Chicago, IL

Thursday, February 14, 2008

MY FAVORITE HEDGE FUND

By Janet Tavakoli, president of Tavakoli Structured Finance

I run a hedge fund. Given the low barriers to entry in the hedge fund world, that's a fairly easy thing to declare. As for my strategy, it's a proprietary secret. Domicile? My fund is chiefly located onshore in the U.S. At the moment it is unleveraged, but, sorry, you are not entitled to even that much information. There is no waiting period for withdrawing an investment from the fund. My returns after all expenses and taxes are enviable by any hedge fund standard, and I don't disclose them.

You won't find my fund covered in the financial press, because it has no outside investors. That's because what I'm referring to is not a financial product that I am marketing to outside money, but my personal investment portfolio.

Not to boast, but actual hedge funds haven't given me much competition. They are experiencing their worst period since 1998, with approximately 50% of them showing losses. Most of the hedge funds that aren't showing losses are showing returns in the low single digits.

THOSE CONFOUND COMPOUND FEES

Part of the reason my personal portfolio returns are so healthy is that unlike actual hedge funds, I reinvest my "fees." I don't withdraw 2% of the value of my portfolio, nor do I gouge myself for 20% of the upside. I also don't charge myself administrative fees of around 0.5% per annum, and I don't pay for research using "soft dollars" paid to investment banks by marking up trades at the expense of my investment portfolio. This brings up a pointed question: If I wouldn't take out fees for my own use, why would I pay them to a manager who has a mediocre track record? Yet that is what many investors are doing.

Many hedge funds are small, undercapitalized shops that hang a shingle. If a fund rents offices, purchases computers, phone systems, reporting systems, trading systems, hires staff and retains accountants, it may not break even on the 2% annual fee unless it has several hundred million dollars under management. The trouble is, it won't have the portfolio for long if its results aren't good. The temptation is to lever up just for the sake of making a lucky bet so that the 20% fee on the upside kicks in to keep the fund solvent. Can you trust that leverage is employed for the right reasons when the fund is feeling a cash crunch? Is it any wonder they want a waiting period to return your money?

Given that hedge funds have proliferated like mushrooms, some are bound to make lucky bets and appear to be doing well, even if they have a flawed strategy or no strategy at all. Yet most of them can't beat the ongoing performance of low-cost, well-managed equity mutual funds. Furthermore, even hedge funds with the right critical mass of funds under management and a good strategy may have a bad year. Finding the right hedge fund is like finding a truffle.

Investors may find that fund of funds managers are no help. Instead of sniffing out truffles, they are often merely fee hogs. A large Chicago-based fund of funds manager recently observed that out of the universe of hedge funds, only about 25 met his standard for investment. He looks for a critical mass of employees, comprehensible strategies, and well developed back office operations. But he's having his own infrastructure problems, since his staff can't keep up with the new structured credit products that the hedge funds embraced. This lack of expertise comes at a high price. On top of hedge fund fees, many funds of funds charge a 2.5% load, more than 3% in annual expanses, and ask for 25% of the upside. Instead of compound interest, you get compound fees.

THE VIRTUE OF CRITICAL MASS

Like Fed Chairman Alan Greenspan I am glad hedge funds exist. But what makes it worthwhile to invest in one? I don't currently invest in actual hedge funds, but if I did, I'd look for a hedge fund that can do what I find it difficult to do on my own. A hedge funds that has a portfolio critical mass, has hired smart people, has articulated strategies, has the flexibility to uncover new strategies and can discuss the track record for its strategies without revealing trade secrets (good or bad, since off years will happen) is a good bet.

An established hedge fund can study thousands of technical charts to look for a market anomaly. It can amass the funds to make a run at the equity of an undervalued company (and take the inevitable regulatory heat). It can scan the market for convertible arbitrage potential. It can take large loan positions in interesting ventures. It has "depth on the bench" to keep the bases of a risky strategy covered when a key person is out ill or on vacation.

Small hedge funds that have a "patented" investment strategy or that feel they have a "proprietary" model that only they, the smartest guys in the room, have discovered are probably a bad bet. What are they doing that you can't replicate yourself? If hedge funds are to be successful in the long run, they need the flexibility to alter course.

There are a few tiny proprietary-trading funds that have experienced short-term success. But as one of my friends, who runs a private proprietary trading fund, points out, the fund has a single strategy, and it must remain small, under US$100 million. If he executed his trades in large size, it would get noticed and the opportunity would disappear. The fund is closed to any investors except the principals. When their proprietary trade runs its course, they'll open up the fund to outside investors who will enjoy the subsequent mediocre returns.

The average accredited investor benefits from a hedge fund that has attracted the portfolio size and human resources to do what the investor can't do on his own. That usually doesn't involve a new gimmick; it just involves a lot of hard-working smart people employing sound financial principles with sufficient pooled funds to make a difference.

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting and expert-witness services. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business, and she authored a pair of books on the credit markets that are the global bestsellers in their respective fields: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 2nd edition, 2001) and Collateralized Debt Obligations & Structured Finance (John Wiley & Sons, 2003

First Published in the Yearbook and later in LIPPER HedgeWorld in May 2005.

Janet Tavakoli

President

Tavakoli Structured Finance, Inc.

Chicago, IL

312-540-0243

First Url: Tavakoli Structured Finance, Inc.

Second Url: My Favorite Hedge Fund