Invest Like a Hedge Fund Investor

You may not have the money to invest in hedge funds, but that doesn't mean you shouldn't act like you do. In fact, acting like a hedge fund investor could help you improve your portfolio of ordinary funds.

It's as simple as bringing one element of hedge fund investing to your thinking about funds.

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Hedge funds are a glamorous, private-investment-pool cousin to mutual funds; they are the domain of the wealthy and are largely unregulated, allowing them to pursue some investment strategies that are out of bounds for the ordinary mutual fund. While some people see hedge funds as pursuing maximum returns all the time, the basic idea for most hedge funds is more pedestrian, namely trying to make money in all market conditions.

Hedge funds carry huge expenses, with the manager typically taking 20 percent of the investing profits, plus 2 percent for expenses, compared to a typical stock mutual fund's expense ratio of 1.5 percent.

Following complex strategies requires some stability in assets, so hedge funds, which have a limited number of investors, don't allow willy-nilly trading. Instead, most operate with a "lock-up" — a time period when the investor agrees to stay put. Most often, the lock-up period is 12 months, although some funds are now going out for two and three years. When the lock opens, a hedge fund investor either agrees to another year, or pulls out.

Act as though it's a lock

It's the lock-up that ordinary fund investors should lock down and make part of their investment criteria.

The lock-up requires the investor to answer one basic question: "Do I like this fund enough to be locked into it for another year or two?"

More than 5 percent of all hedge funds have been liquidated each year for several years, with the attrition owing to investors deciding that they don't want to lock up their cash with the same fund again. A hedge fund manager who sees a bunch of shareholders making a no-confidence vote when it's time to re-up for another year may simply pull the plug before most of the cash heads for the exits.

Mutual funds not only have no lock-up, they practically encourage inertia and mediocrity. With no pressure to make a hold or sell decision — and with management free from worry that investors will rush the exits — shareholders often settle for mediocrity.

An annual portfolio review is good, but it doesn't force action, the way accepting a year-long lock-up would.

"When someone is facing a lock-up, they think long and hard, they are hesitant to invest unless the fund has a long track record, and they make a real commitment," says hedge fund manager Mark Sellers of Sellers Capital, a hedge fund that does not impose a lock-up, but does have a 10 percent penalty for removing money before a year is up. "There's way too much switching that goes on in mutual-fund land, and a lock-up would end a lot of that."

Dump the laggards

Acting as if your fund has a lock-up period is helpful on two fronts. It forces you to think long term and not touch your holdings during the commitment period, and it makes you weed out laggards.

Investors often stick with fallen angels — funds that once had good performance but that have fallen on hard times — hoping for a return to past glories, a bounce-back to break-even, or simply because the fund has been good to them in the past.

Inertia is easy because the shareholder can always get his money out tomorrow, or the next day. Locking in for a longer period is different; it quickly makes you testy about below-average performance.

"If the public had a lock-up in their mutual funds — if they had to sign something that forced them to evaluate what they are doing and make long-term decisions — they'd fare better," says James P. Owen, managing director of Austin Capital Management, a hedge fund firm that invests in other hedge funds.

"If you're not confident about a fund - if it has disappointed you once - you're out the door before you get locked up again. With a long-term commitment, you don't settle for funds that failed you in the past."

Do it yourself

Since mutual funds don't have a lock-up, average investors should put one in place on their own.

When you next review investment performance, add in one little factor: Unload any fund that you wouldn't want to be chained to for the next 24 months. By having to stick around that long, you'll scrutinize funds much more closely. Anything that you can't be comfortable with for that long shouldn't keep its place in your portfolio.

Says Owen: "When you can't chase performance and you can't jump around, and you have to commit to one manager for a length of time, you're forced to make the most informed decision possible. Fund investors would benefit from doing that."

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