Although I’m sympathetic to the view that a hedge fund is just a fee structure, the very best hedge funds generally do better analytic work than better mutual funds. If you’ve read David Einhorn’s recounting of his meeting with Wasatch founder Sam Stewart regarding Allied Capital, you’ve cringed at how inferior Stewart’s analysis (if it can even be called that) of Allied was in comparison to Einhorn’s. Clearly, when Einhorn was shorting it, Allied was mere portfolio filler for Stewart’s Wasatch funds, and he hadn’t done any real analysis on it. Along similar lines, I also interviewed mutual fund managers who had long positions in for-profit education companies while Steve Eisman was making a bundle from shorting them. The mutual fund analysis generally didn’t compare to Eisman’s analysis.
Governed by an absolute return ethos, the best hedge funds also protect the downside better than mutual funds and aren’t afraid to look different from an index. They know they’re paid to look different from an index more than mutual fund managers do.
The very few mutual funds that give their investors a hedge fund-like experience do so not simply because they can hold cash or derivatives, or short stocks. They provide that experience mostly by the higher quality of their analytic work.
Here is an example. FPA Crescent’s First Quarter 2012 letter contains an explanation of an investment where the fund has created a “stub” position in automaker Renault. Renault owns positions in other automakers, and, taking those positions into consideration, is trading as if its own business has negative value. So manager Steve Romick has shorted the stocks of the automakers Renault owns in addition to owning Renault itself to create a stub stock isolating Renault’s business. Indeed, as Romick explains in the letter, he’s done this before successfully.
Actually, this isn’t an amazingly difficult trade to understand, and anyone who’s read Joel Greenblatt’s You Can Be a Stock Market Genius knows that he goes through discussions about stub stocks including how to create your own. Unfortunately other mutual fund managers won’t engage in this kind of activity. Sometimes they’re not smart enough, and sometimes they’re governed by the institutional imperative requiring them to track an index closely. Nobody wants to go out on a limb by creating a stub position, thereby forcing themselves to have to explain it to institutional and retail investors — especially if it doesn’t work out immediately.
The courage to buck the institutional imperative, however, can get you the 10-year performance (Jan. 1, 2002 – March 31, 2012) depicted below:
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