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Disgusted With Hedge Funds? Fight Back

James Altucher

07/06/07 - 10:55 AM EDT
I've invested in hedge funds, I've traded for them, I run a fund of hedge funds, and I've written constantly about them.

But now I'm disgusted with hedge funds. There are two new hedge fund blowups in the news, a continuing litany of the woes inflecting this investment vehicle.

So now, instead of investing in hedge funds, I have a way you can be your own hedge fund by merely piggybacking on the true hedge fund greats.

But first, let's look at hedge funds' latest travails.

About a year ago I wrote about John Devaney's United Capital Asset Management for the Financial Times. United Capital is one of two hedge funds in the media this week after having to suspend redemptions because it's stuck in illiquid asset-backed securities that are crashing in value.

I interviewed Devaney just over a year ago and documented his rise from rags to hundreds of millions of dollars. He started out in college when he bought a video, Buy a House With No Money Down!

"Do those actually work?" I asked him.

"Hell yeah!" he told me, "I ordered the videos on my Citibank credit card that had a $350 limit and bought a house where I cleared $500 a month in cash flow."

Devaney then became a partner in a bar that made him $50,000 a summer for two years. With that capital he opened a brokerage account and began trading options. By the time he left college, he had $150,000 saved and owned a home, a boat, several cars and motorcycles.

His track record only improved. Starting with capital of $500,000 in 2000 he made $5 million in 2000, $20 million in 2001, $35 million in 2002 and $110 million in 2003 trading junk bonds, mortgage-backed securities and asset-backed securities. Here's how he explained it to me:

"Every couple of years there's a crisis that creates opportunity," John told me when I asked him how he did it. "When LTCM [Long Term Capital Management] blew up, everyone dumped the high loan-to-value BB-rated bonds that were all the rage then. Prices went from $95 to $50 even though the underlying collateral wasn't any more or less risky.

"This type of thing happens all the time. When aircraft debt, for instance, got downgraded after 9/11, insurance companies were forced to mass-dump it for regulatory reasons. We were the buyer of last resort. Pooled leases on aircraft that we valued at 80 cents on the dollar we were buying for a lot cheaper just because the insurance companies were required to sell."

Unfortunately, right now he's on the wrong end of the crisis, and I feel bad for him and sorry for the investors.

Do you think hedge funds can justify their fees?
Answer Here

The other fund that's in the media a lot this week is Braddock Financial. For years these guys were putting up enormous returns with no down months, sometimes exceeding 20% or more in a month. I tried to interview them, but they turned me down because they didn't want to give up their "secrets."

I couldn't believe it with both of these funds. No down months, enormous returns every year? How could it happen? Well, this is the problem with hedge funds. It can't happen.

Hedge funds succeed now because of the charisma and salesmanship of their founders. They are illiquid, non-transparent vehicles where you send your money, and you'd better pray to your god that ever see that money again, no matter what the returns are in between.

And all along, mammoth fees are sucked out of the marked-up pool of exotic securities -- everything from wildly illiquid, regulated "carbon emissions futures" profiled in The New York Times today to exotic baskets of derivatives of derivatives, profiled glowingly in today's Wall Street Journal.

A friend of mine asked me a few months ago what fund of hedge funds he should put his money into. I told him he might as well flush it down the toilet. He laughed because he knows I run a fund of funds, but I wasn't kidding.

Here's what you should really do if you are desperate to put your money into a fund of hedge funds. I'm biased, but this is why I set up Stockpickr.com.

Pick some good hedge funds whose portfolios we track on Stockpickr. Pick two or three positions from each until you have somewhere between 20 and 30 positions. Try to be diversified.

For instance, go to Warren Buffett's portfolio and maybe pick out Burlington Northern(BNI Quote) and Johnson & Johnson(JNJ Quote).

Go to T. Boone Pickens and perhaps choose GlobalSantaFe(GSF Quote) and Transocean(RIG Quote).

Check out Eddie Lampert's holdings, from which you could choose Sears(SHLD Quote) and Citigroup(C Quote).

From Carl Icahn's portfolio, you could glean Blockbuster(BBI Quote) and Motorola(MOT Quote).

You could check out Atticus Capital for TD Ameritrade(AMTD Quote) and Eagle Materials(EXP Quote).

If you want some Internet exposure, go to the Jacob Internet Fund for ideas such as Google(GOOG Quote) and Sohu.com(SOHU Quote).

When you've got your basket of great positions, keep these things in mind:

  • You're not paying the enormous 2-and-20 fees -- 2% of your principal each year plus 20% of any profit -- that most hedge funds charge.

  • The smartest minds in the business have done all of the legwork and research for you.

  • In the situations where they are activist -- for instance, Carl Icahn on Motorola -- they foot all the costs for lawyers and proxy fights. Your investment is not being drained by that.

  • You're diversified.

  • You can get the heck out whenever you like. Want to send your kid to college? No problem. Sell some J&J and pay for it. You aren't gated every which way from Sunday by the charming salespeople who promised you enormous returns.

  • And with the market in general moving up 9% a year and with these stocks representing the best positions of the top professionals in the business, you have a decent chance of making some money.

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