Although Master Limited Partnerships (MLP) have sort of flown under the radar of many investors, over the last couple of years they are beginning to be “discovered” by more and more investors, as well as fund companies looking to profit in this area as well. With an annual total return of 15.5% since 1995 and current yields in the area of 6% it is easy to see why. Let’s take a brief look at what MLPs are and why they have become more popular of late.

MLPs are companies that operate in the transportation, processing, refining, storage, marketing and production of minerals or natural resources. There are essentially four areas of natural resources operations that fall into the qualifications to operate as an MLP:

• UPSTREAM – Natural Gas, Oil & Coal reserves & drilling.
• MIDSTREAM – Oil & Gas pipelines, storage, & transportation.
• DOWNSTREAM – Refineries, transportation by rail, truck or boat.
• OTHER – Timber, Geothermal Energy, Fertilizers, etc.

The majority of MLPs are in the energy sector. Many own and operate pipelines primarily for natural gas, oil and propane; they transport the resources from one place to another. They effectively operate as “toll collectors” that collect a “toll” from oil and gas producers who use the pipelines.

MLPs operate as a publicly traded limited partnership whose shares of ownership are referred to as units. It combines the tax advantages of a partnership with the liquidity of publicly traded stock. It also does not pay tax at the corporate level but, rather, at the unitholder (shareholder) level. To qualify for this favorable tax treatment, 90% of their income generated must come from what the IRS terms as qualified sources, which includes producing, processing or transporting natural resources. Although MLPs do not have a set requirement to distribute a certain percentage of their income to maintain their tax status, they do as a matter of policy distribute a large percentage of their current operating cash flow to unitholders. This differs from Real Estate Investment Trusts (REITs) which are required to distribute at least 90% of their ordinary income to shareholders to avoid corporate-level taxation.

Comparison of the Alerian MLP Index (in black) to the S & P 500 over the last 5 years

(The chart does not include dividends, which would make the difference even larger)

Why MLPs Are Getting More Attention?

As mentioned in the opening paragraph, the 15.5% annualized return since 1995 is one reason, but other reasons include:

Qualified Dividends - Most distributions qualify for 15% dividend income tax treatment.

High Yields – In this current low interest rate environment, it is tough to find attractive yields on income producing securities. Currently many MLPs are yielding north of 6%.

Price Appreciation – Most MLPs, in addition to their attractive yields have also had very good price appreciation as well.

Reduced Correlation with the Stock Market – MLPs have historically only had a modest correlation with the stock market. This has made them a good portfolio diversifier.

Predictable and Growing Cash Flows – Since many companies that operate in this space are effectively “toll” collectors, their revenues are generally fairly stable, since it is predicated on the amount of resources that flows through the pipelines, not so much the price of the natural resource.

Risks of Investing in MLPs

Even though MLPs have a lot of good things going, to get those kind of returns is not without some risks as well, such as:

Higher Interest Rates – Higher interest rates generally have an adverse effect on income securities such as bonds, REITs and MLPs. In a rising interest rate environment, MLPs may be subject to price weakness (although in the current rising rate environment we have been in since November 2010, MLPs have done very well). However, MLPs may perform better than bonds since the companies have the ability to grow their cash flow base and increase their distributions.

Tax Complexities – For many people, the K-1 tax form that individual MLPs issue each year can be daunting (see below), and a reason to not invest, however, as shown below, there are plenty of alternative ways to invest in this market, and avoid this issue.

Volatility - Even though MLPs have reduced correlation with the markets, they still can go through periods of extreme volatility. In the credit crisis of 2008, MLPs were hit hard along with virtually every other asset class. Part of the reason was that a lot of large hedge funds had significant exposure and were forced to liquidate which put further pressure on prices. However, during this time very few MLPs cash flows and distributions were affected.

Tax Law Changes– MLPs currently enjoy an attractive tax structure, with higher tax rates, and the government looking for ways to increase tax revenues, there is always the possibility that these advantages could be taken away in future tax legislation which could have an adverse effect on the sector. On an individual level, with current tax laws the 15% qualified dividend exemption is set to expire at the end of 2012, so this could reduce the tax efficiency of MLPs.

