Hedge funds for Average Joes? Yes, They Do Exist

July 12, 2009— -- Irish-American author J.P. Donleavy, in his wonderful book The Unexpurgated Code, details the difficulties of social climbing in England if you are not to the manor born. People who try to invest in hedge funds will find themselves having conversations similar to those in the book:

You:Hey, what a great hedge fund! Can I invest?

Hedge fund:No.

You:Gee, what a bunch of snobs. I've got money, and that's good enough for me.

Hedge fund:Yes, but it's not good enough for us.

Some mutual funds use similar investment strategies as hedge funds, the freewheeling, lightly regulated investment pools for the ultra-rich. Should you invest in hedge-like mutual funds? Possibly. But remember that many hedge-fund strategies depend on brilliant hedge-fund managers — many of whom are already running hedge funds.

The basic idea of a hedge fund is reasonably simple, however. A hedge is a kind of insurance bet, one that pays off if your other strategies go wrong. A hedge fund might take 80% of its portfolio and bet that certain stocks will rise, called "going long." It might take 20% of the portfolio and bet that certain stocks will fall, called "going short." In theory, if the stock market goes sour, your short positions will offset some of the losses in your long positions.

In recent years, however, the term "hedge fund" has come to mean any aggressive investment pool aimed at wealthy, sophisticated investors. Some hedge funds can invest in pretty much anything they like: currencies, futures, bonds, stocks, yaks. Others specialize in specific strategies, such as merger arbitrage, which involves simultaneously going long and short on the stocks of companies involved in an acquisition.

The fund industry has rolled out two categories of funds that borrow from the hedge-fund book:

•Market-neutral funds. These funds roughly match their long and short positions, so that their return depends on stock selection, rather than the market's broad movements. These funds have gained 0.5% this year, vs. -1.2% for the Standard & Poor's 500-stock index.

•Long/short funds. These funds buy the stocks they like and short the stocks they hate, in the hopes of getting good returns from both rising and falling stocks. Unlike market-neutral funds, they can be biased toward bullishness or bearishness. The funds have fallen 0.6% this year.

In both categories, there's a wide divergence between the best and worst funds, so it makes sense to choose your fund carefully. For example, one of the top-performing market-neutral funds the past three years is the Arbitrage fund ARBNX, which specializes in merger arbitrage. It's up 15.9% the past five years.

The worst-performing market-neutral fund, the Beta Hedged Strategy fund, has fallen 23% the past three years. That's a bit better than the S&P 500's 29% drop the same period but still disappointing.

Long/short funds are more volatile, and the difference between the best and worst funds is even deeper. Caldwell & Orkin Market Opportunity, the top fund for the past three years, has soared 41%. The worst, Old Mutual Analytic, has fallen 37%.

If you're looking for a fund that doesn't have large ups and downs but tends to make money consistently, then the Arbitrage fund may be for you. When done correctly, merger arbitrage is a relatively safe investment style, and the fund seems to do it well.

If you're looking for a more volatile fund, but one that is decent in making money in hard times, Caldwell & Orkin Market Opportunity is a good bet. The fund has been in the business for 16 years now, and manager Michael Orkin worried about the long-term future of the stock market. "In the intermediate term, I'm not as pessimistic, because so much liquidity — fiscal and monetary — has been poured into the system," he says.

Both market-neutral and long/short funds seem to be dominated by a few very good funds. There's a reason for that, says Mike Shinnick, manager of Wasatch 1st Source Long/Short fund. "Most mutual fund managers are trained to look for longs," Shinnick says. "When you have that mind-set, it's difficult to run a long/short fund."

For most of us, long/short funds or market-neutral funds are the closest we'll ever come to being hedge-fund investors. Top-performing funds, such as Arbitrage, Caldwell & Orkin, and Wasatch seem like the best of the lot, and worth a look. The rest just aren't good enough.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com. Twitter: www.twitter.com/johnwaggoner.