Product and Strategy Notes

More On Retail Hedge Fund Index Products

After last month’s article on retail hedge fund products, a number of readers asked us why we had not mentioned products such as Rydex Capital Partners Sphinx Fund, the Deutsche Bank DB Hedge Strategies Fund, or the Oppenheimer Tremont Opportunity Fund. The answer is straightforward: we were looking for index based hedge fund products that would make a mix of absolute value strategies available to all individual investors. The funds noted above (and others like them) require minimum investments of $50,000 and are only available to qualified investors (e.g., minimum net worth of $1.5 million) through registered investment advisers. On the other hand, we also recognize that these are considerably lower minimum investment amounts than have traditionally been required of hedge fund investors. So let’s take a closer look at these funds.

While hedge funds are typically organized as limited liability companies, these products are closed end investment management companies that are registered with the Securities and Exchange Commission. This enables them to sell shares to a larger number of qualified investors than would normally be the case for a hedge fund. The funds received by the closed end investment management company are placed in different hedge funds representing a range of absolute return strategies (e.g., arbitrage, event-based, and directional). Compared to traditional "funds of funds" these closed end funds charge somewhat lower fees. For example, the Oppenheimer Tremont Opportunities Fund has a 2.5% front end sales load (called a "placement fee"), an annual expenses of 2.16% of its assets. In addition, the fund manager receives an additional performance related fee equal to 10% of any return above 8% (and note that this 8% return is after the underlying hedge funds have taken out their operating expense and performance related fees). On the other hand, the DB Hedge Strategies Fund charges a front end load of 3.5%, and has annual operating expenses of 2.20%, but has no performance related fees. Of the three funds cited, the Rydex Capital Partners Sphinx Fund offers the best pricing, with no front-end fee, and annual expenses of only 1.95%. Moreover, while the Oppenheimer and DB funds leave the actual hedge fund selection up to the closed end investment fund manager, the Rydex fund invests in the forty hedge funds that make up the Standard and Poor’s Hedge Fund Index, which includes a wide range of absolute return strategies.

TRAKRS: Another Way to Invest in a Commodities Index

While interest in commodities as an asset class has been growing, many individual investors still balk at the high cost of the two existing index mutual fund products from Oppenheimer (QRAAX) and PIMCO (PCRAX). The former tracks the energy heavy Goldman Sachs Commodities Index, while the latter tracks the Dow Jones AIG Commodities Index, which is more evenly balanced between metals, agricultural, and energy commodities. That being said, both of these funds are still very expensive as index funds go, not only in terms of their operating expense ratios (1.68% at QRAAX, and 1.24% at PCRAX), but also due to the fact that they carry high front end sales loads of up to 5.5% (which are almost never charged by index funds). An important exception to this are the Class D shares on the Pimco Commodities Fund, which have no front end load, but which are only available through Registered Investment Advisors or some fund supermarket programs (e.g., Fidelity). Inevitably, this raises the questions about what is driving these high costs, and whether we can expect them to decline in the future.

On the one hand, the operation of a commodity index fund is quite different from that of a "normal" stock or bond index fund. Given the high costs that would be involved in holding physical commodities (transportation, storage, financing, etc.), commodity index funds instead hold a portfolio of commodity futures contracts. However, since these are leveraged instruments (that is, $1 invested in a futures contract gives you control over more than $1 of the underlying commodity), you don't need to invest the full amount of the money you have received (as the operator of the fund) in futures contracts. Both QRAAX and invest the remaining funds in bonds. We prefer PIMCO's approach to this, which uses primarily real return bonds (U.S. Government issued TIPS). This seems logical, since the commodities fund serves as an inflation hedge many portfolios. On balance, we believe that the additional costs inherent in operating a commodity index fund probably account for some of QRAAX and PCRAX’s higher expense ratios. However, until somebody (e.g., Vanguard or iShares) introduces a lower priced product, we won’t know the extent to which this is the case.

On the other hand, the high front end loads charged by both QRAAX and PCRAX have nothing to do with the operation of the fund per se, but rather reflect the costs involved in distributing them (e.g., brokers’ commissions). We believe that, at this point in time, these high front-end loads reflect the difficult nature of the "sales process" for a retail commodity index fund. More specifically, we believe that most individual investors currently do not appreciate the potential diversification benefits offered by the commodities asset class, and as such are likely to regard it as a highly speculative (that is, risky) investment. Providing the education needed to overcome this initial investor resistance probably requires substantial amounts of a broker (or financial planner’s) time. Given this, Oppenheimer and PIMCO have probably had to charge a substantial front end load on their respective funds in order to induce brokers and planners to spend the time required to sell these funds to their respective clients. Going forward, however, we believe that the average level of investor understanding of the benefits of investing in commodities will increase to the point that another company (e.g., Vanguard or iShares) will launch their own no-load, low cost mutual fund or ETF commodities index product. The fact that PIMCO has started to offer – on a limited basis – a no load class of "D" shares is very encouraging in this regard.