Ways to Purchase MLPs

You can purchase MLPs in one of five ways:

Individual Company – There are about 80 individual companies that trade on the stock exchanges that you can purchase. Some of the larger companies are Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP), and Magellan Midstream Partners (MMP).  Since you are now a limited partner, you are entitled to distributions and share price appreciation or depreciation that may occur. As long as you continue to be a unitholder you will annually receive a fairly complex tax form called a K-1, which you will use to report your income received from the MLP during the tax year. If you happened to own 5 MLPs you would receive 5 K-1’s. This form can be cumbersome, and it will make your tax return a more complicated, but if these companies continue to do well it can be worth it. You also have to be careful buying these companies in your IRA, because they generate what the IRS calls Unrelated Business Taxable Income (UBTI), and if you have more than $1,000 of this during a year, the amount over $1,000 is taxable to you in the IRA. If you are looking to avoid the hassle of the K-1 form, the following four options are also available:

Closed End Mutual Funds – There are a handful of closed end mutual funds, which invest in MLPs. Funds such as Fiduciary/Claymore MLP Opportunity Fund (FMO), & Tortoise Energy Infrastructure Corp (TYG) , that have been around for some time. Closed end funds also trade like stocks, but can trade at a premium or discount to the underlying holdings. The advantage of buying a closed end fund is that you get a diversified portfolio of MLPs, run by an investment manager, receive a 1099 tax form (much simpler) instead of a K-1, and can hold in an IRA without any tax problems. The disadvantages are some closed end funds can have rather high fees, and some may use leverage to enhance returns and yields, but can also make them more volatile.

Mutual Funds – Within the last year or two there have been a couple of fund companies that have started traditional mutual funds that invest primarily in MLPs. The advantage of these over closed end funds is that they do not use leverage, and have lower expense ratios. So far the new mutual funds have shown similar results to the closed end funds that have been around for some time. The mutual funds also issue 1099 tax forms instead of K-1s and are IRA friendly as well; since no UBTI is generated. Steelpath runs 3 funds that each takes a slightly different approach. Another company called Cushing began in October 2010. There are also more companies that are in the process of launching funds or have just done so recently.

Exchange Traded Funds (ETFs) – ETFs have become very popular with many investors because of their ease of use and flexibility compared to mutual funds. ETFs will have the same benefits as the traditional mutual funds (maybe even lower expense ratios), but with the flexibility of an ETF that trades like a stock. They will also issue 1099s, do not use leverage, and would also be IRA friendly. Alerian is a company, which has for years kept a benchmark index of MLPs; they started an ETF in 2010 as well called the Alerian MLP ETF (AMLP) which is based on this index. All of the other funds listed above are actively managed funds compared to the ETF which is a passive index of MLPs.

Exchange Traded Notes (ETNs) – ETNs are very similar to ETFs in the way they trade, but are actually a debt security in that it combines the features of an ETF with a bond. The returns of the ETN are based upon the performance of a market index and the value of the ETN can be affected by not only the market index it tracks but also the underlying credit of the firm that issues the ETN, since it is an obligation of the issuing company in much the same way as a bond. JPMorgan has issued an ETN based on the Alerian MLP Index (AMJ) that has performed very well since its inception in 2009.

Where Are We Now?

MLPs have had a very nice run the last few years, and still make a very compelling long term investment for a diversified portfolio. However, some indications are that, you may consider waiting for a correction in the market before committing new money to this area. Currently, the yield on the Alerian MLP Index (AMZ) is right around 6%, which is near the low end of the range of yields that MLPs have enjoyed. The record low was 5.37% in 2007, before the 2008 swoon.

Another valuation metric to strongly consider is the yield spread between the MLP Index and the yield on the 10 year U.S. Treasuries. In July 2007, the spread was as low as a few basis points, and by the end of 2008 the yield spread was about 1200 points (12%). Currently in February of 2011, the yield spread is around 260 basis points (2.6%), which is also getting close to the low end of the historical range. Historically, when the yield spread gets narrow, MLPs have run into some headwinds, so it is important to be cognizant of the yield spread.

Overall, the MLP sector can be a very lucrative market sector to invest in; with attractive yields, good tax efficiency, the chance for price appreciation, and a modest correlation to equities, they can make a good addition to a diversified portfolio.

Disclosure: Nothing in this article constitutes investment advice or recommendation as to the suitability of any product or security mentioned above.

Even though the stock market has been doing very well as of late, many investors still have vivid memories of the stock market crashes of 2000-2002, and 2008. Many people wonder what they can do to help reduce the volatility of their portfolio. We have previously discussed using options to reduce risk, now, we turn our attention to another strategy that can provide good portfolio diversification, reduce volatility, and enhance overall portfolio returns. That strategy is Managed Futures.

What are Managed Futures? Essentially, it is a trading strategy that may involve going long or short futures contracts in areas such as:

• Metals – Gold, silver, platinum, etc.
• Grains – Soybeans, corn, wheat, etc.
• Equity indexes – S & P 500, Dow Jones, etc.
• Soft Commodities – Cotton, coffee, cocoa, sugar, etc.
• Foreign Currencies – U.S. Dollar, Swiss Francs, etc.
• U.S. Government Bonds – Futures on Treasury Bills

The strategy has been used successfully by large endowments such as Harvard & Yale for many years, as well as successful Hedge Funds. For smaller investors, though, it has been more difficult to access this strategy. However, that has changed over the last few years as there are mutual funds available now that offer this strategy such as the Rydex Managed Futures Strategy Fund or the Altegris Managed Futures Strategy Fund. Generally, these mutual funds will use a trend following strategy to go long or short the particular future, and to stay consistent with the index which could be either the Altegris 40 Index mentioned below, or the Standard & Poor’s Diversified Trends Indicator (DTI).

