Q&A: Bringing Hedge Fund Strategies To The Mutual Fund World

Feb 8 2012 | 9:31am ET

Direxion president and CIO Dan O’Neill says portfolio diversification is about asset classes, but it’s also about strategies. To O’Neill’s way of thinking, Direxion has been in the alternative asset business for years, having cut its teeth in the leveraged index mutual fund space before expanding into leveraged index ETFs. Now, the firm is poised to launch additional “alternative” investments—both mutual funds and ETFs—and has brought industry veterans John Cadigan and Ed Egilinsky aboard to guide the process. FINalternatives’ Senior Reporter Mary Campbell spoke to all three Direxion executives recently about the company’s new (no pun intended) direction.

First, can you tell me something about Direxion?

O’Neill: Since I have the longest tenure of the four of us, I should probably take this one. The firm has been in existence for over 14 years, and grew up in the leveraged index mutual fund space. I would consider that a form of alternative investing because leveraged indexed strategies have always been used by very tactical traders however they are not suited for long-term buy-and-hold investors.

We have been providing leveraged index mutual funds for the better part of a decade and launched leveraged index ETFs in 2008. We’ve got about $7.5 billion in assets within our ETF business. I think historically people talk about alternatives more in terms of asset classes—and we would agree with that—but we also think strategy diversification is important.

So, we’ve had great success with the leveraged index ETFs and feel we can duplicate that with our buy- and-hold strategies. I have made a significant commitment to the buy-and-hold marketplace by bringing in two industry veterans in John and Ed to lead the build-out and distribution of alternatives. One of our advantages relative to our peers is that we have always been, and continue to be, a non-traditional money management firm and building out buy-and-hold liquid alternative strategies is just an extension of our core competencies.

Can you tell me something about leveraged index ETFs?

O’Neill: Leveraged ETFs are very short-term trading vehicles for people who are essentially trading the market, are not at all interested in buy-and-hold investing, and are very tactical. Some of it is purely speculative, but a lot of it is very highly risk managed, where they’re taking a position on one security and shorting something else, so it’s a certain long/short trade, it’s very mathematical… Our investors/ traders usually will have expectations about what they think the market or the index they’re trading is going to do and then they will act on that. If they’re wrong, they’ll act on it; if they’re right, they’ll act on it. The term I use is that they’re much less deferential to the market than traditional investors, and that’s the key to leveraged index investing. Leveraged index ETFs were only started in 2006, so they’re about five years old and we have around $7.5 billion in them. The leveraged index space is about $35 billion in total, which is about 3% of the ETF business in the States.

Cadigan: What it comes down to, simplistically, is that you have two opportunities in this marketplace: either you’re more tactical with your asset exposure, as Dan mentioned, with some of the tradable vehicles, or [you belong to] the larger audience, which is seeking low to non-correlating strategies which one can find in the convenience of a mutual fund. So you’re increasingly seeing long/short commodities, long/short currencies, hedge fund-like strategies that are more of a strategic application to diversify your return source away from long-only investing. We see that as the broader audience or opportunity set, because if you talk to advisors, there are those that do have a tactical bent, but the majority of them have never been educated on how to be active managers. They’ve been, really, educated over the years to gather assets, so they would prefer to get their exposure through buy-and-hold types of hedge fund-like strategies. The firm can attend to both of those equations—tactical or strategic applications. As a consequence, our representatives are able to have effective implementation discussions, to problem-solve with advisors, given the opportunities and challenges that they face.

Where are you going from here? What strategies are you looking to introduce?

Egilinsky: We are planning to build out a suite of different types of alternative investment strategies that are either in a mutual fund or exchange traded structure. We would like to have representation within those broader alternative investment categories that are conducive to daily liquidity. This includes hard assets such as currencies, commodities and real estate along with alternative strategies such as global macro, managed futures and hedge fund strategies.

