Wednesday, September 12, 2007

What Is a Hedge Fund Anyway - And Could It Be Right For Me?

There was a recent conversation that we overheard during a break at a seminar on current market trends that we ran in Long Island. With the popularity of hedge funds and hedge fund of funds, it is no surprise that their numbers have been growing at an explosive rate. By the end of 1999, it was estimated that about 4,000 hedge funds existed. In 2005, although just an estimate, that number has doubled to roughly 8,000.

The conversation that we witnessed went something like the following (please note, in the spirit of full disclosure, we point out that our firm is the General Partner of a hedge fund of funds):

Dont you have to invest at least a couple of million bucks in order to be able to join in on the action? asked Rob. Thats the way it used to be, but the vast majority will accept investments much lower than that! said Dave and Mary, the one were invested in has a $250,000 minimum, and many others keep the same standard.

But arent these types of things risky? asked Rob. That depends on how you categorize risk, responded Dave, when Mary and I were looking into investing this money, we found that similar to mutual funds and stocks, risk varies enormously among the different hedge fund strategies, and you can bet that theres a lot of strategies to choose from. Because of our lack of experience, we felt as if we were venturing into unchartered territory, so we wanted to position ourselves to have substantially lower risk with our investment, and thats why Mary and I decided to go with a hedge fund of funds.

Oh no, now Im really confused. Are you serious when you say that theres more than just a handful of optionsyou mean that I can pick a fund to invest in based on the type of strategy it uses, or I can go with that other fund of something or other you mentioned, said Rob. Yes, Mary said, Dave and I chose to invest in a hedge fund of funds because it significantly reduces individual fund and manager risk. As a matter of fact, we heard that the minimums were much higher on the individual manager side, and we even ran into funds that were closed to investments from us. Dave and I were so frustrated with all the decisions that had to be made, so we decided it was best to have someone knowledgeable and qualified to make the decisions for us. Not only do we gain the expertise of the fund of funds manager, but we get to reap the benefits of having multiple individual hedge fund managers working in similar or different styles, each with various strengths, and have that all pooled together within a single investment. Not too bad, huh?

Yes, but I still see a lot of risk in investing in hedge funds or fund of funds in general. Dont you guys worry about losing money? asked Rob.

Dave answered, Yah, of course we do. Nobody wants to lose money. But the way we look at it is that investing is not for the faint of heart. You have to be willing to go through the tough periods and weather the storms in order to do well. Our goal is to try to reduce the volatility in order to make that trip a little smoother. I dont know about you, but Mary and I never had an investment that went straight up.

Of course Rob asked, So you think that I should put money with a fund of funds too?

Mary answered back, quite rationally, No one can make that final decision other than you Rob. There are lots of alternative investments out there that you can get involved in. Whether youre thinking about real estate, hedge funds, or fund of funds, the most important thing is to take a look at your own financial situation and see if the potential investment youre considering can fit into your portfolio. The bottom line for Dave and I was that we had money invested in stocks, bonds, mutual funds, and even a couple of annuities, but we didnt have an alternative investment that would act as a hedge against potential market slides. After a lot of looking into, we decided that a fund of funds would be the most fitting for us and provide the best long-term strategy that we were looking for, so we narrowed our search and chose the one we felt most confident with.

Wow, ok, I guess Ive got some homework to do, smiled back Rob.

Rob continued, So, can we back up here for a minute and discuss what a hedge fund even is exactly?

Well, from the way I understand it, answered Dave, it all started around when I was born in the late forties. It was this guy Jones who started the whole thing.

Mary interrupted, Youre so bad with names Dave! The guys name is Alfred Winslow Jones and he went to Harvard back in the 1920s and received a doctorate from Columbia in the early 1940s before raising some money and forming what later became known as the very first hedge fund.

Dave added, What was so special about this fund that Jones created was the fact that he was hedging his portfolio. From my understanding, what this boils down to is that in addition to buying stock and betting that it goes up (going long), he would try to take advantage of drops in stock prices by placing bets that prices will go down (short selling), and thereby potentially making money regardless of what the market does. He also used leverage (borrowed money) to try to increase gains.

Ok, now you guys are starting to intimidate me, said Rob. You make a really good team by the way. Tell me more.

Mary answered, Basically, Jones said it best. He said that short selling and leverage are speculative tools used for conservative purposes. This guy basically owned this space until an article came out in Fortune magazine in 1966 entitled The Jones that nobody can keep up with The article compared his strategy and returns with some of the best mutual funds out there, and Jones fund outperformed the top mutual fund by such a huge percentage that soon after, many investors were trying to clone this new and unique investment strategy, including the likes of George Soros, Michael Steinhardt, and Warren Buffet.

Don Conrad is president of Conrad Capital Management, an independent registered investment advisor, in Melville, New York. Can be reached by phone: (631) 439-7878 or email:

Don started his career in the late 1970s at a nationally recognized mutual fund company and was recruited after three years by E.F. Hutton Company to work in the consumer retail division. During his thirteen-year tenure there, he spent two years specializing in and trading the 30-year treasury bond. For the last five years, he served as a senior vice president focusing his efforts in the Consulting Services division, maintaining offices in both Long Island and Manhattan.

In 1993, he was recruited by PaineWebber as a Senior Vice President in the consumer retail division. In addition to managing his clients assets, he was asked by senior management to conduct a nationwide tour to train financial consultants in the Consulting Services division. Don also made a video on the use of advanced technology in the financial services industry. This video was distributed to PaineWebber offices internationally.

After almost five years at PaineWebber, Don decided to pursue his dream by starting Conrad Capital Management in order to offer his clients more choices and flexibility.