In the meantime, the high fees that now exist have led some investors to ask if there are other alternatives available for gaining exposure to the commodities asset class. We know of one other vehicle that tracks the Dow Jones AIG Commodities Index, but it is an unusual one. "Total Return Asset Contracts" were recently launched by Merrill Lynch, and are perhaps better known by their brand name "TRAKRS". Technically, they are neither mutual funds nor exchange traded funds: they are futures contracts, but of a very special type. Unlike typical futures contracts, they can be through a brokerage account, and do not require a separate futures trading account to be set up (although some reports suggest that other brokers may be reluctant to do this, given that TRAKRS are a Merrill Lynch product).

The reason TRAKRS can be held in a brokerage account is that unlike a typical futures contract, no leverage or margin calls are involved. Individual investors must post one hundred percent of the contract’s value when it is purchased. The value of the commodity TRAKRS fluctuates in line with the total return on the Dow Jones AIG Commodity Index. The current commodity TRAKR contract is traded on the Chicago Mercantile Exchange (www.cme.com) and expire on June 28, 2006, when they are settled for cash (presumably, Merrill will introduce another contract at or before this date, to enable investors to maintain their position in this asset class). TRAKRS can also be sold before maturity. TRAKRS are not treated like other futures contracts for tax purposes, and instead become eligible for capital gains treatment after they have been held for more than six months. Because they are futures contracts, TRAKRS pay no dividends; the only taxable event occurs when they are sold or expire.

Another attractive feature of TRAKRS is that, because they are futures contracts, they carry no annual operating expense charges. There are, however, other costs involved in owning them. First, there is a brokerage commission when they are purchased (similar to the brokerage commission one pays when buying an exchange traded fund). Second, due to the structure of the contracts themselves, TRAKRS typically trade at a slight premium to the underlying index value. This premium has been estimated to be about three percent, on average. How, then, would you evaluate the trade-off between the PCRAX mutual fund and the commodity TRAKR? There are a number of issues involved. The first is the relationship between the front end load on PCRAX and the combined brokerage commission and price premium on the TRAKR. Let’s assume (unrealistically, but for the sake of illustration) that the sales load equals the brokerage commission. The question then becomes what discount rate should you use to convert the three percent price premium to an annual equivalent fee (analagous to a fund operating expense charge) over three years? Logicallly, the rate you use should reflect the opportunity cost of that money – that is, the rate you could otherwise earn on the TRAKR premium charge. To keep this example nice and tidy, let’s assume that this discount rate is what you would expect to earn if you invested that three percent in PCRAX. The breakeven discount rate that would make your three percent estimated TRAKR premium equal to the 1.24% annual expense charge on PCRAX is 11.5%. If you expected to earn more than this each year on PCRAX, it would appear to be a better deal than the TRAKR, assuming that the front end load on the former was equal to the brokerage commission on the latter.

But of course, this assumption isn’t true – the front end load on PCRAX is probably much higher than the brokerage commission you would pay to buy the TRAKR (though because the latter is a futures contract, you should check on the size of that brokerage commission in advance). This means that the breakeven opportunity cost is actually much higher. For example, if the difference between the sales load and the brokerage commission reduces the effective TRAKR price premium to 2%, the breakeven discount rate rises to over 38%. In this case, it seems like the TRAKR is a cheaper way to gain exposure to the commodities asset class.

On the other hand, what about the case where you can purchase the PIMCO "D" shares without a front-end load? In this case, the TRAKRS don’t look like such a good deal. If you assume the brokerage fee to purchase the TRAKRS equals 0.25% (twenty five basis points), the breakeven rate of return falls to only 7.00%. If you expect the Dow Jones AIG Commodity Index to increase by more than this much per year over the next three years, you would be better off investing in the PIMCO "D" shares and giving TRAKRS a pass.

The bottom line is that TRAKRS are new, different, but potentially very interesting products. In addition to commodities, TRAKRS have been introduced that track gold as sell as the Euro/U.S. dollar exchange rate. If you are looking for a cheaper way to invest in the commodities asset class, at least for the next two and a half years, TRAKRS may make sense if you don’t mind the additional operational hassles that investing in them entails. For more information, visit www.trakrs.com.

When Is An "Index Fund" Not An Index Fund?

