Hedging Strategies: How Hedge Fund Returns Go Mainstream
by Alexander Green, Chairman, Investment U
Louis Basenese, Advisory Panelist
Wednesday, August 22, 2007: Issue #704
For years, hedge funds have been the Rolls-Royce of investments – exclusive, and way out of reach for most of us. Well-heeled investors, though, have been piling in capital, helping this often mysterious asset class raise more than $1.5 trillion in record time.
Fortunately, times are changing. And even in spite of the recent blowups, there’s reason for investors to use different hedging strategies with their portfolios
According to one of my colleagues, Louis Basenese, you no longer need to be an accredited investor or pay high minimums, management and performance fees to enjoy hedge fund-like returns.
In fact, Louis edits a fast-paced trading service, which is dedicated to providing everyday investors with similar opportunities, without the hassle and expense.
I recently sat down with Louis to ask him about the allure of hedge funds, the secret to their success and, of course, how you can turn your very own brokerage account into a personal hedge fund. Here’s what he had to say…
The Obsession with Hedge Funds
Alexander Green: First off, what’s behind the obsession with hedge funds?
Louis Basenese: In one word, performance.
As investors, we’re all looking to maximize profitability. And historically speaking, no other asset class has done a better job of doing so than hedge funds.
The classic example, of course, is the Quantum Fund, founded by Jim Rogers and George Soros. In its first 10 years, it returned a whopping 3,365% (equivalent to 42.5% per year). And that impressive performance extended well beyond the early years.
In fact, if you invested a measly $1,000 when the fund started in 1969 and let it ride until 2000, you would have been $4 million richer.
You can see why this is the most often mentioned hedge fund. But plenty of others have delivered similarly impressive returns, including funds led by Edward Lampert, Steven A. Cohen and David Einhorn.
How Hedge Funds Turn Such Impressive Performances
Alexander Green: How are hedge funds able to turn in such impressive performances?
Louis Basenese: It’s simple, really. First, they’re completely flexible.
By that I mean hedge fund managers search the world over for investment opportunities. One week they could be buying emerging markets. The next it could be commodities, or hot IPOs. It doesn’t matter.
Unlike your typical mutual fund, a hedge fund is not limited by a prospectus. Accordingly, the universe of available investments, and the chances for profitability, are significantly higher.
The second factor behind hedge fund success is their willingness to trade short. As we all know (especially now), markets don’t just go up. They go down, and sometimes violently.
This willingness to trade short obviously increases the universe of available investments. But it also reduces risk as managers can hedge their long picks.
For instance, if a long investment turns south, the total impact on the portfolio can be offset by a carefully selected short investment that will be increasing in value at the same time. This works in reverse, too – losses in any short positions can be offset by gains in long positions.
In the end, the biggest benefit from trading both sides of the market is that it allows hedge funds to profit in both up and down markets.
Duplicating Hedge Fund Strategies in Your Brokerage Account
Alexander Green: How do you go about duplicating hedge fund strategies and success in your own brokerage account?
Louis Basenese: First and foremost, you have to be willing to play both sides of the market, long and short. And in today’s world, with ETFs and inverse funds, you can even do so without a margin account.
Second, you need to be fluid with your investment focus. Holding times will vary based on market conditions. Sometimes you will hold an investment for months to benefit from an emerging macro trend. Other times, your holding period could only be a couple of days to take advantage of a market anomaly.
After that, it becomes a matter of identifying compelling investments. And I go about that in two distinct ways
First, I selectively copy the trades of actual hedge funds.
On a daily basis, I monitor filings of SEC forms 13-G and 13-D, which indicate when a fund has acquired a 5% (or more) interest in a particular stock. This is a significant enough of a stake to suggest the manager believes the opportunity is particularly compelling.
Whether or not I recommend the particular stock depends on my own fundamental analysis and the hedge fund. I give more weight to hedge funds that have demonstrated consistent success in picking winners.
Second, I embrace the adage that “the trend is our friend.”
I constantly scour all areas of the market to find emerging opportunities. Whether it’s a sector that’s coming under heavy selling pressure or an individual stock that is enjoying strong momentum. It doesn’t matter.
At all times, we remain completely flexible and invest only where the opportunities exist not where we think they might be several weeks or months from now.
Part of this process involves confirming hedge funds are hot on the same opportunities by reaching out to my contacts on Wall Street.
