Hedge Fund Stuff

Before I get into this, a quick public service announcement; I responded to a medical call tonight and let me just say if you do an activity that might need a helmet with a faceguard...wear a helmet with a faceguard.

With the Amaranth blowup there have been and will be articles questioning whether people need hedge funds or not, questioning the purpose, calling them out for the blight that they are, you know, that sort of thing.

First a word about Amaranth. As best as I can tell being wrong about the trade did not blow up the fund. It was the misuse of leverage. Too much leverage seems to be at the root of most of the problems that arise, here I am excluding fraud.

The fact is that hedge funds do provide liquidity to certain markets and when coordinated properly, here I am thinking Swensen at Yale or El-Erian at Harvard (or Jack Meyer before him), they do serve a purpose and are appropriate. Of course this probably is of little importance to your portfolio.

The point of this will not be whether you should or should not buy into a hedge fund or build your own but more of an exploration of a couple products that make hedge fund strategies easily available.

Merger arbitrage is a strategy most people are familiar with. There are several OEFs that invest in the strategy, the best known of the bunch might be the Merger Fund (MERFX).

This chart compares the fund in red, to the S&P 500 in green and its fund category. By and large it offers a pretty smooth ride and seems to have captured most of the market's move.

The correlation to the S&P 500 is 0.519, the standard deviation is 2.6 and the beta is 0.12 (all according to PortfolioScience.com). Regardless of what they are doing in the fund and how much (or how little) you are interested in the strategy, the results are compelling and doesn't seem to be inappropriately crazy.

A similar strategy might be long short funds that do pairs trading. I think all of the sector ETFs create the chance to go long a stock and short a sector ETF. If you can pick a stock that outperforms its sector (this may not be easy), maybe with an above sector dividend yield, that has a high correlation to its sector and the result exceeds the current risk free rate of return it might be worth considering for someone that can spend a lot of time monitoring their portfolio.

As an example, National City Corp (NCC) yields 4.3% and has a 0.705 correlation to iShares Financials (IYF), I should note it has lagged the ETF but this is just an example. Going long NCC and short IYF in equal dollar amounts nets you a dividend of 2.49%. If NCC goes up 15% and IYF goes up 12% simplistically speaking you net 3% for a total return 5.49%. If your stock pick ends up lagging or the financials decline you have mitigated some of your risk.

The new single commodity ETFs that I wrote about a couple of weeks ago create all sorts of strategic opportunities, ditto the existing and any new currency ETFs.

To reiterate, the point of this post is not to encourage anyone to do any of these trades. Various ETFs, OEFs, CEFs (which I did not get into here) open the door to many interesting possibilities. At some point if someone pitches a fund to you or you think about buying into one it is possible you can recreate the same effect yourself or, by virtue of having thought about some of the types of trades mentioned here, make a more informed decision.