Just one other thing about the firm regarding our core competencies—Dan mentioned that Direxion has been involved with leverage and shorting in the mutual fund and ETF space for quite some time. The ability to apply leverage and shorting are two major components which are necessary when executing most alternative strategies. In addition, there are very few firms with our expertise in the use of derivatives whether inside a mutual fund or ETF. This gives us a competitive advantage over most of our peers who do not have this level of expertise. So when people ask, why Direxion in terms of buy-and-hold alternative strategies? We feel that this is just an extension of what we’ve been doing all along but now for the buy-and-hold investor as well.

You actually do your own trading rather than allocating to sub-advisors?

O’Neill: Historically our strategies have been index based with a few minor exceptions. We prefer indexes for a variety of reasons and so the majority of our alternative strategy products will be indexed. We’ve seen over the last decade a move from purely beta-seeking indices to the development of indexes which are, in some sense, alpha generating or at least…designed to provide performance characteristics which are different than simply traditional indexes….

What we’re doing is, we’re working with firms that create intelligent indexes in these areas…We don’t have a manager making decisions on a daily, weekly or monthly basis, but rather we invest in quantitative/rules-based indices that are verifiable and repeatable over time. It’s an index-based strategy but it seeks performance and has certain intelligence that differentiates it from traditional indexes.

Who is your target client for these new products?

Egilinsky: Most of our clientele are through intermediary distribution channels, consisting primarily of national and regional broker-dealers, independents and registered investment advisors (RIAs). Our target client is a financial advisor who believes in diversification outside of stocks and bonds for their clients. These advisors understand that alternatives can mitigate the risk of their clients’ portfolios and provide an independent source of returns. With the advent of alternative strategy mutual funds, advisors can incorporate alternatives with the majority of their clients.

One of our continued initiatives is working with our distribution partners in educating advisors on the merits of alternative investments.  .     

You have extensive experience running alternative strategies within the mutual fund wrapper, what challenges does this present?

O’Neill: If you think of the mutual funds world, historically, it’s been an equity and fixed-income world. And so, traditional mutual fund families would have great expertise in equities and/or fixed income but they wouldn’t necessarily be comfortable using derivatives of any other kind.

The alternatives world tends to be much more dependent on futures, options and other derivatives. The way you trade commodities or currencies is different than the way you would trade equities and fixed income. Our expertise lends itself to being able to trade areas outside of traditional equities and fixed income.

Cadigan: Historically, financial advisors have typically gotten their exposure to alternatives through black box-like, somewhat opaque instruments that are typically associated with a certain level of illiquidity. We’re providing products in [a] mutual fund structure that provides for tremendous transparency, liquidity, and simplified tax reporting. This is the type of structure that advisors are used to and, quite frankly, their clients, are increasing looking for is a more simplified way to access the types of strategies that Ed mentioned.

And at the end of the day, we’re really trying to solve for two key needs. First, our partner firms are trying to get money off the sidelines and back into investments that have significant potential to generate returns and are not reliant on traditional stock and bond investing. Second, both the boomers and generation X/Y have become increasingly conservative in nature and they’re looking for ways to manage the volatility of their portfolios better. We keep these needs top of mind as we develop and manage the strategies we offer.

As boomers are increasingly moving to the distribution phase of their personal investment cycle, they face some significant challenges. The typical reliance on fixed income to support this phase of their financial plan is precarious given the multi-decade long bull run in fixed income, and rates are low and investors find themselves reaching for yield. Looking at two of the three primary traditional asset groups of cash and bonds (represented by the 10-year treasury) you actually lose money after inflation and taxes. With rates so low you will see an increased utilization of “systematic withdrawal” plans where managing downside risk is critical in volatile and unpredictable markets.

As for the GenX/Y investor, they are clearly not taking on enough “risk” in their portfolios with over 30% in cash because they no longer believe that wealth is created though equity exposure in the traditional sense. They should now be more open to a discussion on how alternatives can help achieve their long term goals.

Direxion is committed to educating advisors on the nuances between various alternative strategies, what role they play in an allocation model and how to have a dialogue with their clients regarding a prudent use of alternatives. Lastly, we stress to advisors that they need to give careful consideration and analysis to determining the proper allocation to alternatives to achieve the desired portfolio characteristics—simply dabbling won’t do it.


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