Hedge Funds for the Masses!

As has been widely noted, the biggest long-term determinant of a portfolio's performance isn't security selection or market timing, but asset allocation. And while hedge funds like mine have been regulated out of reach for most investors, a hedge-fund-style philosophy of asset allocation is an option I think you should investigate.

First, let's define some terms. Like mutual funds, hedge funds are simply investment pools managed by a portfolio manager. While most people assume that hedge funds trade frequently and take big bets on financial esoterica like derivatives, the main difference is that hedge funds have tremendous flexibility in how they can allocate their assets. Hedge funds can invest in almost anything. They can sell short, use options and futures, and even take positions in illiquid securities like real estate and collectables.

Because hedge funds are totally unregulated, the government makes it very hard for individuals to invest in them. Securities and Exchange Commission restrictions say that you need a net worth of at least $1 million simply to be eligible for hedge funds, even if you invest only a small portion of that amount. And while mutual funds and brokers spend billions a year on advertising, hedge funds aren't allowed to advertise. Essentially they have been closed out to individual investors through massive regulation. Even investors who meet the SEC's requirements find it difficult to invest in hedge funds. As it's depicted in a bunch of humorous television ads, you can open an online brokerage account and begin trading your 401(k) in seconds flat. On the other hand, my hedge fund's prospectus is 50 pages long and requires two signatures. So much for economic freedom, eh?

The government's intention is to protect the "unsophisticated" individual investor, for whom instruments like options or techniques like selling short are supposedly far too advanced. The upshot: An investor who doesn't quite have a million bucks can put $999,000 into the Nasdaq 100, but isn't legally permitted to allocate even $100,000 to a hedge fund of his or her rational choosing.

By maintaining such tight controls and keeping hedge funds behind closed doors, the government isn't protecting individual investors, but punishing them. And while hedge funds beat almost everything else last year and continue to outperform in 2001, it's their investment philosophy, not historical returns, that would ultimately benefit all investors — especially those the government insists aren't smart enough to make investment decisions on their own.

From my perspective, hedge funds offer a unique advantage over mutual funds and registered investment advisers simply because they are focused on what's really important: absolute returns. Mutual-fund managers and financial planners like to point to "relative performance." But relative performance is the stuff of excuses: Sure, I lost money — but I outperformed my benchmark. The reason we invest isn't to beat an index of highly capitalized (and still historically overvalued) stocks (read: the S&P 500), but to maintain the purchasing power of our hard-earned dollars. Benchmark your equity allocation against a major stock index if you must, but when it comes to your overall net worth, absolute performance is what really counts. It answers the question that matters most: "How am I doing?"

As I tell my clients, hedge-fund investors are partners in a business whose business is making money, not cheerleading some bow-wow stock sector or figuring out how many light bulbs General Electric (GE) is going to sell in the first quarter. The reason I wanted to start a hedge fund is because I respect how managers of these funds are held accountable to produce in real time. And as thousands of brokers and mutual funds attempt to explain away why equity-shocked investors should "wait for the long haul," now is the time they should return to why we invest in the first place: to make money and protect the purchasing power of our assets.

When growth funds were kicking butt and the market was booming, it wasn't so difficult to bite on the proposition that the S&P 500 was all that separated you from Easy Street. But even after a huge haircut off the major indexes and bearish cover stories in both Newsweek and Time, many investors still have a majority of their net worth in stocks. The group-think supposition that stocks will always outpace inflation over the long term still hasn't been seriously challenged, and most people are just waiting around for the rebound.

But if you stop thinking in terms of relative return — which is really just a justification for being long equities — and instead focus on absolute return, you're suddenly forced, like hedge funds, to look at a much broader universe of investments. There is always a bull market somewhere, and whether it's bonds or bellies, soybeans or Sonus Networks (SONS), hedge funds can be where the action is. Can mutual-fund managers like Robert Stansky or Bill Miller make the same claim?

If you are surprised that stock mutual funds had another terrible quarter, remember that with the exception of a few niche offerings, stock funds are required to buy stocks. Even if portfolio managers think the best thing to do would be to raise cash or sell short, they've got to stick to their mandates. And while growth funds, in which most investors remain heavily invested, are focused on making money, they can do so only to the extent that the stock market goes up. This is especially true now that the SEC, always out there protecting the individual investor, has adopted its so-called truth in labeling rule, which requires a fund to have 80% of its assets in the type of investment suggested by its name.

Many fund shops offer both stock and bond funds, but they all follow essentially the same philosophy — namely, that stocks will outperform other investments over long periods of time. Most of the 10,000 or so mutual funds out there, whether actively or passively managed, are essentially "long" bets on the equity market.

Hedge funds simply don't carry that bias. Even though most investors aren't permitted to buy hedge funds, they'd probably be best served by adopting their investment philosophy of absolute return. That begins by thinking like a portfolio manager, not a stock picker, and focusing on the bottom line. Stocks deserve a place in everyone's portfolio, but the dramatic (and often noncorrelated) performance of other asset classes, including hedge funds, can't be overlooked. So now that I've got you thinking about asset allocation and your portfolio on a macro level, next week we'll break it down to the micro level. I'll talk you through making a trade and managing an individual position, one week from today.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management. At the time of writing, his fund was short shares of Home Depot and General Electric.