Before writing about hedge funds, I'd like to describe two ingenious methods that stock analysts have used to "add alpha" – to do abnormally well in the stock market.
1. How much would its new iPhone benefit Apple?
Eric Platt, an analyst at iSuppli, bought one of the first iPhones. And proceeded to take it apart. Now, the phone's original price was $599; the components, Platt calculated, cost a mere $265.83. The gross margin was far higher than most analysts' estimates. When Platt published his report, Apple's stock price jumped.
2. Would the iPhone become popular overseas?
Kathryn Huberty, a Morgan Stanley analyst, noted in March 2008 that Steve Jobs, Apple's chief executive, had just spent $550,000 on air travel – far more than he usually spent. Her conclusion: "...Apple is preparing for meaningful product launches." Her conclusion seemed warranted: Over the next four months, Apple's stock soared 33.9 percent – versus 0.9 percent for the Nasdaq.
These two instances are reported in the fine new book, "Hedge Fund Alpha," edited by John M. Longo and published by World Scientific (2009). They demonstrate how intense, imaginative research can add alpha. (The book's cover, by the way, shows money coming out of a flower – I think. So that's where money really grows!)
Longo is clinical associate professor of finance at the Rutgers Business School and chairman of the investment committee at the MDE Group, an investment company in Morristown.
He is also a proponent of hedge funds, and helps run a fund-of-hedge-funds at MDE, a fund open only to MDE clients (who have a minimum of $1 million under management).
But, I remonstrated; didn't hedge funds disgrace themselves in 2008? Aren't they coming under more regulation? Didn't Long Term Capital Management, which imploded, tarnish the image of hedge funds? As did a dastardly Ponzi imitator named Madoff? Isn't the bloom off the rose?
Hedge funds did poorly in 2008, Longo grants, losing around 20 percent, but a great many hedge funds don't hedge a thing. They don't even sell stocks short. A good many of these pseudo-hedge funds – maybe a thousand – have recently closed up shop. Their problems: too much leveraging (borrowing), over-concentration, lack of liquidity.
But in 2009 hedge funds did reasonably well, Longo points out. In a high-flying market, he says, you don't expect a true hedge fund to do exceptionally well. Because it's hedging its bets.
Hedge funds became popular largely due to the bear market of 2000-2002. In 2002, for instance, hedge funds in general gained 3.04 percent; the S&P 500 was off 22.10 percent, the Russell 1000 growth was off 27.88 percent.
Exactly what is a hedge fund? A definition that Longo gives: a fund that charges an incentive fee as well as an asset-based fee. (I would suggest that they also are more speculative ... have more tools in their toolbox ... and are targeted toward wealthier clients.)
And while traditional mutual funds are becoming more like hedge funds, Longo notes that they are chary in their use of leverage, they don't charge an incentive fee, and they usually have lower expenses.
Still, hedge funds will surely become more transparent and less expensive, and their managers will face higher taxes.
They should also become more popular, Longo believes, because the best and the brightest will be attracted to them – for the really big money. In 2007, one hedge-fund manager, John Paulson, earned $3.7 billion (Almost as much as NewJerseyNewsroom.com pays me for writing these columns).
Another reason hedge funds should become more popular: hedging activity in such markets as China, Russia, Brazil, and India – which are covered in the book.
Interested in buying a hedge fund? Longo's advice: "Don't invest unless you know what it's doing."
One hedge fund targeted to ordinary investors that Longo mentions is TFS Market Neutral, a long-short fund, which yours truly happens to own shares of. I bought them in 2008, and they've just about broken even since. Morningstar gives the fund its highest rating, and calls it "a good diversifier." Minimum is $5,000. Another possibility is Hussman Strategic Growth, which gets only three Morningstars. Minimum is $1,000.
