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The real difference between hedge funds, mutual funds

Date: Monday, February 5, 2007
Author: Richard Croft, Financial Post

One is rewarded for taking risks, the other is not.

On March 12, 2003, AMR Corp., parent of American Airlines, closed at US$1.40 per share. At the time AMR was in a serious battle with its labour unions to gain concessions it needed to win part of a rescue package from government agencies and the private sector.

There were great risks with AMR in 2003. Without those concessions, many analysts believed the company would have fallen into bankruptcy.

Now, let's assume a manager of a U.S. equity fund wanted to buck the trend and decided to buy shares of AMR Corp in March, 2003. In the next five weeks, AMR Corp. climbed to US$5 a share, making the manager's move look like a shrewd decision. But was it?

We know that traditional portfolio managers evaluate investments from the risk side of the equation. The best portfolio managers are the ones who can produce above average risk-adjusted returns, usually against a benchmark.

So the traditional manager, because of the desire to maintain a diversified portfolio, would have owned shares of a number of other companies in different industries. The AMR position, because of the risks associated with the company at the time of the purchase, would not likely have represented more than 2% of the overall portfolio.

So what effect would that have had on the overall portfolio? Not much, unfortunately. While the AMR trade would have returned almost 357%, it would have added only 7.1% (354% x 2% of the portfolio = 7.1%) to the value of the equity fund. And while that is still a decent return, the manager would likely still have had to explain why he took on that kind of risk with clients' money. And there is the rub: The average equity fund manager can only really get into trouble by taking risk.

Now let's look at the same investment from the eyes of a hedge-fund manager, specifically a long-short hedge-fund manager.

Inside a long-short hedge fund, managers usually make sizeable bets on a single position, perhaps 5% to 10% of the portfolio. Let's assume that our hedge fund manager

put 5% of the portfolio into AMR Corp.

Since this a long-short hedge fund, the manager may, if he chooses, sell short another stock in the same sector. Or he might sell short the sector, or even the market. The point is there has to be a short side to accompany the long side, and the money received from the short sale would in part finance the purchase of the long side. That's how many hedge funds use leverage (you can also use futures contracts and options to create leverage) as part of their mandate.

In this case, let's say the hedge fund manager sold short Federal Express Corp. (FDX/NYSE) on the same day he purchased AMR On March 12, 2003, FDX closed at US$49 per share. Obviously, if the hedge-fund manager wants to be fully hedged, he will have to buy approximately 35 shares of AMR for every one share of FDX he sells short.

Five weeks later, when AMR was trading at US$5 per share, FDX was trading at US$59 per

share. The hedge-fund manager decides to close out the position. On the AMR trade he makes US$3.60 per share, multiplied by 35 shares, for a profit of US$126.

For every 35 shares he owns in AMR, he will lose US$10 on each share of FDX he sold short. In total, this trade nets the fund US$116 per long-short hedge. In percentage terms, the fund makes 236% on this trade. Since he has 5% of the portfolio committed to this trade, the fund's net asset value rises by 11.8%.

In the hedge-fund industry, the manager earns a share of the total profit. So rather than having to explain why the risk was taken, the hedge fund manager actually has an incentive to take risk.

When you break through the noise, that distinction is all that really separates a traditional equity fund manager from a hedge-fund manager. In this example, both added value by picking AMR. Both, then, were excellent stock pickers, but only one of them was rewarded for taking the risk.

That distinction carries other risks. We know that many equity managers are not particularly adept at making great trades. For the equity fund manager, that generally means third- or fourth quartile rankings. If a hedge fund manager is not adept at making successful trades, it can result in the fund going bankrupt.

The long-short hedge fund is only one strategy among many hedged approaches. Next week we will look at convertible hedging and finally, within the next couple of weeks, look at the best ways to incorporate hedge funds into your portfolio. Financial Post

- Richard Croft is president of Croft Financial Group and co-author of Protecting Your Nest Egg. Direct portfolio questions to rcroft@croftgroup.com.