Your Hidden Advantage Over Top Hedge Funds

Date: Monday, November 1, 2010
Author: Adam J. Wiederman, The Motley Fool

Hedge funds are having what might be their toughest year ever.

According to the editor of Bloomberg Markets, even managers "who foresaw both the mortgage implosion of 2007 to 2008 and the financial stocks recovery of 2009 are finding the search for alpha elusive in 2010."

John Paulson's flagship Advantage fund is flat. David Einhorn's Greenlight Capital is up just 4% this year. This is the top dogs' performance while the market rose slightly over the same period! Hardly impressive.

The effects of this lackluster performance are noticeable. Nearly 3,000 funds have gone out of business since 2008, and another 400 are likely to close in the rest of 2010, according to Hedge Fund Research, Inc.

But it all makes sense when you think about it. After all, there's one crucial disadvantage even the best hedge fund managers operate with. I'll share it with you just ahead, and then let you in on a unique opportunity to profit even as hedge funds struggle.

A huge setback
Hedge funds' huge disadvantage is their fee structure. Typically, hedge funds charge investors a 2% management fee of their balance and a 20% performance fee (2 and 20).

As long as they're able to deliver outsized returns, the effects of these fees aren't usually noticed. But in this flat market -- on both the long and short side -- it's beginning to have a drastic effect on their numbers.

To get an idea of how these fees can hinder returns, let's look at David Tepper of Appaloosa Management. He bought shares of Bank of America for around $3 in the first quarter of 2009, just before the stock's rally.

Here's how mirroring his move with $5,000 would have fared compared to the typical 2 and 20 structure on the same trade:

Source: Yahoo! Finance and author's calculations.
*April 2010.

Under a typical fee structure, you'd be missing out on over $6,500 of profits, winding up with 27% less. It also makes clear how a hedge fund manager can quickly become so wealthy (David Tepper is No. 62 on the Forbes list of billionaires).

Now don't read too much into this. There's nothing wrong with hedge fund ideas, and a long/short strategy, as you're about to see.

Hedge funds present unique solutions
It's most readily noticeable when activist investors get involved (mainly because they're the most vocal about their investing moves).

David Einhorn's recent presentation at the Value Investing Congress did a favor for investors who were short St. Joe. Prior to it, shares traded around $25 per share. The next day, shares were below $20 and might still have further to drop -- Einhorn pegs shares to be worth $15. Good news to any investor short St. Joe.

It also works on the long side. Bill Ackman recently admitted to purchasing shares of J.C. Penney (NYSE: JCP). Many are speculating he's going to attempt to do with J.C. Penney what he unsuccessfully attempted with Target (NYSE: TGT), namely trying to transform what The Wall Street Journal calls a "staid retailer" into a cash cow for investors by spinning off its real estate into a REIT. Fortunately for Ackman -- and shareholders of J.C. Penney -- this attempt might be more successful than his attempt to do the same with Target, since Vornado Realty Trust (NYSE: VNO) also took a position in the company, confirming that they like what Ackman sees.

And to be completely honest, of course there are also those times when activist attempts to improve a company fall flat. This was the case recently with restaurant chain Denny's (Nasdaq: DENN). In March, an activist group solicited proxies to get board members of its choosing on Denny's board of directors in an attempt to reverse the declining, aging, failing franchise. Unfortunately, these attempts to get on the board were unsuccessful. And though it garnered a lot of special-situation investors' attention, when this move fell short, it left a lot of hopeful investors disappointed.

After these examples, you might think it'd be smart to monitor the 13-Fs of top hedge fund managers and attempt to mimic their moves in your portfolio. But this might actually set you up for disaster. Often the reported information comes months after a hedge fund manager took a stake in a company, meaning the trade might not be timely anymore.

What's more, 13-Fs don't disclose a fund's short position. So while you might be able to mirror the long side of a top hedge fund manager, you'd have a tough time on the short side.

Which is why I'd like to share with you a solution to get hedge fund-like performance in a real-time fashion, without the oppressive 2 and 20 fee structure.

Bringing it full circle
Back to that "unique opportunity to profit even as hedge funds struggle" I mentioned earlier ...

The Motley Fool is about to unveil Motley Fool Alpha, a new investment service that will bridge the gap between traditional stock newsletters and the world of hedge fund investing. The best part? It's not set up with 2 and 20 fees-- and every trade will be shared with you in real time!

The aim is to think long-term but act short-term: have a long-term mind-set in how to think about businesses, the economy, and our investment results -- but with a short-term, opportunistic willingness to capitalize on market volatility by trading around positions and reshuffling the portfolio based on changing opportunities and risks.

Sound interesting? I think so, too. However, only a small group of investors will be invited to join us. If you would like to learn more as soon as details are available, click here.