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October 2, 2006 8:14 pm

Mutual funds: Attractions of selling short

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The level of difficulty involved in convincing retail investors that short-selling is a good idea is not unlike that of attempting brain surgery on yourself.

Alongside the negative sentiment that is heightened each time a hedge fund suffers a blow-up, the main reason for this is that, while the potential gains as a result of short selling are capped, potential losses are unlimited. As a result, short-selling strategies are often viewed as the preserve of hedge fund managers investing on behalf of institutional or high-net-worth clients – the “accredited investors” deemed by the government to have the necessary level of sophistication.

But there is an enormous opportunity for anyone who can take strategies developed in the hedge fund world and market them to retail investors.

Thus several asset management and mutual fund firms are developing hedge fund-like products for retail customers that aim to push the investment envelope more than traditional “long-only” funds. They are doing this by harnessing techniques, including short selling, designed to boost returns.

UBS Global Asset Management recently unveiled the US Equity Alpha fund for retail investors, a year after launching a similar fund for institutions. The fund seeks to generate alpha – or excess return over the benchmark – by taking both long and short positions.

Hedge fund-like products hold several advantages over true hedge funds, including daily liquidity, greater oversight and regulation, and lower fees.

The other key difference is that mutual funds cannot use the same kind of leverage as hedge funds. This eliminates much of the risk.

UBS’s alpha fund seeks to outperform the Russell 1000 index by 250 to 500 basis points a year, gross of fees, over a full market cycle, with a similar level of market risk as the index. It seeks to generate alpha in three ways – taking long positions in securities deemed underpriced, plus taking short positions in securities deemed overpriced and making pair trades.

A pair trade takes a long position in an undervalued security and a short position in an overvalued security which is correlated. For example, it might go long in an apparently overvalued bank while selling short an undervalued bank. Providing the call about the relative valuations of the two banks is correct, this trade will make money whatever direction the banking sector takes in the overall market.

John Leonard, head of North American equities at UBS GAM, said the house had proved successful at identifying both overpriced and underpriced securities. “In long-only portfolios, we can capitalise only on a portion of our research convictions: the underpriced securities,” he said. “By relaxing the long-only constraint, the fund has the flexibility to capitalise on all the mispriced securities our research identifies.

“Markets go in cycles, with growth outperforming value for a time and then value outpacing growth. This fund seeks to add value throughout a full market cycle.”

UBS is not the only group looking to attract the retail dollar. Alternative Investment Partners’ alpha hedge strategies fund can be purchased directly through retail brokers with a minimum investment of $10,000.

Others include the Legg Mason opportunity fund, the Boston Partners long/short fund and the Hussman strategic growth fund, which uses S&P 500 and Russell 2000 put and call options to hedge the portfolio. In spite of perceptions, this should make it lower risk than a conventional mutual fund. This year Mellon Financial Corporation made its Global Alpha fund available to individual investors. The fund seeks total return by investing in instruments that provide exposure to global equity, bond and currency markets, and in fixed-income securities. The concept is to provide alpha while taking on somewhat greater risk. It does this using a systematic, quantitative screen designed to identify and exploit relative improper valuations across global capital markets.

As part of its strategy, it will use derivatives instruments, including futures, options, forward contracts, swaps and hybrids, to a degree as a substitute for investing directly in equities, bonds and currencies. The fund may also sell short.

As recently as a decade ago, only hedge funds with a minimum investment of $1m could call on such an array of investment possibilities. But Mellon Financial’s fund has a minimum initial investment of just $1,000 – an amount that even the most unsophisticated investors might have to spare.

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