A Value Fund That Uses Hedge-Fund Tools

Oppenheimer Quest Opportunity Value has held its own by betting against mortgage-backed securities.

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After nearly a decade in the hedge-fund world, Emmanuel Ferreira took over as portfolio manager of the Oppenheimer Quest Opportunity Value Fund in 2005—but brought his former profession's tool belt with him. With hedge-fund-like latitude to take both long and short positions (in effect, betting both on and against different investments) in a broad array of equity and fixed-income instruments, the $1.4 billion asset fund has held up relatively well in the current market turmoil. It is down some 3 percent year to date, significantly outperforming the Standard & Poor's 500 index, which has dropped about 8 percent during the same period.

Ferreira recently spoke with U.S. News about the advantages of the fund's flexible approach, why he's sitting on a pile of cash, and the outlook for Grand Theft Auto game maker Take-Two Interactive Software. Excerpts:

How does the Oppenheimer Quest Opportunity Value Fund compare with a hedge fund?

It has the investment flexibility of a hedge fund, but here are the two differences. Because we don't have the fee structure of a hedge fund, we don't have an incentive to take a disproportionate amount of risk. And primarily because of that, we don't use leverage. It's fundamentally a long-term value fund that has the ability to use the full investment flexibility of a hedge fund, because we don't think there is any reason that a common investor shouldn't be able to benefit from those opportunities. How does this flexible approach benefit your shareholders?

I will give you an example. About 18 months ago, when we were looking for opportunities throughout the market, what we noticed was that almost everywhere across the spectrum, risk premiums were extremely low. You just weren't being compensated for the unit of risk that you were taking. One of the places where this was most extreme was in credit spreads in the fixed-income markets. One of the ways that we were able to [play this development], which very few funds—even hedge funds—did, was to short mortgage-backed securities of lower ratings [betting that they would lose value] through a structured product. Needless to say, we've done extremely well on that. What is the current breakdown of your portfolio in terms of equity and fixed-income instruments?

It's basically 70 percent long equities and 20 percent short equities, for net exposure to the equity market of 50 percent. The other net 50 percent is almost all in cash-equivalent securities, mostly very short-duration U.S. treasuries currently yielding about 4 percent. Why do you have such a large percentage of your holdings in cash-equivalent securities?

When I looked at fixed income from a long-term perspective, the yields that you were getting just did not seem to me commensurate with the risk exposure. At the very short end of the yield curve, cash yielded as much as 5.25 percent for us for a time. And when I looked at longer-term opportunities in the fixed-income market—in treasuries—you weren't getting those types of yields, so there was no necessity to take on the incremental risk. Will your fixed-income strategy change in light of the Federal Reserve's rate cuts, which have lowered the federal funds rate from 5.25 to 3 percent?

As the Fed has lowered its rate, what we are getting for short-term paper has come down. And so the relative opportunity set begins to broaden, and we anticipate that if this were to continue that we would deploy some of that capital in the highest, risk-adjusted alternative that we would find. But that may not mean that it's redeployed necessarily in fixed income. It may just mean that we redeploy it in equities. Where are you considering putting that cash to work?

We are actually finding that cash—still today—is the best use. And part of the reason is that what is happening in the financial market and the fixed-income markets, in our opinion, is not necessarily over yet and that there is still a tremendous amount of unknowns. You've seen that reflected in the large financial institutions still in self-preservation mode in that they are really looking out for themselves and they are not extending credit. It's not just that credit standards have tightened, but capacity right now at the bank level to extend credit [has waned.] What that's telling you is that there still seems to be a lot of risk.