The Pros and Cons of Using a Hedging Approach
Alexander Green: Is it an advantage or disadvantage for someone using this hedging approach in their own account?
Louis Basenese: It’s a definite advantage. Again, by going both long and short in a single account, you dramatically increase the universe of available investments and reduce risk. And this is what the first hedge funds set out to do.
Sure, there are some non-public opportunities (like venture capital and private equity) that we can’t access directly like some hedge funds. But that minor limitation doesn’t come close to outweighing the benefits.
Remember, by trading like a hedge fund in your own account, you don’t have to worry about high minimums, 2% to 4% management fees, 20% to 40% performance fees or a lack of liquidity.
And in my opinion, an investment strategy that provides you with low expenses, ultimate flexibility in selecting potential investments and instant liquidity can’t be beat.
Recent Market Volatility and Short-Term Trading
Alexander Green: Given the recent market volatility, how have you changed your approach in a short-term trading service like this?
Louis Basenese: We’re staying much more fluid and reactive. And, in turn, our investment timeframes have become shorter.
For instance, on August 6, it became obvious that volatility was going to be the norm for the time being. Accordingly, I recommended subscribers take a short position in the Diamonds (AMEX: DIA), which tracks the performance of the DOW, as insurance against a steep selloff.
We all know what happened next. And just nine trading days later, subscribers were able to book a quick 71% options gain. Meanwhile, most of Wall Street was licking some deep wounds.
At the same time, I’ve been scanning for bargains on the long side.
As of this writing, I’ve been considering entries into Lindsay Corporation (NYSE: LNN) and Perfect World Corp. (Nasdaq: PWRD). Both have become particularly attractive, given the selloff and their respective growth opportunities.
I’m also considering Huntsman Corp. (NYSE: HUN) and the Dow Jones Global Titans Index Fund (AMEX: DGT).
This shortlist of potential trades alone speaks to the diversity of opportunities we consider.
Lindsay manufactures irrigation equipment for the agricultural industry. Perfect World is a recent China-based IPO in the online gaming space. Huntsman is a takeover arbitrage opportunity, with a practically guaranteed double-digit upside. And DGT is a broad-based way to participate in the long overdue out-performance of large-cap growth, which many hedge funds are positioning for as we speak.
As you can see, when you invest like a hedge fund, there is never a shortage of opportunities.
Alexander Green: Do the recent fund blow-ups at Bear Stearns and BNP Paribas change what you’re doing? Or your expectations for the future?
Louis Basenese: Not one bit. Here’s why
The blowups you mentioned were a result of three factors – too much leverage, too concentrated of a portfolio and a lack of liquidity.
This time, the particular culprit was subprime. Last year, it was natural gas with Amaranth. And inevitably, in the months ahead, there will be more blowups because of the same underlying reasons.
But this is something we never have to worry about. We never take on too much leverage, too concentrated of a position, or invest in any illiquid securities. In the end, our outlook is decidedly positive, despite all the bad news coming out of the hedge fund industry.
Alexander Green: Thanks, Lou.
Louis Basenese: My pleasure
Today’s Investment U Crib Sheet
As the volatility persists on Wall Street, now’s as good a time as ever to review your risk profile.
One way to reduce your overall portfolio risk is to consider investing in less economically sensitive stocks – like utilities, pharmaceutical companies, food companies and defense contractors. Another way is to reduce your exposure to small-cap stocks, which get hurt more in a down market.
For 4 more risk-reduction tips, see Investment U #682 Financial Risk Management: Six Ways to Reduce Your Investing Risk and When to Re-Enter A Stock After You’ve Stopped Out.
Related Investment U Articles:
- How to Track Sidelined Cash As it Moves Back into the Markets
- Merger Arbitrage Funds: When Market Volatility Triggers a Panic, Buy These Investments…
- Does Low Volatility Put Your Portfolio At Risk?
- Timing the Market: If Only You Knew What Mark Hulbert Knows…
- Treasury Funds: Get These Time Bombs Out of Your Portfolio
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Alexander Green is the Chief Investment Strategist of Investment U. A Wall Street veteran, he has more than 20 years of experience as a research analyst, investment advisor, financial writer and portfolio manager.
In addition to being the foremost expert on small-cap stocks, Louis is also well versed in special situations including IPOs, mergers and acquisitions, spinoffs and contrarian investments. His commentary has been featured in several media outlets, including MarketWatch. And he's also a top-rated speaker at financial conferences throughout the country. 
