Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds

During her recent interview with Tobias, Professor Nicole Boyson discussed Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds. Here’s an excerpt from the interview:

Tobias: Last question, last topic. I just wanted to discuss your hedge funds for retail investors and examination of hedged mutual funds. It’s a fascinating topic. What do you find? Let’s talk about first, what is a hedged mutual fund?

Nicole: Yeah, I like that paper a lot too. It was one of my very first papers that got published in a decent journal and, and my coauthors were lovely. But we were really interested in thinking about mutual funds that use hedge fund strategies. Within the mutual fund space, the 40 Act, if you like the Investment Company Act of 1940, call those mutual funds 40 Act funds, they have restrictions, but they’re not totally restricted. If I’m running a mutual fund, I can use some leverage. I can short sell. I can use some derivatives, but I’m limited as to how much, so that’s the whole point. It’s a mutual fund, I can’t go crazy. But what we found was that during that time– I think our sample ends in 2004, 2005, we were looking at a very small sample of mutual funds that were doing hedge fund strategies in the mutual fund space. And so, that was kind of cool. Our sample is tiny like 67 funds, but we had the whole universe and we thought this is novel enough. Let’s give it a shot and take a look.

We came up with some ideas about why those funds ought to either be better or worse than traditional mutual funds. And so, we ran a study that looked at– we just call them hedge mutual funds, there’s still not a great name for them, called them hedge mutual funds. We compared them to traditional mutual funds with similar style, stock to stock and so forth. And then, also hedge funds.

We had a data set of hedge funds. We found that the performance and the risk of the hedge mutual funds was better than traditional mutual funds, not as good as hedge funds. And this was the heyday for hedge funds too, remember. We argued that it makes sense. It’s restriction. I’m in the mutual fund space. I can’t do all the crazy stuff hedge funds can do, it’s incentives. Most managers in mutual funds get fixed asset fees, not a percentage of profit, not a carry, not an incentive fee. So, the incentives are different as well. And so, it was this, what can I invest in and how do I get paid?

The really cool part of that paper, and I remember being so excited when I figured it out was that about half of those hedge mutual funds were also run by a manager that had a hedge fund. It wasn’t just like Fidelity’s run in a bunch of like long-only funds and they grab a guy and go, “Go do a hedge mutual fund.” The guy’s like, “I don’t know how to short. This is not what I do.” But the hedge fund guys, for them to go into that space, makes sense. Especially if I’m a hedge fund guy that’s already within the mutual fund limits on leverage and shorting and things like that. If it’s not a huge adjustment, to take my hedge fund and stick it in the mutual fund space, why wouldn’t I do that?

We found that those were actually driving the performance. If you are a hedge fund manager with hedge fund experience and you know how to run a hedge fund, you’re going to run a hedged mutual fund pretty well, otherwise, disaster. Well, maybe not disaster. During that time, maybe not. But if you take that sample and push it forward, there’s other work looking at this space. They do find disaster, like a lot of these funds that are trying to use hedge fund strategies in the mutual fund space are just not great. They’re really expensive, their performance is not that impressive. And so, our paper really was very specific and said, “If you know how to be a hedge fund in a hedge fund space, you’ll probably figure it out in the mutual fund space. You just got to keep to some slightly tighter restrictions.” We actually talked to a couple guys. There’s this guy Dennis Bein, he’s at Analytic Investors, he may have moved by now, it was 100 years ago out there.

Tobias: In hedge fund world, that’s– everybody ages in dog years.

Nicole: I met Dennis at this conference, and we were talking about my paper and I was like, “Dude, why would you go into mutual fund space. That’s slumming,” or whatever. And he’s like, “Hey, mutual fund assets are much stickier than hedge fund assets. If we can raise, if we can increase our assets under management, sure, we don’t get carry on them, but it’s a nice steady annuity. It’s a nice stream of income. And if we can adapt our strategy to fit in that space, then why wouldn’t we do it?” It made sense to me.

There’s another guy, Leuthold, I can’t probably pronounce his name, he had some stuff. I talked to these guys and they were first of all super excited that an academic cared about their stuff, but it’s fun to talk to them. And they said, yeah, it’s asset gathering. Sure, if I was running some crazy macro fund that relied on like 100 times leverage or taking big bets, it couldn’t. It doesn’t fit in the space, but the long-short equity and equity market neutral, those work okay. So, that was a fun paper. And I think it did have some influence, I think. I remember there was some people that were running assets in that space. So, this is kind of a cool result.