The New Hedge-Fund-Like Retail Funds

Mutual funds that aim to copy hedge-fund strategies are proliferating.

ROB COPELAND

March 21, 2014 5:24 p.m. ET

It is getting easier to invest like a hedge fund. That doesnt necessarily mean you should.

Hedge funds have long served an exclusive clientele of deep-pocketed institutions and wealthy individuals. Now, an expanding array of mutual funds is bringing hedge-fund strategies to the masses.

Investors who crave a seat at the table have poured billions of dollars into the mutual funds, swelling their assets to $286 billion by year-end, compared with $41 billion at the end of 2008, according to fund tracker Lipper.

The cover charge is relatively affordable—some of the mutual funds have minimum investments as low as $1,000, far below the seven-figure commitments many hedge funds demand. And they are available to most investors. Traditional hedge funds are only available to accredited investors, which the Securities and Exchange Commission defines as an individual whose annual income tops $200,000 or whose net worth exceeds $1 million, excluding a primary residence.

The new mutual funds aim to re-create the secret sauce of hedge-fund investing, which typically involves spreading bets around so that if one asset drops in value, another could log offsetting profits. The funds are run by Wall Street banks such as Goldman Sachs Group  GS -1.34%  and Morgan Stanley , MS -0.58%  as well as by well-known hedge-fund firms such as Avenue Capital Group, which is based in New York and manages about $13 billion.

Like hedge funds, the mutual funds take varying approaches. Among the most common is what is known as long/short, meaning the funds wager that some assets will increase in value and others will decline. The largest long/short mutual fund is New York Life Investment ManagementsMainStay Marketfield Fund. which charges annual fees of 2.95%, or $295 for every $10,000 invested, and has $21.5 billion in assets.

But dont rush to join the club. The strategies many of these mutual funds pursue are complex and difficult for investors to track closely. Many also have short track records and, like actual hedge funds, they often generate tepid results that fall short of the popular image of outsize gains.

I wouldnt touch it with a 10-foot pole, says Harry Markowitz, who shared the Nobel Prize in economics in 1990 for his research into how investors should allocate their assets to get the best balance between risk and reward. Opaque is bad, and complicated is bad.

Membership fees also can be steep, as they frequently are with hedge funds, which have traditionally charged investors two and 20, or 2% of assets annually plus 20% of any gains. Annual fees for so-called alternative mutual funds—many of which follow hedge-fund-like strategies—average 1.87%, compared with 0.75% for passive index funds, according to Chicago-based investment-research firm Morningstar.

Many experts preach caution. Kevin Myeroff, president of NCA Financial Planners, an advisory firm based in Cleveland that manages about $900 million, says he is dabbling in alternative funds, but recommends that clients put no more than 2% of their investments into them.

For the average investor, they are better off keeping to the basics, he says.

For those considering taking the plunge, here is what you need to know about hedge funds—and the retail funds that try to mimic their approaches:

What the Funds Do

Hedge funds are often associated with high-risk, high-return bets that make the fund managers fabulously rich. Famous managers capture the spotlight, such as George Soros. who scored big with his 1992 wager against the British pound, and John Paulson. who netted $15 billion for his firm by anticipating the drop in housing prices that triggered the financial crisis.

The typical hedge-fund manager, however, has tamer aims. The goal is often to generate steady gains and avoid gut-wrenching drops, and to produce returns that are unlikely to move in lock step with broad market indexes. That is why hedge funds often appeal to foundations, family offices, endowments and other investors with long-term funding commitments

A lot of times people think about hedge funds and they think they are going to get some very high returns, says Lisa Shalett, head of investment and portfolio strategies at Morgan Stanley Wealth Management. In fact, many hedge-fund strategies are aimed at almost the exact opposite, which is very unexciting returns.

Over the five years through December, hedge funds that focus on stocks have generated an average annual return of 9%, according to Morgan Stanley, compared with 18% for the S&P 500, including dividends.

Investors in a long/short mutual fund also may find that their returns are lower than stock-market indexes might suggest, particularly in the short term. For example, New York Lifes MainStay fund earned 17% for investors last year, compared with a 32% rise in the S&P 500, including dividends. Over the past five years, the fund has generated an average annual return of 14%.

The fund mostly buys shares of large companies such as Facebook and Alcoa and of exchange-traded funds such as SPDR S&P Regional Banking that track market indexes. The fund also sets aside a smaller portion of its assets to bet against certain stocks, which can damp volatility but also reduce returns when stocks boom. The minimum investment is $2,500.

Another type of alternative fund, known as alternative beta, aims to replicate the performance of widely followed hedge-fund indexes by shifting investments among broad buckets of assets in which hedge funds are known to invest.

