Start Your Own Personal Hedge Fund (and Pay Yourself the 2 & 20)

by: Joseph L. Shaefer

The “standard” fee arrangement at most hedge funds is 2% of the assets they place at risk for you and 20% of any profits they make. Losses? That’s your problem, though new fees are typically not assessed until / unless you have surpassed the previous “high water mark” – that point at which your assets were at their highest paper value.

So give some hedge fund a million bucks and if they turn it into $1.2 million, they get 2% of $1.2 million and 20% of the $200,000 they made for you. Total fees: $20,000 + $40,000, or $60,000, leaving you with a profit of $140,000, or 14%. Not bad – when everything is sunshine and lollipops.

If, the next year they lose 20%, however, that leaves you with $912,000, less $18,240 in fees, or $893,760. Bottom line, you made 20% then lost 20% -- but thanks to their fees alone, instead of your original $1 million being worth $960,000, for a 4% loss, you’re down $106,240.

Supposedly the smartest kids in the classroom are running your hedge funds so they will always make money. Riiiiggghhhhttt. Look, there are only so many exceptionally bright kids with exceptionally good discipline who are exceptionally lucky in exceptionally good bull markets. As John Kenneth Galbraith observed, “Financial genius is a short memory and a rising market.”

There are as many types of hedge funds as there are clever pitches on how to separate a fool from his money, but there must be a better way. One of the earliest types of hedge fund was a “long/short” hedge fund where the manager would decide to enter, say, the airline sector, and would go long the airline he thought most highly of and short the worst. So he might have gone long Southwest (NYSE:LUV) and shorted US Air (LCC). If you want to establish your own long/short hedge fund, I can suggest two possibly “better ways.”

The Lazy Man’s way is to buy shares of the ProShares Credit Suisse 130/30 ETF (NYSEARCA:CSM) which is a publicly-traded variation of a long/short hedge fund called a 130/30 fund. The portfolio managers of this actively managed ETF use margin to buy 130%, rather than merely 100%, of the positions they believe will do best on the long side, then short for 30% of the combined portfolio those firms’ stocks they believe will do best on the short side, giving them a net net 100% long exposure. If they are among the brightest lights in the night sky, they will earn hedge fund-like returns for you without hedge-fund fees.

The second way intrigues me even more. Sy Harding is a friend and competitor who takes technical analysis as seriously as I take fundamental analysis and his results show that fact. Sy is consistently ranked #1, 2 or 3 for market timing by Timer Digest. He is among the best of the best. Sy’s flagship publication and financial website StreetSmart Report and his free daily market blog are must reading for a great market timer’s take on current markets. But to these two, Sy has added a new, subscription publication, The Street Smart Long & Short Stock Advisory, which has a fine grasp of both technical and fundamental analysis.

I may be somewhat swayed because many of Sy’s technically-selected picks mirror those I’ve chosen based upon fundamentals. In the current issue of Long & Short, for instance, he has four selections on the long side, all of which are in our own favored metals, energy and food & ag sectors. He notes that closed-end fund ASA Limited (NYSE:ASA) is invested 75% in gold mining firms with the rest in platinum, silver and diamond firms, and currently sells at a 6% discount to NAV.

Another of our favorites that Sy profiles is Silver Wheaton (NYSE:SLW), a “royalty override” company. SLW produces no silver itself by drilling for or operating silver mines but rather buys some part of (and sometimes all of) a mine’s future output, thus providing capital to silver miners to do what they do best – find silver – and a steady cash flow to provide SLW investors with what we like best – steady cash flow on what we believe will be an asset that rises in value over time.

In the energy sector, Long & Short recommends Frontier Oil (NYSE:FTO), an operator of complex refineries (“complex” meaning they can process the heavy crude from Canada and elsewhere and turn it into usable products like gasoline and other petroleum products.) Sy notes that FTO has nearly half a billion dollars in cash and sells at just ten times earnings.

Finally for the long side, in the food industry Long & Short features Diamond Foods (NASDAQ:DMND). Sometimes you feel like a nut; sometimes you don’t. When you do, you’ll probably reach for a can of Diamond or Emerald brand nuts. When you don’t, you might instead go for their Pop Secret brand popcorn. In either case, DMND provides snacks that are healthy and inexpensive, two trends that bode well for it whether in recessions or expansions.

The two short recommendations of Long & Short Stock Advisory this issue are Garmin (NASDAQ:GRMN) and Marriott Intl (NYSE:MAR). Sy’s logic for shorting Garmin is that it is the leader in an industry that is about to become as commoditized as personal computers. The “early mover” advantage is gone – with every deeper-pocketed smart phone vendor now incorporating navigation into their phones, it will be difficult for Garmin to “stay relevant.”

As for Marriott, its entry into the timeshare market may prove to be quite the albatross when added to the industry-wide decline in both business and vacation travel for its basic hotel business. Losing $466 million in the 3rd quarter alone, the additional 25,000 rooms Marriott is in the midst of constructing is likely to mean another big anchor on earnings.

So you could construct your own long/short portfolio, buy CSM, or establish an account of your own that mirrors the one Long & Short Stock Advisory already puts together and gives the logic of its recommendations every couple of weeks.

If you are tempted to create your own personal long/short hedge fund, try to remember that the inherent logic of any such portfolio is not that the longs will all rise and the shorts will all fall, no matter the market. Rather, well-selected stocks continuing to make money in favored sectors will likely do better than others even in bad markets, and poorly-run companies or inappropriate-for-the-times business models will do less well even in up markets. The idea of creating a long/short portfolio is somewhat similar to using fixed income for a portion of your portfolio: you want to dampen the effects of market volatility and earn more consistent returns – and perhaps sleep better at night, as well.

There was a time when your stockbroker held all the information about the companies you bought. He or she enjoyed a monopoly on information. You called your broker to find out what a particular stock was trading at or sat in his lobby to watch the magic of the tape showing all (on slow days) buys and sells. By the same token, hedge funds once held a monopoly on the ability to create long/short portfolios without you having to do extensive research and paperwork on your own to establish and maintain the portfolio.

But sitting in a broker’s office just to see the tape is now so yesterday. And with the advent of 130/30 ETFs like CSM or services like Sy Harding’s Long & Short Stock Advisory – both of which I predict will be the first in their category, but not the last – giving “20 & 2” to some guy just because he has an address east of the Hudson will be a sucker’s game, eschewed by those smarter and more knowledgeable.

Full Disclosure: Long CSM, ASA, SLW, & DMND. Short MAR.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless –our Investors Edge ® Growth and Value Portfolio has beaten the S&P 500 for 10 years running but there is no guarantee that we will continue to do so.

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

About this article: