Playing the Hedge Fund Craze

Schultheis' $69 million no-load mutual fund allocates assets among a group of specialized hedge fund managers that employ long/short equity hedging techniques including convertible bond, merger and fixed-income arbitrage. In order to meet regulatory approval, Schultheis doesn't invest directly in hedge funds like a hedge fund of funds. Instead, he has subadvisers manage funds according to their style in separate accounts.

A basic hypothetical example of a long/short strategy would be if a manager buys shares of Coca-Cola (KO Quote) and shorts shares of Pepsi (PEP Quote). The result is that the market risk is offset because extraneous factors like rising interest rates and energy costs should hit both companies roughly equally. Nevertheless, managerial risk increases because the manager better be correct in his choice of soda stocks.

Alpha Hedged Strategies fund had a banner year in 2004, finishing first in Morningstar's conservative allocation category out of 367 funds with a return of 17.23%. That's more than 6 points ahead of the S&P 500.

On the issue of a potential hedge fund "bubble," Schultheis points out that most bubbles occur when too many players are making directional bets that an asset's price will rise or fall. He believes nondirectional strategies like the ones used in his fund pose far less danger.

"A run-up in hedged investing like we are seeing now just leads to lackluster returns because too many people are piling into the same space, thereby squeezing out the returns," says Schultheis.

While Schultheis uses a variety of hedging strategies in his fund, the recently reopened (ARBFX Quote)Arbitrage fund and the (MERFX Quote)Merger fund, which is closed to new investors, employ a single hedge fund strategy called "merger arbitrage." In that concept, a manager simultaneously buys the stock of a company being acquired and sells short the stock of the company doing the acquiring. Merger arbitrageurs look at the risk of the deal not closing on time or at all. Because of this slight uncertainty, the target company's stock will typically sell at a discount to the price that the combined company has when the merger is closed, thus creating a so-called riskless profit.