By Mark Smallwood, TEP, Smallwood Trust Co., Ltd.

After the performance of equity markets in the last year and a half, most investors might think that the definition of Alternative Investment Management might be “making money.”

Certainly, the last year has seen a wild ride in markets, particularly the NASDAQ in the United States, and the ease with which money was made in the late 1990s is now but a distant memory. Looking ahead, the road is far from clear, but with valuations in stock markets still at historically high levels, many investors remain concerned about the ability to make money in what are increasingly volatile markets.

Whilst a diversified portfolio of stocks and bonds should provide sound long term returns, for many investors the very apparent short term volatility is very uncomfortable to experience. To this end, whilst sophisticated institutional investors have been utilizing alternative methods to increase portfolio returns whilst reducing volatility for some time now, the opportunity for the smaller investor has been somewhat limited. This limitation is partly due to restricted access to the investment managers who deal in these areas, and also partly due to domestic tax laws making it almost impossible to access these actively traded investment vehicles, other than with tax exempt funds (e.g. pension plans).

In recent years, however, primarily driven by European demand, and with the benefits of technology now at hand, the smaller (under $1 million) investor now has the ability to invest in what are loosely called “hedge funds.” The reason for this demand is quite simple– professionally managed hedge fund (and for this our definition precludes highly leveraged speculative funds) often demonstrate low, zero or even negative correlation with equity and bond markets.

Even more importantly, hedge fund managers are paid to make money (target absolute returns) rather than try to outperform indices (targeting relative returns). How many readers have spoken to their investment advisor who has joyously exclaimed, “Mr. Client, I am delighted to inform you that whilst the NASDAQ was down 20% in the last quarter, you were only down 18% . . . hip, hip hurrah!”

As part of a balanced portfolio, hedge funds can therefore provide important additional diversification, providing returns independent of traditional asset classes such as equities and bonds. This diversification in itself can lower the overall volatility of a portfolio, as professionally managed hedge funds will also target lower volatility in themselves, trying to achieve sound positive returns without experiencing violent swings.

So how do the managers achieve these returns? There are a number of recognized strategies, and funds may concentrate purely on one strategy, or more typically, they will adopt a number of complementary strategies, which in turn helps to lower the risk of the fund–i.e. if one strategy does not work, it may be offset by one of the others. This continues the theme of reducing risk and volatility by diversifying.

The basic hedge fund involves long and short and combination positions in stocks. Thus, a long bias fund will typically have both long and short positions in a portfolio of stocks, but with a net long position. A short bias fund will be the reverse, whilst a market neutral fund will have matching long and short positions, but is seeking to achieve positive returns through market inefficiencies. These inefficiencies may be inter-market (i.e. long Footsie, short DAX), market sectors (long oils, short technology) or specific industry groups (long Sun Micro, short Intel). In many cases, funds will leverage their positions so it is important to assess the level of leverage that the fund permits to determine the potential risk. (The Long Term Capital Management Fund leveraged over 100 times and unsurprisingly, did not last very long!).

On a more sophisticated level are the arbitrage funds–once again a loose description as the arbitrage is not pure arbitrage but a derivative of going long and short closely correlated financial instruments. Thus, for example, a convertible arbitrage play will involve the purchase of a convertible bond and the sale of the ordinary shares, seeking to benefit from price anomalies created by short term market volatility.

Similarly, a big market in arbitrage is in the fixed income sector where multiple yield plays exist in the government and corporate bond markets. Thus the U.S. banking system was saved in the early 1990s by the steepening of the yield curve, allowing banks to borrow at low short term interest rates and then invest in the longer term fixed interest securities at much higher interest rates, resulting in the restoration of their balance sheets to more solid levels. This has also happened in Japan where, for example, institutions have borrowed Japanese Yen at 1% (or thereabouts) and then converted to U.S. dollars and invested in longer-dated U.S. bonds returning 5% or 6%–free money, provided the currency is hedged properly. This was known as the Yen carry trade.

Other strategies involve merger arbitrage, where one buys the stock of a company that is being purchased and sells the stock of the purchasing company and distressed securities, which involves the purchase of stock or bonds in a company in trouble and either benefiting from a recovery or from the breakup of the company and a larger payout as a creditor than was priced into the bonds.

Finally, there are the trading funds, which are hedge funds that actively trade stocks, bonds, currencies and commodities with a view to making a profit, and using different strategies with some leverage. The main impetus with these funds–as with the others described here–is that the managers have the objective of making positive absolute returns, whether or not the equity or bond markets are rising or falling.

So how does one invest conservatively in hedge funds? Firstly, the investor’s domestic tax position has to be assessed to determine the suitability of the fund. For example, many of the leading offshore hedge fund managers will not accept direct investment by U.S. tax payers. This is not a great problem, for the U.S. investor can simply utilize an offshore tax structure which meets U.S. Internal Revenue Service rules, and because the tax structure itself is not a U.S. person, access to these fund managers can be obtained.

As with all investment decisions, an analysis of the investor’s entire portfolio holdings is necessary in the first instance, to determine available assets and the level of diversification required to reduce overall risk. Having identified the assets that may then be invested in hedge funds, the next assessment is as to the level of concentration of risk. If a client has $5 million to allocate to hedge funds, then this might be allocated to (say) five different single manager funds adopting different investment styles. If, on the other hand, the investor has $100,000 to allocate, then this diversification might be better achieved by investing into a multi-manager fund, i.e. a fund of funds where the professional fund manager allocates the fund’s assets to a number of different managers, thus securing the portfolio diversification whilst only limited assets are available.

The era of easy money in the stock market is now over and the investment stars of the next ten years will be managers who earn their keep by making money in both rising and falling markets–managers who manage funds for all seasons.

Mark Smallwood is managing director of Smallwood Trust Company Ltd. and Smallwood Insurance Company Ltd., based in Providenciales since 1994. He is a director of two hedge funds with over $100 million in assets under management, and is experienced in advising on the selection of and investment into hedge funds managed by major international investment management groups. He can be reached at smallwd@tciway.tc or see www.smallwoodco.com.