The key advantages of using Managed Futures as a portfolio diversifier are:

• The very low correlation to stocks and bonds.
• The ability to profit in any kind of market environment.
• Can enhance returns and reduce overall portfolio volatility.
• Generally, have produced consistent long-term returns (see below).

Some disadvantages:

• The strategy in a mutual fund will have a higher expense ratio than most traditional mutual funds.
• Not really the most tax efficient strategy so is generally better utilized in tax advantaged accounts such as an IRA.

The information below is obtained from the Altegris website and gives a general view of how an index of Managed Futures has performed the last 10 years versus US Stocks.

Performance Statistics: Managed Futures vs. US Stocks

July 2000 – June 2010

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Managed Futures represented by Altegris 40 Index; US Stocks represented by S&P 500 TR Index. Source: International Traders Research (ITR). The referenced indices are shown for general market comparisons and are not meant to represent the Fund. The Fund is new and has no performance history.

So, even though the Managed Futures Strategy has been around for 30+ years, it is a more recent addition in mutual funds. The long term results have been very good, and the benefit of reducing the volatility and increasing the diversification in your portfolio make them worth a look.

Many people think of stock options as a risky investment strategy used mostly by highfalutin Wall Street types with millions to burn. While it’s certainly true that you can get yourself into trouble with an ill-advised option position, options can also be used to effectively reduce portfolio risk. One option strategy that can do this is called “collaring”.

Collaring uses options to greatly reduce the risk inherent in a stock position by putting a limit on the possible losses, with the trade off of limiting the upside. The most basic use of an option to reduce downside risk in your portfolio is the purchase of a Put. When you buy a Put, you are buying the right, but not the obligation, to sell your stock at a certain price.

First, a couple of definitions:

Put Option -A Put option gives the owner of the Put the right, but not the obligation to sell stock at a certain price by a certain date. A single Put option contract covers 100 shares of the underlying stock

Call Option -A Call option gives the owner of the Call, the right, but not the obligation to purchase stock at a certain price by a certain date. The person who sold the Call is obligated to sell his stock at the strike price of the option if the Call owner exercises his right to do so. Like a Put option contract, a call option contract covers 100 shares of the underlying stock.

Strike Price – The strike price is the price noted on the option that dictates whether the owner of the option is able to exercise his rights.

Example:

You own 1,300 shares of Amgen (AMGN) that has a current value of $55.50 a share, thus your holding is worth $72,150 currently.

One of your primary concerns is capital preservation, so you’d like to protect your portfolio against a big drop in the value of your AMGN stock. You’ve decided that you’re not comfortable with the thought of that stock dropping much below $50 a share. Let’s assume that right now that it’s May. You learn that there are Puts available for AMGN. Some of the put options available are the October $50 Puts. Purchasing these puts would give you the right to sell your AMGN stock at $50 a share between now and the date the put expires in October in the event that the market price of AMGN is below $50/sh. So you go ahead purchase 13 put contracts for $177.00 each or a total cost of $2301.00. [$1.77 (cost per share) x 100 (number of shares per contract) x 13 (number of contracts purchased) = $2,301]

Now that you have purchased these Put options, you not only have the right to sell AMGN for $50 between now and October, you also have the right to sell the Put options themselves. If the price of AMGN stock goes down, the value of your Puts goes up. If the value of AMGN drops between now and October, the value of each Put option will increase by about a $1 for each dollar below $50. Thus, if we are near the third Friday in October (options expire on the third Friday of the month), and the value of AMGN is $40, each Put option price should be near $10 per share, causing the value of your puts to increase to $13,000. [$10 x 100 (number of shares per contract) x 13 (number of contracts) = $13,000] Now you have a choice to either exercise the option and sell the stock at $50 a share, ($50 x 1,300 = $65,000) or keep the stock and sell the options for $13,000, which offsets your loss on the stock below $50 a share.

