%.