How to beat hedge funds

Good news for the average investor: You can do better than the über-rich.

By Jason Zweig, Money Magazine senior writer

(Money Magazine) -- For the past several years, the hottest thing on Wall Street has been mostly off-limits to Main Street: hedge funds.

These portfolios for the rich - you need not apply unless you earn at least $200,000 a year or have a net worth of $1 million or more - are barely regulated, don't have to say what they own and are not obligated to let you cash out whenever you want.

jason_zweig_inv.03.jpg
mill_top_widget.gif

They can invest in anything from stock in Microsoft to uncollectible credit-card bills in Kazakhstan. Hedge funds can also profit by betting that investments will go down, not just up (a tactic called short-selling). Thus they often thrive in bear markets, when falling prices make this technique pay off.

From 2000 through 2002, as the U.S. stock market sank 37 percent, the average hedge fund gained 21.5 percent, according to the Barclay Group.

The result was a mad dash for the entrance. Roughly 9,000 hedge funds now manage more than $1.2 trillion. And the people who run them make ungodly sums of money: This year nearly one out of every 20 billionaires on the Forbes 400, the roster of the richest people in America, is a hedge fund manager.

But Wall Street never learns from its own history, which proves that every good idea, taken too far, turns into a bad one. Yes, some hedge funds make gobs of money. But with 9,000 of them swarming over the same markets, they can't all be successes.

"Hedge funds have probably come too far too fast," admits Cliff Asness, who himself hedges more than $9 billion at AQR Capital in Greenwich, Conn.

Sure enough, so far this year, as the U.S. stock market gained more than 8.5 percent, the average hedge fund rose only 6.8 percent. (It's worth noting, too, that hedge funders use notoriously fuzzy math in calculating returns; a Yale study estimated that average performance may be overstated by up to five percentage points a year.)

So what does all this mean for Average Joe investor? That you didn't miss much by not being invited to the party.

How to outperform the hedge fund average

Fairly recently, us normal folk have been offered a foot in the door via "retail hedge funds" or "fund of hedge funds," portfolios that sample the hedge fund market at lower minimum investments.

If a broker tries to sell you on these, tell him to go fly a kite. The fees are so high (often 20 times what an index mutual fund costs) that the managers would have to be geniuses to overcome the expense burden. (And the brains of the biz would generally rather work with the likes of Bill Gates.)

These retail hedgies start in the hole in another way: Historically, the market is up two of every three years, while hedge funds, as the name implies, "hedge" against decline.

So in the long run, the market offers better odds. If you want the downside protection of a hedge fund with better luck for up years, spread your risk in a diverse portfolio and stay with it.

Many hedgies trade as though their underpants are on fire, holding "investments" for days - sometimes hours - at a time. But in markets like these, patience is a virtue. It keeps your taxes, brokerage costs and emotions from running amok.

As veteran Wall Street watcher James Grant says, "You can do what the professionals can't afford to do: nothing."

- Additional reporting by Asa Fitch

-----------------------------------------------------------------

The bond market's dirty secret

Saving for more than retirement

The retirement plan Uncle Sam has right and how you can copy it Top of page

YOUR E-MAIL ALERTS
Follow the news that matters to you. Create your own alert to be notified on topics you're interested in.

Or, visit Popular Alerts for suggestions.
Manage alerts | What is this?
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.