By just owning Puts, your upside is still unlimited, but your downside is limited .One drawback of this strategy is that Put contracts come at a cost. These costs can add up over time and hurt portfolio returns. However, there is a way to offset the cost of the “put” insurance. This can be accomplished by selling Calls on the AMGN stock. Selling Calls generates income which can be used to pay for the Puts. This is what is meant by the term collaring, which is simply the practice of buying Puts and selling Calls on the same stock. Here is an example:

Since the cost of the put protection alone can be very expensive over time, we can sell Calls to implement the collar strategy. Using the same example from above with AMGN trading at $55.50 a share, we learn that the October Calls with a 60 strike price are selling at $1.72 a contract. By selling Calls we can generate $2,236.00. [$1.72 (price of call per share) x 100 (shares per contract) x 13 (number of Call contracts sold to cover all 1300 shares owned) = $2,236]

By selling this Call with a strike price of 60, we are obligated to sell our shares of AMGN to the buyer of the Call if the shares of AMGN rise above $60 a share between now and October. However, we have offset the cost of the Put protection with the proceeds from the sale of the Call options, leaving a net cost of $65 for implementing the collar strategy. [$2,301 (cost of Puts) - $2,236 (proceeds from selling Calls) = $65] The stock is now protected if it falls below $50 a share, but its upside is limited up to $60 a share.

Now 3 things can happen:

• The price of AMGN can stay within the range of $50 to $60 until October. If this happens, both the puts and calls expire worthless, and we would consider initiating another collar to keep protection in place. The $65 is considered a cost of insurance.
• The price of AMGN, could fall below $50 a share between now and October and we can either sell the shares at $50 or sell the put option (which has now increased in value) to offset any loss resulting from the stock’s decline.
• The price of AMGN could rise above $60 a share between now and October, in which case the stock can either be called away (meaning we will have to sell it at $60 a share) or we can repurchase the calls we sold. If we repurchase the calls that were sold, this cost would be offset by the rise of the stock above $60 a share, so we have still limited the gain on the stock to $60 a share, but have retained ownership of the shares of AMGN.

Example: AMGN is at $63 a share near the expiration date in October, and we decide we still want to hold onto the shares of AMGN instead of having them called away at $60. The value of the Calls is now around $3.00 a share, so $3 a share x 100 shares per contract x 13 contracts = $3,900 to buy the calls back, but the 1300 shares of AMGN are also up $3,900 ($63 – $60 = $3 a share x 1,300 shares = $3,900), so the net effect is we only participated in the gain in AMGN up to $60 a share during the time the options were held.

We can also use different time frames, and use options with expiration periods longer than just a couple of months. This is generally what we would do in order to avoid having to make frequent adjustments to the collar.

Tax Effects – Quite often, options expire with no value. Depending upon which side of the transaction you were on, this results in a gain or a loss. Investors are required to recognize the gain on the sale of Puts in the year they expire, but any losses resulting from Puts cannot be recognized until the stock is sold. Also, whenever options are exercised (which results in the sale of the underlying stock) there will likely be a gain or a loss on the sale just as there is in any normal stock transaction.

Although the Collaring strategy does produce some additional taxes, they are fairly modest and can be avoided by implementing the strategy in an IRA account. Where that isn’t possible, the tax consequences have to be taken into consideration and weighed against the benefits of the strategy.

In order to introduce you to what may be a new concept, we have simplified this discussion of option collaring. We intentionally omitted a detailed discussion of how options are priced and what factors affect option prices. Also, the example we used here did not consider commissions, which are generally not much of a factor. It is also important to also note that the Collar can be implemented for both stocks and market indexes. Collaring is considered a conservative strategy that does a good job of preserving capital over time. Collars allow you to have exposure to the stock market while limiting the downside to a tolerable, predetermined amount. The trade-off is that you give up some upside potential. For investors concerned about preserving wealth while allowing for modest growth, collaring options can be a very effective strategy.

If you are a client of ours, you have probably heard us at one time or another talk about Monte Carlo Simulation (or Monte Carlo Analysis). The term itself is kind of strange sounding, and the first time you hear it you’re bound to conjure up images of either the famous casino in Monaco or a two-door Chevy coupe. Believe it or not, the former image would be more correct, but I’ll explain that later. Monte Carlo simulation is a calculation method used in a wide variety of fields ranging from physics, weather forecasting, architecture, and of course financial planning. Its purpose is to estimate the probability of a certain outcome using random input numbers. In most cases, thousands or even tens of thousands of calculations are made in order to produce the result. The advent of today’s high-speed computers has made it possible for these calculations to be done quickly and has made it possible for small companies like ours to use Monte Carlo simulations.

Have I lost you yet? Let me try to bring you back by telling you how we use Monte Carlo analysis. Most of our clients are very interested in knowing if they are on track to live the lifestyle that they desire. Whether they are retired with their earning days well behind them, or they are just entering their peak earning years, Monte Carlo analysis is one of several tools we can use to provide them with some guidance on what their future might look like. In its simplest application, we can us it to calculate the probability that someone’s nest egg will last a given number of years assuming that person is drawing on that nest egg at a given annual amount. Monte Carlo analysis will produce that probability using projected market returns that reflect the investment composition of the nest egg. But instead of simply applying the portfolio’s average historical return, the analysis will arrange the annual returns in a random fashion so that one year the portfolio might return 6% and the next year it might return -3%. (It is this random generation of results that led the creators of Monte Carlo simulation to name it after the casino where roulette is so popular.) The possible range of investment returns applied to the simulaton will depend upon the risk profile of the portfolio. More aggressive portfolios will have a wider range of possible returns, while the range on more conservative portfolios will be narrower. To provide a more reliable figure, the calculations are done thousands of times. The idea is to simulate what happens to the nest egg by running multiple scenarios using the entire range of expected investment returns.

