Compromise Between Hedge and Mutual Funds

Physician's Money Digest, August 2005, Volume 12, Issue 12

Webster's Dictionary

The word "hybrid" is defined byas "a composite,formed or composed of heterogeneouselements." For example, the offspringof two animals or plants of differentvarieties would be considered a hybrid.

The goal, at least where plants are concerned,is to develop a new and attractivevariety of flora. In the investment world,hybrid mutual funds that mimic the characteristicsof hedge funds yet carry thelower cost and more tax-friendly featuresof a mutual fund may be as attractive tosome physician-investors as a new varietyof flower is to a botanist.

Hybrid Benefits

BusinessWeek

According to a recent report, hedge funds are private investmentpools that make use of sophisticatedtools that are usually off-limits to mostmutual fund investors. They operate outsidethe regulatory guidelines that governmutual funds, making them more flexible.

For example, while mutual funds canborrow $1 for every $3 held in assets,hedge funds can borrow as much as theirbrokers allow, thus amplifying returns, protectingagainst a stock market decline, oremploying other investment-related strategies.Some mutual funds are also constrainedby their own self-imposed limits.

However, a recent study found thatnot only do hybrid funds share some ofthe beneficial qualities of a hedge fund,they may also be comparable in terms ofstock market performance. The study,published by the Center for InternationalSecurities & Derivatives Markets at theUniversity of Massachusetts at Amherst,found that half of the 12 hybrid fundsexamined for risk-adjusted returns outperformedthe hedge fund indexes theymimic during a 5-year period from 1998to 2003. In addition, several hybrid fundsposted gains during the bear market.

The article points out that hybrid fundsalso have lower expenses than hedgefunds. The average expense ratio forhybrid funds of 1.82% might seem highcompared to a traditional mutual fund.But compared to hedge funds, which usuallygarner between 1% and 2% in managementfees plus 20% of the profits,hybrids seem like a steal.

BusinessWeek

Many physician-investors buy into afund-of-funds to delve into a diversifiedhedge fund portfolio. These funds,notes, not only pass on thefees of hedge funds they're invested in,but an additional 1% in management feesand a healthy 10% slice of the profits.

Tax Disadvantage

It's also important to understand thatmany hedge funds, particularly those ofthe fund-of-funds variety, contain hiddentax costs. The article explains that a fundof-funds earning 11% might put an 8.9%return in your hands after removing feesand its share of the profits. However, youcould still end up paying tax on an amountgreater than the profit you received.Because taxpayers can only claim miscellaneousitemized deductions that exceed 2%of their adjusted gross income, no portionof the fees a physician-investor incurs is eligiblefor a deduction. With hedge funds,investors must also pay tax on their gains,though they won't realize their share ofthe profits until they sell off the fund.

Of course, that doesn't mean that allhybrid mutual funds are created equal.These funds will often vary based on theirability to hedge, or reduce, their exposureto the market. As an example, the articlepoints out that the Hussman StrategicGrowth Fund has ranged from 75% to100% hedged, while the Legg MasonOpportunity Trust had no hedge in placeas of Sept. 30, 2004.

Hybrid funds with strong track recordsare sometimes closed to new investments.They will open again as opportunitiesarise, so it's important to keep checkingback with them.