A hedge fund manager's mutual twist

One of the biggest names in the business is looking for new ways to drum up more business.

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By Beth Kowitt, reporter

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NEW YORK (Fortune) -- In what looks like a sign of the hard times in the hedge fund world, AQR Capital Management - one of the industry's biggest names - is opening its doors to the retail market.

In January, the investment management firm launched its Diversified Arbitrage Fund, its first mutual fund. Its Class I shares are up just 0.15% through the end of February, but that doesn't look so bad compared with the S&P 500, which dropped 12.5% during the same period.

AQR says it wants to give average investors access to strategies that were once only available to hedge fund clients. While the fund may not be designed as a main holding, David Kabiller, co-founder of AQR with Cliff Asness, John Liew and Robert Krail says it can help individual investors balance out their portfolios.

"These are absolutely alternative investments, but when you cut through the label, what they're meant to do is to offer you diversification," says Kabiller.

The fund also allows AQR to expand its client base. After a poor 2008 performance and unprecedented withdrawals cut sharply into fees during hedge funds' worst year ever, managers have been looking for new customers. Part of their survival may be through mutual funds, analysts say.

Most actively managed mutual funds simply try to pick stocks that will beat the market. They're called "relative return funds," and they try to outperform a benchmark index such as the S&P 500. AQR's mutual fund instead takes an "absolute return" approach, with results that are not supposed to depend solely on market gains.

"Most of the kind of investments that you're dealing with basically do well when the market goes up," Kabiller says. "Our strategy can still do well in down markets."

How it works

The fund uses a merger arbitrage strategy, where it buys shares of a target company and shorts the stock of the acquiring company. The fund tries to capture the difference between the market price of the target and the offer price. It also uses convertible arbitrage where it buys a convertible bond and shorts the underlying common stock. The convertible bond includes an option to convert to stock, and the idea is that this option is inaccurately priced at a discount.

There already are a handful of mutual funds using some of the same alternative investment strategies. The Merger Fund was the first to use solely merger arbitrage. But Kabiller believes that AQR's new offering is the only one that uses merger arbitrage, convertible arbitrage, investing in special acquisition companies, and other alternative strategies all in one. Nadia Papagiannis, a hedge fund analyst at Morningstar, says this is the only general multi-strategy arbitrage mutual fund that she's heard of.

But while alternative strategies might sound good in theory, they don't always work in practice. Investors found that out the hard way with market-neutral funds, which were popularized in the 1990s. They were supposed to have positive returns independent of the market's performance, but they often fell short of the mark. Papagiannis thinks arbitrage strategies might have similarly inflated expectations.

"Arbitrage is something that's nice in theory, but doesn't really exist," she says. "Arbitrage means that there's a risk-free trade and doesn't cost anything. There's no such thing as a risk-free, costless trade in reality."

The fund has about half the risk of the equity markets, says Kabiller, with about a third or half the volatility of the S&P 500 index. But Papagiannis notes that these strategies can be riskier than one might think. Merger arbitrageurs get hurt when deals don't close, and they got hit especially hard in 2008 with a record number of withdrawn deals.

Jeff Tjornehoj, a senior research analyst at Lipper, says funds like AQR's Diversified Arbitrage are not meant to be the core holding in an investor's portfolio; their purpose it to mitigate risk by adding diversification.

While some fund managers understand the arbitrage concept but fail in its execution, AQR's experience with its hedge funds makes him believe it can deliver on its approaches. "AQR is a well-established quantitative shop," he says.

How to get in

The minimum investment in the no-load fund is $5,000 with an expense ratio of 1.75%, which is about average for market neutral funds, but expensive compared to ordinary actively-managed funds and index funds.

In this tumultuous market, Kabiller says you can expect returns of about 6% or 7%. The fund launched with about $7 million of its own principals' capital and can handle a capacity of about $1.5 billion.

This is not a hedge fund. The Diversified Arbitrage Fund (ADANX) can only use a modest amount of leverage, which means lower returns than what it might have in the lightly regulated hedge fund space, but that also means lower risk, Kabiller says.

And mutual funds, unlike hedge funds, have to offer daily liquidity, so they have to be more mindful of investing in assets that can be bought and sold quickly. Institutional investors, AQR's core clients, already have access to these strategies in hedge funds but the daily liquidity of a mutual fund might appeal to them.

Some investment managers such as Lou Stanasolovich, founder and CEO of Legend Financial Advisors, like funds that focus on alternative strategies including merger arbitrage. Compared to ordinary mutual funds, they tend to avoid wide swings in returns. "We're the tortoise and they're the hare, but we know who wins that race," he says. "We don't tend to zig and zag a lot." To top of page

Company Price Change % Change
Ford Motor Co 8.29 0.05 0.61%
Advanced Micro Devic... 54.59 0.70 1.30%
Cisco Systems Inc 47.49 -2.44 -4.89%
General Electric Co 13.00 -0.16 -1.22%
Kraft Heinz Co 27.84 -2.20 -7.32%
Data as of 2:44pm ET
Index Last Change % Change
Dow 32,627.97 -234.33 -0.71%
Nasdaq 13,215.24 99.07 0.76%
S&P 500 3,913.10 -2.36 -0.06%
Treasuries 1.73 0.00 0.12%
Data as of 6:29am ET
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