Now, the previous example doesn’t really reflect a real-life situation for most people. First of all, almost no one spends the same amount of money every year. Also, the composition of your portfolio in most cases changes as you get older to a more conservative asset allocation. Fortunately, we are able to account for these things in our analysis. Modern software also allows us to take other real-life variables, like inflation, into account, because after all inflation can have as much impact on the success of a plan as investment return can. Better versions of the Monte Carlo analysis allow the user to factor in the effects of bad timing of returns to account for the fact that a couple of bad years in a row can have a larger or smaller impact on the success of a plan depending on when they occur. Perhaps the most serious limitation of Monte Carlo is its inability to effectively account for high impact events which are outside the realm of what is thought to be possible, otherwise known as “Black Swan” events. The market crash of 2008 certainly qualifies as such an event. Its difficult to build these types of events into the Monte Carlo model, but after 2008 software vendors are making an effort.

If the simulation for a particular person indicates the probability of success at say 65%, we may consider a number of steps to take in order to increase the odds. Usually those steps will include more saving, less spending, or perhaps working a little longer than they had planned. Another option would be to consider increasing the risk profile of the portfolio by adding more exposure to stocks, but we are usually hesitant to ask anyone to step out of their risk tolerance comfort zone.

Monte Carlo Simulation is not perfect, but we believe it is a useful tool in financial planning to offer some guidance on the probable success of a plan. It would be great if it could predict the future, but it can’t, and we make certain to tell our clients about its limitations. For instance, we cannot predict tax rates with any degree of certainty, and attempting to apply probabilities to tax rates does not make much sense mathematically. Yet tax rates have a definite impact on any financial plan. Also, Monte Carlo simulation does not take into account human behavior. After a particularly good year of investment returns, many people would likely spend a little more money the following year than they normally would, and this is not taken into account. Ultimately, the percentage number that a Monte Carlo simulation spits out is only as good as the data that’s entered to arrive at that percentage. In order not to create unrealistic expectations, we run the simulations using conservative investment returns and liberal inflation numbers.

Finally, we know that financial plans must be viewed as living organisms that are constantly changing and evolving. Whenever Monte Carlo simulations are used in financial planning, they should be revisited regularly to account for real-life changes. They also must be viewed for what they really are; a useful but imperfect guide that should never be relied upon as the sole analysis tool of anyone’s financial plan.

This is a term you may have come across occasionally, but Market Makers have been in the news quite a bit in the past few weeks in reference to the “Flash Crash” that took place earlier this month. Unless you live in a cave, you’re probably aware that during the Flash Crash the Dow Jones Industrial Average fell 600 points in seven minutes and then gained it all back nine minutes later. This all started at about 2:40 PM EDT when the market was already down 400 points on fears of a Greek financial default. The alarming rate of the decline was at first blamed on a trading error, or “fat finger trade”, but that event has largely been dismissed as the cause. The focus of investigation into what caused the crash has now turned to automated computerized trading, but there are also many questions being asked about what role, if any, that market makers had in causing or contributing to the Flash Crash.

So just what is a market maker? Quite simply, it is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. These firms act as dealers who hold an inventory of the stock in which they “make a market”. They stand ready to buy or sell the stock at all times while the market is open. Market makers earn profits through the spread between the prices at which they buy and sell the stocks. Example: Let’s say that a firm makes a market in the stock of XYZ Corporation. XYZ has a current bid price of $20.00, and its current ask price is $20.05. The market maker will buy the stock at $20.00 and sell it at $20.05. The five cent difference is the market maker’s profit. Like in this example, the spread is normally only a few cents per share, but it can add up to a tidy sum at the end of the day. This may seem like easy money, but market makers bear the risk of loss if the price stock in which they make a market goes down.

Market makers keep things moving and provide the stock market with the liquidity needed to operate efficiently. Think about it, when a trade is placed with a broker, it is normally executed within seconds. This is due to the fact that market makers are always available to buy and sell. If you decide to sell 200 shares of XYZ Corp., it is unlikely that at that moment in time a particular buyer will be looking to buy exactly 200 shares of XYZ. But a market maker will buy your stock regardless and keep in inventory with other shares of XYZ to be held or sold later. For every stock there are several firms who act as market maker. This serves to increase liquidity and it promotes fair pricing through competition.

