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Wednesday, December 15, 2004

Wall Street Journal flashes yellow light on hedge funds 
Here's the URL. (It requires a subscription)

http://online.wsj.com/article/0,,SB110306065772900022,00.html?mod=money%5Fpage%5Fleft%5Fhs


Hedge funds have been one of the hottest investment vehicles during recent years, given their record of posting often impressive gains even in down markets. But a growing chorus of Wall Street advisers are cautioning individual investors to pare back their exposure to the funds. Already, returns are diminishing as a growing number of hedge funds chase the same investments and strategies.

The problems include too much money chasing the same opportunities, a growing shortage of top managers, high fees and a tougher performance environment. In addition, the returns reported by hedge funds may be inflated, according to recent academic studies.

Already, performance is faltering. According to an index of hedge funds monitored by Hedge Fund Research Inc., a Chicago hedge-fund research firm, hedge funds gained 19.6% in 2003 and 7.1% year-to-date through November. Meanwhile, the Standard & Poor's 500-stock index posted total returns of 28.7% and 7.2% for the same periods, according to Ibbotson Associates.


Some super reporting from Jane Kim.

Yeah, it feels good to be ahead of the Journal.

Here's the thing: hedge funds simply CANNOT sustain fees of 2% of assets/year, PLUS 20% of any profits, and expect to outperform the asset classes they invest in over long periods of time.

Most of the hot money is using them wrong. Hedge funds shouldn't be used in hopes of getting rich. Hedge funds are best used to DECREASE risk, and prevent yourself, once rich, from getting poor.

THAT'S WHY THEY CALL THEM "HEDGE FUNDS," PEOPLE!

There is certainly value to, say, identifying a stock fund with a very low correlation to the S&P 500, but still has some healthy potential for growth. And lots of analysts are predicting an upswing in merger and acquisition activity in the next couple of years. If hedge funds avoid a total collapse, that's going to be a big reason why. Hedgies love M/A opportunities, and the pricing inefficiencies they bring.

The thing is, a lot of hedge funds are going to be forced into the M/A world, just because there's not much else to do with the buckets of stupid money coming in. So a lot of the usual inefficiencies in the M/A market are going to be bid away, and profits will become more and more in line with the overall stock market.

Meanwhile, hedge fund fees will remain the same.

Further, there are still ways the retail investor can get involved in some of the stock-based hedging strategies. I like the Merger Fund. It's been pretty successful at delivering smooth, consistent returns through merger arbitrage. But it's closed to new investors, and has been for quite a while. Which tells me that the manager doesn't think he can find profitable opportunities for more than modest amounts of money. Otherwise, he'd reopen the fund.

There's another fund called the Arbitrage Fund that looks promising, although it doesn't have a track record yet in a bull market. But that, too, is closed to new investors. (See a pattern here?)

So the pure arbitrage/merger play is getting difficult to find already, even with some analysts predicting profitable opportunities in the future.

Don't watch what money managers and analysts SAY. They're a bunch of cheating scoundrels. Watch what they DO.

If you want to take the edge off of the volatility of the S&P dominated portfolio, though, you can still do it through one of several "Special Situations" funds. UK readers: Fidelity offers one. Value Line offers one in the US. Just google "Special situations" and "mutual funds" and you'll get a series of ideas.

I don't have time to look at each one, but here's what I'd look for:

• Manager tenure of several years. So you know the fund's track record is HIS track record.

• A low R-squared relative to the S&P 500 (you can get that on Morningstar.com, under "risk measures." I'd look for an R-squared, or correlation coefficient, of 0.5 or less.

• Reasonable expenses. (All these special situation funds are expensive as hell - their investment approach is extremely research intensive. But if you can come in under 1.75% or so, you've got a leg up on the hedgies already.)

Me? I'll probably skip the special situations funds for now, anyway, and just stick with my little portfolio of mostly index funds with Vanguard, and just focus on asset allocation

I like to keep things real simple.

Splash, out

Jason






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