Ms. Shalett of Morgan Stanley says she is in observation mode to see how these funds perform in a falling market, as most have been launched in the past few years and havent yet been tested in a significant downturn.

Funds of Funds

One of the fastest-growing categories of alternative funds is a spin on a so-called fund of funds, which spreads its assets around to a variety of underlying hedge-fund managers. That can make it difficult to figure out what stocks your fund holds, since hedge funds typically only have to disclose holdings at the end of a quarter.

Over the past year, Blackstone Group , BX +0.36%  Neuberger Berman Group and Legg Mason s LM -0.27%  Permal Group all have launched funds of hedge funds that are available to ordinary investors.

The Goldman Sachs Multi-Manager Alternatives Fund. which charges annual fees of 2.55%, has amassed $350 million in assets in less than a year. The fund has generated a 0.8% return for investors in 2014, through February, compared with 0.6% for the S&P, including dividends. The minimum investment is $1,000.

The idea behind a fund of funds is that investors will be exposed to a variety of different strategies, with success for some compensating for weakness in others.

There also are a number of mutual funds that follow a common hedge-fund approach known as managed futures, which involves trying to detect market trends and ride the wave. The returns on managed futures funds often zig when stocks zag, and that lack of correlation is particularly prized by investors who seek to maintain wealth rather than maximize short-term gains.

Fans of alternative funds say the potential benefits of a hedge-fund approach are particularly clear in the current investment environment, when returns on bonds are limited amid persistently low interest rates and stock-market ups and downs highlight the risk of losses.

But the new hedge-fund-like mutual funds also carry risks that could make them unsuitable for many investors, experts say.

For example, the new funds face a potentially costly problem that most established hedge funds dont: Since the funds are organized as mutual funds, they are required under securities laws to be able to satisfy investor requests to withdraw their money on a daily basis. As a result, they are sometimes known as liquid-alternative funds.

Some hedge-fund managers are salivating at the chance to profit if these funds must sell assets at a loss to meet investor requests for redemptions.

Traditional hedge funds, by contrast, often require investors to commit money for months or years.

Who are they going to sell to? I hope its us, Paul Westhead, chief executive of Irvine, Calif.-based Rimrock Capital Management, a credit-focused hedge-fund firm, wrote last month in a letter to investors. We may be the ones to provide the liquidity, but they are not going to like the price.

In addition, the returns of alternative mutual funds may differ from the returns of similar hedge funds—even if the mutual fund and the hedge fund are run by the same managers.

Results May Vary

In most cases, alternative funds cant precisely replicate their hedge-fund counterparts, both because of regulatory restrictions on their trading and the need to let clients get their money back at the end of any given day.

Alternative mutual funds that are focused on the credit markets, for example, may avoid holding structured bonds—securities formed by pooling debts such as mortgages or credit-card receivables—because a limited pool of buyers and sellers means they could take weeks or months to unload. Traditional hedge funds routinely hold such assets.

Ramius, a New York-based hedge-fund firm, last year launched the Ramius Event Driven Equity Fund. a mutual-fund similar to a hedge fund it runs that bets primarily on corporate mergers. Its annual expenses are 1.90%. In the fourth quarter, the mutual fund earned 1.2%, while the hedge fund earned 2.6%, according to investor documents.

While we do target hedge-fund returns, youre most likely going to have a bit of a lower return, with lower volatility, says Andrew Cohen, a portfolio manager at Ramius, who oversees both funds. He says that long-term investor commitments to the hedge fund let Ramius agitate for corporate changes over greater periods and even start its own campaigns, while the mutual fund primarily wagers on existing merger deals.

There are other reasons why results may vary, experts say.

For example, investors considering a fund of funds should investigate whether the underlying hedge-fund managers are investing the money they take in from their mutual-fund investors in the same way that they invest money from wealthy individuals and institutions who are clients of their flagship hedge funds.

There are too many conflicts of interest if you dont run it all together, says Brad Balter, a Boston-based adviser on hedge-fund allocations who in December started a mutual fund that invests in hedge-fund managers, the Balter Long/Short Equity Fund. which charges 2.19% in annual fees and is currently only available for a $50,000 minimum investment.

Some funds of funds also pay performance-based fees to underlying hedge-fund managers they invest with. Those fees are on top of the annual fees, and can also take a bite of profits.

Sometimes-middling returns and the difficulty of figuring out where your bets are placed are among the chief reasons why even sometime fans take a cautious approach to alternative funds.

Fees, however, are the top concern of advisers weighing liquid-alternative products, according to Goldman Sachs Global Investment Research.

When youre talking about something that may only deliver a mid-single-digit return, a manager that is trying to overcome 1% to 2% of additional expenses has a huge challenge, says Charles Mires, director of fixed-income and alternative strategies at wealth manager Franklin Street Partners in Chapel Hill, N.C.