The SEC and NASDAQ are examining the actions of market makers during the Flash crash for two primary reasons. First, it has been reported that during the 16 minutes of near chaos, market makers seemingly ignored higher bids and stocks were sold to lower bidders. Second, some market makers apparently stopped trading altogether, thereby severely impairing the liquidity of some securities. This possibly exacerbated the extreme price drops that occurred. The initial downturn created a large group of sellers looking to bail out. In the absence of the market makers, simple economics dictated that prices would continue to decline because of the large supply of sellers and lack of available buyers. Authorities are still sifting through the rubble in the aftermath of the Flash Crash. It remains to be seen who or what will ultimately be blamed, and whether any regulation is proposed to prevent a similar event in the future.

There is yet another way that investors can access the “alternative” strategies that traditionally have only been available through hedge funds. This is the creature known as the “fund of hedge funds” (FOHF), which is simply a fund that invests its assets in two or more hedge funds. Some FOHFs register with the SEC, and some do not. The ones that do register are required to furnish a prospectus and file quarterly reports. Registered FOHFs often have fairly low initial investment requirements, typically around $25,000. The idea behind a FOFH is to diversify the risk inherent in owning a single hedge fund by creating a portfolio, or fund, of hedge funds. This diversification comes with a cost because there is an additional layer of fees built in. On top of the management fees that are paid to the individual hedge funds (1 – 2% of assets plus a portion of the profits), the FOHF charges a fee for its efforts in researching, vetting, selecting, and monitoring the hedge funds it holds. Plus, some FOHFs also tack on their own performance fee based on the funds’ profits. Want some more fees with that? If you own a FOHF through your investment advisor who charges a percentage of assets under management, you have yet another level of fees. There’s no question that these things are a little pricy, but they do offer access to some effective strategies that before were only available to the wealthiest investors. No doubt this has contributed to their popularity. A 2005 article in The Wall Street Journal reported that FOHFs accounted for nearly 30% of all hedge fund assets. So, unlike the “hedge-like mutual funds” discussed in Part III, investors in FOHFs are participating in real hedge funds, not just light versions of hedge fund strategies.

So, you don’t qualify as an accredited investor, (It’s okay. There are lots of us.) but you’re yearning for those sexy and sophisticated hedge fund strategies? Or perhaps you are an accredited investor, but you can’t stomach the big initial investment required by most hedge funds? Well friends, when there is a demand for something that doesn’t exist, the market almost always responds by providing that something, and this case is no exception. Hedge funds have gone retail! Sort of. Actually, hedge fund strategies have gone retail. Yes, many of the tactics used by hedge fund managers are now available through mutual funds. This isn’t that recent of a development. In fact some of these mutual funds have been around for ten years or more. What is a recent development is the rapidly expanding number of these types of funds, and the willingness of the average investors to make these offerings part of their portfolios. What is behind all of this?

As we know by now, hedge funds invest in assets and employ strategies that go well beyond basic buy and hold strategies using stocks and bonds. Many investors are drawn to hedge funds because of their perceived potential to either beat the market or provide returns independently of it. Until recently, most people were not even aware that these types of investment strategies were available. The increased interest in these alternative investments is most likely due to the wild ride that the stock market has taken investors on for the last decade. Although hedge funds have been around a long time, they weren’t really talked about much in the main stream press until relatively recently. This could be due to the fact that in the past so few individual investors could own them, leaving big institutions as the primary investors. Now that there are reportedly 7.8 million millionaires in the US, hedge funds are more news and conversation-worthy. Initially it was the juicy returns that some famous hedge funds were churning out that brought them into the public eye. More recently it has been the catastrophic collapses of some funds and outright fraud perpetrated by the managers of others that brought them notoriety. It was only natural that average investors became intrigued by the returns but turned off by the horror stories.

Enter the hedge-like mutual fund. These are funds that attempt to create a sort of “best of both worlds” investment product. Let’s take a quick look at what this means. Okay class, let’s see what you remember from parts I and II of this series. What do mutual funds have that hedge funds don’t? Anyone? Anyone? Don’t make me call on someone! Alright, you in the back. Yes, that is correct. Mutual funds have the following benefits that hedge funds don’t:

• Daily Pricing
• High Liquidity
• Transparency
• Relatively Low Fees
• Close SEC Oversight
• Availability to Nearly All Investors
• Low Minimum Investment Requirements

This sounds like a good thing, does it not? Sophisticated hedge fund strategies with all the benefits that mutual funds provide. But do hedge fund strategies really work under the traditional mutual fund format? The answer is yes, but with limitations. First of all, not all hedge fund strategies can be used by mutual funds, some for practical reasons, and others for legal reasons. On the practical side, strategies that depend heavily on long-term investments in illiquid assets are difficult to use effectively in mutual funds. This is due to the fact that mutual funds are required to be redeemable on a daily basis. On the legal side, hedge fund strategies such as fixed income arbitrage, which rely largely on the use of leverage, may not work as effectively in mutual funds due to the strict limits our federal government imposes on the amount of leverage mutual funds can have. On the other hand there are several hedge fund strategies which work quite well under the mutual fund format. These strategies include market neutral, long/short, absolute return, and commodities futures. But even these strategies might underperform their hedge fund cousins, again, because of liquidity requirements, as fund managers have to be ready to redeem shares on a daily basis. Even so, some investors might consider any underperformance issues as a small price to pay in exchange for the relatively inexpensive access to the sophisticated strategies that these hedge-like funds provide.