On November7, 2003, the iShares Dow Jones Select Dividend Index Fund (DVY) started trading on the New York Stock Exchange. With an annual expense ratio of .40%, it tracks the returns on the new "Select Dividend Index" recently introduced by Dow Jones, whose press release noted that it was "designed as a tool for the income investor, [with] fifty companies selected and weighted based on their dividend yields." One could also say that its introduction may mark something of a turning point, since it would seem that the sponsors of what are, in effect, actively managed funds now believe it is to their advantage to be known as an "index fund." Let us be clear: in our view, this is very much an actively managed fund. A look at the average price/book value data for the companies included in the "Select Dividend Index" shows that they have the low price/book ratios one would normally associate with value stocks. And, indeed, a high dividend yield is one of the stock screening factors typically used by active investors who pursue a value strategy. So why don’t we just view this as another "value tilt" that an index investor could take? First, because of the small number of stocks included in the index, and second, because of the way they are chosen. Fifty stocks is a relatively small number to hold in a portfolio, even by the standards of most active managers. Moreover, the stocks included in the index are not chosen according to some mechanical rule (e.g. "divide the S&P500 into two equal groups based on the companies’ price/book ratios, and call one group the value index, and the other the growth index), but rather at the discretion of Dow Jones. In short, just because I have chosen fifty stocks to include in an index (presumably on the basis of some theory of relative value or relative momentum), and then created a fund that tracks it does not make the end result an "index fund", at least in so far as we understand the meaning of that term. In fact, if one really wanted to pursue a high dividend strategy, you might actually be better off in an actively managed fund whose manager could distinguish between companies whose high dividends reflect impending bankruptcy and those who pay them because of a highly profitable underlying business model. Unless of course that is what the Dow Jones team believes it is doing when it selects those fifty companies (hint: seven of the original fifty were dropped from the index and replaced by other companies in December).

The Mutual Fund Scandals at the End of 2003

The last few months have seen a number of developments in the widening mutual fund scandals. In November, the U.S. Securities and Exchange Commission ruled that Morgan Stanley must pay a $50 million fine because its brokers accepted special payments for recommending funds to investors without disclosing those incentives to them. As Stephen Cutler, director of Enforcement at the SEC noted, "few things are more important to investors than receiving unbiased advice from their investment professionals – or knowing that what they’re getting may not be unbiased…In plain and simple terms, Morgan Stanley’s customers were not informed of the extent to which Morgan Stanley was motivated to sell them a particular fund." However, in a world with over 7,000 mutual funds, in which brokers and other financial advisers account for a large percentage of all fund sales, special payments by fund companies to gain brokers’ attention are more likely to be the rule rather than the exception. As a Financial Times editorial noted, "Such deals make it hard for brokers to give unbiased advice to their customers: all too often, the deciding factor will be the commission that a broker receives rather than the investment return that a customer is likely to obtain."

In December, the SEC announced two further investigations: the first into the activities of a high yield bond fund that was accused of using stale prices to inflate its reported returns, and the second into 139 mutual funds that were closed to new investors but which were still charging annual 12b-1 fees (meant to support fund marketing) averaging .625% of their assets. The fund companies in question claimed the charges were legitimate, and were meant to cover deferred commission payouts to the brokers who sold the funds, as well as ongoing account servicing. Time will tell…

Also in December, the U.S. mutual fund trade association, The Investment Company Institute, 12/15/03 Investment Company Institute calls on SEC to limit the use of soft-dollar commissions to proprietary research, and to ban their use to pay for computer hardware, software and data services. Similar proposals have already made in the U.K. The ICI also called for the elimination of directed brokerage arrangements, where fund companies direct all their trading to a brokerage in exchange for that firm promoting its funds. A logical question to ask is what could have prompted the mutual funds’ own trade association to reverse its long held positions on these issues. There is a simple, two-word answer to this question: "Eliot Spitzer", the New York Attorney General who originally broke the market timing scandal. At a November hearing before the Senate Banking Committee, he said that excessive fund fees were a "logical next step" for regulators to address. Spitzer said that his office estimated that Americans paid $70 billion in mutual fund fees in 2002. He went on to note that both market timing and excessive fees were "consequences of a [mutual fund] governance structure that permitted managers to enrich themselves at the expense of investors."

This point was rather colorfully echoed at the Banking Committee hearings by Senator Peter Fitzgerald from Illinois, who noted that "the combination of opaque fees, abusive trading practices, and government policies which channel investor money into mutual funds has transformed this once sleepy industry into a monster." He went on to characterize the mutual fund industry as "the world's largest skimming operation--a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings."

Where is all this leading? We hope that the following editorial by Holman Jenkins Jr. (which appeared in the November 19th Wall Street Journal) proves to be prophetic: "The fund industry paints itself as the salvation of Mom and Pop, then drowns them in brochures for ‘growth’ funds, ‘technology funds’, ‘health care’ funds, ‘overseas health technology growth’ funds, and other absurd permutations. These are nothing more than an invitation to commit the same mistakes by sector that small investors have always made by chasing the latest hot individual stock. The S.E.C., if it were really doing its job, would inform the public that it is wasting its money. But the agency considers itself the protector of the ‘active’ small investor, so it can’t very well tell him that his ‘activity’ is the single biggest menace to his investment returns. Don’t get us wrong, speculators and active fund managers are highly useful people. They do the research and risk taking to make sure prices are ‘right’ – that is, reflect the latest wisdom about what companies are worth. They make the world safe for indexers: smart investors who stick their money in cheap, broad funds…and let Wall Street support them rather than the other way around."

2004 should be an interesting year….