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Bright Futures

Up-and-coming fund makes market inefficiencies work for you.

If you took a finance class in business school or college, your professor probably drilled into your head the "efficient markets" theory, which says that it's nearly impossible for an investor to beat the market in the long run. Well, business professors, take note: There is one mutual fund that's almost certain to prove those theorists wrong--Smith Breeden Equity Plus.

How does the fund do it? Its strategy is complicated, but in a nutshell, it takes advantage of market inefficiencies. The fund buys futures contracts that mimic the performance of the Standard & Poor (S&P) 500, an index of the 500 largest U.S. companies' stocks. The advantage of buying futures contracts rather than the individual stocks in the index is that futures don't require the buyer to pay the full amount owed until three months after the purchase date. This means a buyer has three months to invest that money elsewhere.

When sellers price futures contracts, they assume buyers will put their money in three-month Treasury bills. This is where the inefficiency arises. Smith Breeden doesn't invest its money in three-month Treasuries but rather in longer-term mortgage-backed bonds. Such bonds almost always pay a higher interest rate than three-month Treasuries. The difference in interest rates is what the fund earns in addition to the index's return. For example, if the index goes up 15 percent one year and the difference between three-month rates and longer-term mortgage rates is 3 percent, then the fund will gain 18 percent. When 1 percent in expenses is subtracted, the fund's 17 percent gain still beats the index's 15 percent return.

This strategy involves only a little extra risk beyond the normal risk you would take in buying the stocks in the index. Because the fund uses Treasury futures to protect its mortgages from changes in interest rates, the main risk is that rates on Treasury bonds and rates on mortgages will move in opposite directions. Although this can occur over short time periods, it virtually never happens over longer periods.

Of the 475 funds in Morningstar's database with 15-year records, only 32 have managed to beat the S&P over that period. Smith Breeden Equity Plus' strategy seems to indicate that 11 years from now, it will belong to a similarly select group of funds.

But how does the fund stack up now? It's been around for about four years, and its performance so far has met early expectations: Its return since start-up beats the S&P's by 1.66 percent per year.

Smith Breeden has two other assets that most rival funds lack: Its expenses are fairly low, and because its strategy is highly quantitative, management changes won't seriously affect performance.

The fund has only one drawback. Because it has to roll over its futures contracts, it realizes capital gains fairly quickly. Thus, it's not very tax efficient. For that reason, investors should only own shares of it in a tax-deferred account, such as an Individual Retirement Account or a Keogh plan. The fund would also make an excellent choice for your business's 401(k) plan.

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This article was originally published in the June 1997 print edition of Entrepreneur with the headline: Bright Futures.

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