How Do Hedge-Like Mutual Funds Differ from “Ordinary Mutual Funds”?

First of all, what do I mean by ordinary mutual funds? When most of us think of a mutual fund, we are thinking about funds that employ “relative return” or “long-only” strategies. These strategies are designed to beat or track an index or a given asset class, such as mid cap growth stocks. Such funds generally move up and down with the performance of their sector. These funds can be actively or passively managed (index funds). Actively managed funds try to beat their benchmark by selecting securities they believe will outperform the market, while index funds seek only to stay even with their benchmark. Actively managed funds have higher fees to compensate the management team, and index funds usually have very low fees. Hedge-like mutual funds fall solidly into the actively-managed category. In fact, some of these funds are the most actively managed funds around. Thus, you can expect to pay higher fees in mutual funds that use hedge-like strategies than you would with traditional actively-managed funds. This is not always the case however. The 5.5 billion dollar Hussman Strategic Growth Fund, which clearly falls into the hedge-like category, charges annual fees of only 1.09%, which is more than an index fund, but fairly average for an actively managed mutual fund.

Why would anyone want to invest in funds that have higher fees than many traditional mutual funds? It may well be worth the extra cost if the fund is adding value to the portfolio. Many of the hedge-like mutual funds pursue a strategy that is less dependant on the performance of the market in general. Some of these funds held up very well in the market meltdown of 2008, but they also may have underperformed in the 2009 recovery. Their proper use in a portfolio may serve to dampen volatility and provide investors with a smoother ride, while still producing reasonable returns. The goal is to provide relatively low correlation with stocks and bonds.

In Part IV, I will discuss another method of entry into the world of hedge funds for average investors, the “fund of funds” fund. (Say that three times fast!)

Hedge funds and mutual funds are both investment vehicles that involve a professionally managed portfolio in which investors hope to achieve a positive return. Neither of them are purchased or sold on stock exchanges. Other than that, there are relatively few similarities. Let’s talk about the differences.

Who can invest?

As I discussed in Part I, hedge fund investors almost always must meet the “accredited investor” status, which requires considerable wealth or income. Mutual funds have no such restrictions. Basically, if you can fog a mirror (one of Jon’s pet expressions), you can open a mutual fund account.

How much do you have to invest?

Many hedge funds require an initial investment of up to $1,000,000. However as the hedge fund industry has matured several funds have lowered the requirement to a mere $100,000. On the other hand, many mutual funds will welcome you as an investor with as little as $1,000.00, or even less if you promise to make regular periodic contributions to the fund.

Liquidity – How easy is it to sell my investment?

Mutual funds can be redeemed (sold back to the mutual fund company) on any business day. Since they don’t sell on the open market, shares sold during the course of the day will be priced at their net asset value at the end of the day. Hedge funds are not nearly as liquid. Many hedge funds have “lock-up” periods as long as five years, during which investors are not allowed to redeem their shares. Even after these lock-up periods have expired, hedge funds may require investors to give them several months advance notice of redemption requests. It should be noted here that not all hedge funds are subject to long lock-up periods or advance notice of redemptions. The liquidity of each hedge fund will most likely be dependent on the liquidity of the investments the hedge fund holds. Generally, mutual funds are far more liquid than hedge funds.

Transparency – What’s in there?

Most investors want to know something about what they’re invested in. Some like to know exactly what they’re invested in. If you are in the latter group, you are probably going to be much more comfortable with a mutual fund. Because they are required to register with the SEC, mutual funds have to report their holdings quarterly and they must stay within the investment parameters set forth in their prospectus. Hedge funds are not required to register with the SEC, and they are structured specifically to avoid most state and federal regulation. Therefore, any disclosure issues regarding the fund’s holdings are dictated by the terms of the private written agreements executed between the investor and the hedge fund. Most hedge fund managers take the position that frequent and detailed disclosure of investments would affect investment performance, and therefore most hedge fund operating documents provide for minimal disclosure. There have been increasing calls for regulation in this area.

Valuation – What’s this thing worth?

Mutual funds are required to provide daily valuations. Most mutual funds release that figure, called net asset value, shortly after the market closes for the day. Hedge funds have no such requirement and because of the nature of the assets they hold, current valuation may be difficult to determine without the benefit of an independent audit.

