Online Extra: Hedge Funds: Rolling On?

Geared mainly to the ultrarich, they've held up well and may keep doing so

It's starting to become monotonous -- not that anyone is complaining. For four years in a row, during bull and bear markets alike, hedge funds have beaten the overall market by a wide margin. The numbers for 2002 demonstrated that the hedgies have fulfilled one of their traditional goals -- preserving investor capital.

Through Nov. 30, the average hedge fund fell just 2.5% as the Standard & Poor's 500-stock index plummeted 18%, according to the Hennesee Hedge Fund Index. And with markets continuing to linger in sick bay, hedge funds are likely to outperform again in 2003.

Because of their ability to bet on market declines, hedge funds thrive during distressed times. The best hedge-fund managers advance well into positive territory by canny stock-picking and short-selling. For example, Bessent Capital, run by former Soros Fund Management stock-picker Scott Bessent, gaineds 14% through Nov. 30 by seeking out opportunities where other investors fear to tread.

A CHANGING GAME.

  Careful timing was the key. "We were short Tyco (TYC ). Now we're long," says Bessent. "One of George Soros' great points was, 'We don't try to play the game better. We try to figure out when the game has changed.'"

Hedge-fund investors face the same challenge. Hot fund sectors often turn ice-cold after a period of good performance. Indeed, funds specializing in short-selling, the No.1 fund category in 2002, are notoriously volatile. In 2003, the spate of corporate bankruptcies may well boost funds that focus on distressed securities, which were essentially flat this year. Short funds may also defy their history and remain strong if the downturn continues.

Since hedge funds are structured as partnerships, legal strictures require that investors be "accredited" -- that is, millionaires. But a mere million in the bank, or mattress, won't do. To take a sensible position in hedge funds, one must be a multimillionaire. "Diversifying adequately requires 10 managers, and that can mean $10 million," notes Barry Colvin, chief operating officer of Tremont Advisers Inc., a hedge-fund consulting group.

FEES PLUS FEES.

  However, single-digit millionaires have viable alternatives. One is the hedge fund of funds, which invests in other hedge funds. Some of these specialize in specific fund categories, with emerging-market funds-of-funds turning in solid results in 2002.

The year's top fund-of-fund, the Gems Russia Fund, up 20% through Oct. 31, is a case in point. You still have to be a millionaire to invest in one of these. But since minimum investment investments are as little as $25,000, a newly minted millionaire can put a few hundred thousand bucks in one of these funds and still get diversification.

Alas, funds of funds pile fees on top of fees. Colvin notes that they commonly take 1% of assets plus a performance fee of 10% or so of profits. All that is tacked on to the 15% performance fees and 1% or higher asset charge that hedge funds already impose.

FOR ORDINARY FOLKS.

  Even so, funds of funds performed respectably this year and should continue to be strong in the year ahead. The Center for International Securities & Derivatives Markets, a research center at the University of Massachusetts, says through Oct. 31, funds of funds lost 0.2% after fees, vs. a 22% decline in the S&P and a 4.8% slide in hedge funds tracked by Hennessee Group.

Another potentially attractive alternative to hedge funds -- open even to thousandaires -- are mutual funds that invest like hedge funds. These go by various names, indluding "long-short" funds and "market-neutral" funds. Unlike most ordinary mutual funds, they're allowed to short stocks. Though viewed as declassé by the hedgies, some of these funds -- such as the AXA Rosenberg Value Market Neutral fund, up 38% this year -- have performed as well as the best hedge funds.

Lipper Analytical Services says long-short funds and market-neutral funds fell 3.8% through Dec. 5 -- only slightly underperforming hedge funds. And some of them have initial investments of as little as $500.

These funds are short-term plays -- foul-weather friends, so to speak. Unlike hedge funds, they tend to slump during upturns. So as soon as the gloom lifts, don't be sentimental. Dump 'em.

By Gary Weiss in New York

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