In February, when the equity markets were faring poorly, hedge-fund manager Patrick Adams launched a new mutual fund he thought could take advantage of the market environment. He introduced a fund that also shorts the market; there are only a dozen or so such funds available.


Patrick Adams
Portfolio Manager,
Choice Long-Short fund.

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Adams says he wanted to offer the same investment strategy as his hedge fund, the

Adams Select Fund

, which rose 29.5% last year and is up 10% this year, to a different class of investors. The minimum investment in Adams' hedge fund is $250,000, whereas the minimum investment in the

(CHLAX)

Choice Long-Short fund is $10,000.

In today's Daily Interview, Adams discusses his investment strategy, some of his holdings and how he has achieved a 9.4% return so far this year.

TSC: It's pretty brave to launch a fund in this economic environment. Why launch a fund now, and what relevance do you think a long-short fund will have when the economy turns back up?

Adams:

We thought the timing was actually very opportune in that a lot of people lost a lot of money last year. The Long-Short fund, we believe, has the potential to deliver positive returns, regardless of where the market and the economy are heading. This year, we believe that people are looking for a great deal more stability in their investments and want something that can hedge out the volatility.

Looking longer term, we think that long-short products are going to be extremely popular if they are done right. The reason is interest rates have come down to a level on a long-term basis that we just don't see going down much further. Therefore, it makes the stock market much more dependent on earnings growth, and this makes the stock market more volatile. And the only way to capture returns is to do short rather than strictly long.

We are trying to get 2% returns a month, and we are right on track with that right now.

TSC: What are your long and short positions now?

Adams:

We're currently 43% long and 15% short. We're long on a variety of stocks, although we do have a fair amount of technology right now, and these are large positions rather than betting on the group. Our goal is to deliver 2% a month and never decline more than 4% in a month. For an individual name, if we lose 10% on a short, we get out of the stock, and on a long position, we get out of the stock if we lose 20% -- the reason being that for short positions, timing is 80% of the equation, and long positions may take longer to play out.

My top long positions include

Microsoft

(MSFT) - Get Report

,

Compaq

(CPQ)

,

JDS Uniphase

(JDSU)

,

ONI Systems

(ONIS)

and

Analog Devices

(ADI) - Get Report

.

EchoStar

(DISH) - Get Report

-- we're short that. They're raising $1 billion in convertible bonds, which is pressuring the stock.

TSC: How do you go about shorting stocks, and how hard is it to find information on companies that are poised for disappointment? Is this a more difficult way to invest than going long?

Adams:

We follow 300 to 400 stocks very closely. We have a very fundamental approach to picking stocks, and it lends itself well to finding short ideas. We go through their long-term growth rates to determine what rate we think they are going to grow at over the next three to five years. On a short-term basis we keep earnings models on all of the companies we follow.

What we try to find in a short is a crack in the

fundamentals or an earnings disappointment, and particularly a combination of a decrease in that long-term growth rate with an earnings disappointment. A company that has been growing 30%, maybe it's headed to 20%. Therefore, you get a big contraction in the

P/E.

We also look at the balance sheet a lot to try to find shorts. For instance, we look at pricing or sales outstanding -- whether or not the account receivables are rising during the quarter. Inventory levels are another great indicator for a short idea. And cash flow. If cash flow isn't showing up on the balance sheet, then maybe the earnings aren't real and they are dipping into their reserves to meet their earnings.

I wouldn't say it's any harder to find a short idea, but it requires looking at different things.

TSC: Your prospectus allows for a lot of types of investments and strategies: leveraging, options, futures, unseasoned companies less than three years old, foreign stocks, illiquid stocks and small-cap stocks. Why take on these additional risks in a fund that already assumes a good deal of risk through shorting?

Adams:

My philosophy is growth at a reasonable price, but keep in mind that this fund is more risky than your average mutual fund. Most hedge funds and other long-short funds tend to be very defensive funds. But I would even consider this the least risky fund in our fund family, and we do have a balanced fund. That should give you some idea of how I consider this fund.

TSC: Why go to the trouble of offering a hedgelike fund to a different class of investors?

Adams:

We think there is going to be a big market there, and many of our investors in this fund are advisers who, in turn, are serving individual investors who typically don't have access to hedge funds. Investors today are more knowledgeable and sophisticated.

Currently, there are only a dozen or so of these types of funds, and about half of them are closed to investors. We've raised $63 million for the Choice Long-Short fund, whereas our hedge fund has $30 million.

And it's very difficult for the larger mutual fund companies to offer this to investors because they have significant long positions. For somebody to be working independently going short on these same stocks is counterintuitive and would be considered a conflict of interest, I think.

TSC: One of Jim Cramer's biggest criticisms of mutual funds over the past year has been that portfolio managers who claimed to know and understand the companies in which they were invested failed to unload those positions and move into cash, fixed income or other defensive investments. Your fund has the latitude to do this. Do you think that standard mutual funds should have this latitude as well?

Adams:

I can understand the criticism, but the typical mutual fund portfolio manager is unable to manage that volatility. They just aren't able to manage in a down market because they have mindsets for long positions, not short positions or risk control. It's a rare breed that can see a market downturn because most mutual fund managers just cannot see that coming. In this last market cycle, in particular, I think it was extremely difficult to foresee it because it rolled over fund managers so fast.

Most fund managers like to buy the best companies and hold on to them. That's kind of what they do. I just don't see

Janus

saying they are going to go to 50% cash if the market's going to go down.

TSC: Where do you see the market heading now?

Adams:

I think by the end of the year, the market will be higher, but there's going to be a sloppy second quarter with more earnings disappointments and volatility. My best guess is that the

Nasdaq, which is at 2250, will go to 2500-2600 and stall out there for a while. I don't understand the

S&P 500 and the

Dow as well as the Nasdaq, but I would expect the S&P to follow the Nasdaq, but not as much in terms of magnitude.