Fees – How much is this thing going to cost me?

Since investments costs obviously cut into returns, it’s vital to understand what those costs are. I could probably write a couple pages on mutual fund costs, but I’ll keep it short for the purposes of this piece. I’ll also limit the discussion to no-load funds because we don’t like load funds and we don’t use them. Mutual fund companies are in business to make money and they do that by charging fees. Most annual fees for mutual funds typically fall between .2% (yes, that’s two-tenths of one percent) and 2%. Some funds also charge an additional fee if you sell the fund within 90 days of purchase. Like mutual funds, hedge funds charge an asset management fee. Usually that fee will be between 1% and 2%. However unlike mutual funds, most hedge funds also charge a performance fee which allows them to take a set percentage of any profits generated. You may have heard the term “two and twenty” in reference to hedge funds. What this means is that the fund charges an annual 2% asset management fee, plus twenty percent of the profits. This provides an incentive for the fund manager to perform well, but it may also tempt him to take larger risks to juice up that performance.

Legal Protections

In an attempt to provide full disclosure and to prevent fraud, mutual funds are very highly regulated investment vehicles. Mutual fund companies are subject to direct oversight by the SEC and the large body of law contained in the Investment Company Act of 1940. The Act imposes a fiduciary duty upon the fund company to act in the best interest of those who invest in their funds. Although hedge funds fall under the general definition of investment company for purposes of the act, they carefully structure themselves so as to take advantage of one or more of the Act’s exemptions. There are legitimate reasons they do this, but the disadvantage to the investor is that the fund is not required to register with the SEC. Most of the differences between the two types of funds outlined here in Part II are a direct result of the legal environments they each work under. However, hedge fund investors are not without the protection of law. Despite their exempt status, hedge fund operators are fiduciaries, and if they breach that duty they are subject to legal action in the same manner that a mutual fund manager is. In addition, hedge fund managers are not exempt from the anti-fraud provisions contained in the securities laws and regulation. Finally, because the relationship between the fund and the investor is defined by the fund’s offering documents, a wronged investor may seek relief from the courts under standard contract law.

We have now covered what I consider the major differences between hedge funds and mutual funds. Keep in mind that for the sake of brevity I kept the comparisons general. Other issues that were not covered are differences in tax treatment, audit requirements, restrictions on advertising, custody of assets, internal oversight, and the significance of “offshore” hedge funds.

In part III I’ll discuss the relatively recent emergence of several traditional mutual funds which employ strategies historically used only by hedge funds.

We hear about these things all the time, usually in the context of someone talking about a “billionaire hedge fund manager”. Most people who don’t really know what hedge funds are have nevertheless formed impressions that they are risky and only available to the ultra-wealthy. Is there any truth behind these impressions? Let’s talk.

What’s behind the term “hedge fund”?

Interestingly enough, hedging actually means reducing risk. The first hedge funds were created to do just that, reduce the effects of market downturns. Today, the term applies to a variety of investment strategies, many of which have nothing to do with hedging. What all hedge funds have in common is that they are all pooled private investment vehicles that are largely unregulated, and which are only open to a select class of investors. Like actively managed mutual funds, hedge fund performance depends on the talents of the fund’s managers.

Are hedge funds risky?

All investments carry risk, so the better question is how do they compare with other common investments like stocks, bonds and mutual funds? Okay, I said that was a better question, but I didn’t say that it was a good one. The thing is, hedge fund strategies and objectives are all over the map. Some use strategies that are relatively safe, while others employ strategies that are very speculative.

What are some common hedge fund strategies?

Because hedge funds are subject to relatively little regulation, they have much greater flexibility than mutual funds in the strategies they employ. Some strategies include using leverage to enhance returns (and risk), long/short investing, arbitrage, buying distressed debt, using options and derivatives, and market neutral equity investing.

Who can invest in Hedge funds?

Unlike mutual funds, hedge funds are largely unregulated because they are only available to investors who are considered to be “sophisticated”. Not sophisticated as in rare wine and opera, rather hedge fund investors are thought to have investment savvy. How does one acquire this financial acumen? By having lots of money, of course! Most hedge funds require investors to be what is known as “accredited”. These are people whose net worth is over a million dollars, or whose income has been $200,000 a year ($300,000 for married couples) for the last two years and is expected to stay at that level. The fact that the SEC has determined that the mere status of being a millionaire somehow implies financial acumen is somewhat strange. (Think lottery winners, teenage heirs, and young professional athletes.) In any event, the SEC takes the position that accredited investors, by virtue of their sophistication, do not require the level of regulatory protection that is afforded to the less well-heeled.

In Part II, I’ll cover more on the differences between hedge funds and mutual funds, and some of the legal protections that are available to hedge fund investors.