Beating Hedge Funds at Their Own Game

05/21/2007 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, chairman and CEO of Schaeffer's Investment Research, said in a keynote presentation at last week's Las Vegas Money Show that hedge funds have a tough battle ahead, and investors can profit from it.

I don't disagree there's a hedge fund bubble, but I strongly dispute the widely held belief that the hedge fund bubble will have a seriously negative impact on the stock market. In fact I believe the hedge fund bubble will unwind in slow motion and the process will likely be accompanied by a steady melt-up in the stock market perhaps to heights that we dare not imagine in 2007.

How did this hedge fund bubble get started? From 2000-2002 the stock market bubble burst with a vengeance. [But] the typical hedge fund made 9.6%. It was this record of capital preservation amidst the devastating bear market that began this near-hysterical rush into hedge funds and other alternative assets that continues to this day. Never mind that the hedge funds underperformed the market seriously before this bear market period [and] over the last four years.

The hedge fund bubble may be the first bubble where investors' returns have been mediocre. The only bubble here has been in the assets of the hedge fund industry and the income of hedge fund managers-not because of the great performance of hedge funds but because of the huge increase in hedge fund assets and the aggressive fees that are charged on these assets.

But will the bursting of this bubble [lead to] a stock market crash? I don't think so. In fact a major bear market is the only way hedge funds can clearly outperform the market because they are protected from a major market decline through their hedging activities.

The typical long/short hedge fund is long a portfolio of small- and mid-cap stocks, emerging market stocks, overseas stocks, riskier stocks that are going to outperform the market on the upside. But they hedge themselves on the down side by buying put options, [or] they sell call options against their stocks to generate month-to-month income.

But buying put options is expensive and it only helps under very rare circumstances. Selling call options depletes your returns in rising markets and absolutely kills you in roaring bull markets. This is why hedge funds have had such a problem matching the market over the last four to five years.

But through their activities the hedge funds have basically crash-proofed the market: not only is a bear market not unexpected in our 2007 world, there exists massive insurance against its occurrence and a bear market of significance is least likely to occur under such circumstances.  It's a perfect storm, but it's one that will play out slowly as the market continues to perform well and hedge funds continue to disappoint.

So, how can you profit from this less than rosy outlook for hedge funds? Don't do what they do. Don't sell call options against stock you own. Don't eat into your returns by buying put protection.

What you can do as a conservative investor is to buy SPDRs, S&P depositary receipts (SPY). This is the benchmark index that the hedge funds must beat, and they ain't going to do it. So, you'll beat them just by investing in your plain vanilla index fund.

If you're a little more aggressive, buy exchange traded funds (ETFs) on sectors you think will outperform. Best of all, buy call options six to 18 months out on these sector ETFs if you're worried about a weak market and invest the money you save by buying these call options in cash. You can buy a six-month call option on most ETFs for 6-7% of the amount you'd have to invest by buying the index.

Invest that, put the rest in cash. That's your crash protection.

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