Hedge fund managers are always bargain-hunting. An example is the recent interest in Price Communications ( PR ), a holding company whose sole claim to value is that its stock will become exchangeable into shares of Verizon ( VZ ) on Aug. 15. A year after that, the limited partnership will be liquidated, and owners will get 0.52 shares of Verizon plus roughly $1.25 of cash for each share, says Andrew Baker, an analyst at Cathay Financial.

Currently, Price Communications trades at $16.76, and Verizon at $34.78. The ratio implies a discount in Price, which at Verizon's current price would be worth $19.33, including the cash.

Of course, the exact return will depend on how Verizon will trade in August. But so far, the Price Communications trade looks like buying Verizon at a discount.

Last week, Sowood Capital Management, a hedge fund manager founded by former managers of Harvard University's endowment, announced a 7.9% stake in Price, making it the third-biggest holder of the shares. In fact, the top three largest shareholders are all hedge funds, with Atticus Capital owning 19% of the stock and Westchester Capital Management 8%, according to regulatory filings.

'Superstars, or Average Joes?'

That's the title of a provocative new study by Harry Kat, head of the Alternative Investment Research Center of the Cass Business School of London. His main finding: Very few hedge funds outperform the market.

Kat compared the returns on 1,917 individual funds with various benchmarks, including the S&P 500, 10-year Treasury bonds and eurofutures. He found that only 17.7% of the hedge funds did better than a passively maintained alternative. Kat didn't say much about the winners, other than that they are not the mega-funds managed by star managers.

In 2005, the HFRI Hedge Fund Index returned 9.35%. Other database providers, such as Standard & Poor's, showed lower returns in the plus-2%-to-plus-3% range.

"It is quite surprising that so many people, on the buy-side as well as in academia, are so eager to believe that the sometimes huge alphas reported for hedge funds are truly there," Kat writes in his report. "Returns produced by hedge funds are not very special and there is no specific reason why you should want to invest in hedge funds."

Wash Cycle

The compliance headaches live on. After agonizing over registration with the Securities and Exchange Commission, managers now need to worry about anti-money-laundering regulations. FinCEN, a unit of the Treasury Department, has been cooking up a proposal for three years and should announce its final ruling in 2006, says Ross Delston, managing partner at Kalorama Partners, a compliance advisory firm founded by former SEC Chairman Harvey Pitt.

Hedge funds are one of the last bastions of the financial world not to be covered by money laundering and anti-terrorist financing requirements. Banks, savings and loans, broker-dealers, insurance companies and mutual funds all must comply with requirements similar or even more rigorous than what's in the proposal, Delston says.

Basically, managers will have to come up with written policies, designate a compliance officer and have their workforces go through ongoing training.

Funds should also assume that some elements that are not in the proposals will be imposed in the future, says Delston -- and that's where the pain is. The future rules could include customer identification and verification, the reporting of suspicious activity and on-site examination by the SEC of registered and unregistered hedge funds.

That means that even the funds that have managed either by size or by longer lockups to avoid registering with the SEC may not be off the hook.

Bad Year

The convertible arbitrage sector was down 1.96% last year, according to Credit Suisse/Tremont, with the spring of 2005 believed to be the worst period since 1994.

But, as reported on this site before, a recovery has begun over the past few months. It was fueled by a bunch of new deals, bringing more supply into an ultra-rich sector.

Eric Hage, a portfolio manager with Mohican Financial Management, sees the future in small-cap and mid-cap convertible deals. He says that of 146 deals last year, 23% were mid-cap and 61% small-cap.

That doesn't mean that big companies are not coming back in the market with a vengeance. Last week saw a mega-deal with Amgen ( AMGN) bringing $5 billion of five- and seven-year paper. The last deal of this size was Deutsche Telecom, with $8 billion in 2003, says Argent Financial Group's Bobby Richardson.

Survivor Unbiased

Hedge fund managers can't really advertise, and so, as a substitute, they report their performance to database vendors. In a way, database providers are the marketing arm of the industry, which is why they compete so ferociously with one another. There are many providers and many discrepancies between indices, and that makes the job of the investor difficult.

One of the tricky parts is to figure out why some funds stop reporting to those database vendors. In some cases, it is because the fund is closed to new investors. Successful managers refuse to accept new customers, as they don't want size to compromise their performance.

In other cases, though, managers leave the database because they are in the process of liquidating. This liquidation factor is one of the reasons why there are huge gaps between hedge fund indices. It's also why some indices have an upward bias: If funds stop reporting because they are going under, then, obviously, eliminating them from an index helps its performance.

However, such bias may have been exaggerated. Fabrice Rouah with McGill University says that only a third to a fifth of the funds that stopped reporting did so due to termination.

Price of Protection

More and more hedge fund managers are seeking to buy liability insurance, says Wendy Dowd, a Chubb ( CB ) executive. She noticed the trend picking up in October 2004, when the SEC registration rule was passed.

Dowd estimates that at least 50% of the top 25 largest hedge funds purchased the policies. They get coverage in case of a lawsuit or for costs incurred during a regulatory investigation.

Dowd cites the case of a hedge fund investigated last year by the SEC. The agency found no wrongdoing, but the fund had to pay $10 million in legal fees.

The premium depends on the fund's size. A $250 million fund typically pays $25,000 for the first million dollars of coverage.

Still, says Michael Klaschka, an insurance broker with Integro, many funds remain reluctant to get insurance, simply because they don't want to pay for it.

"They don't believe their sophisticated investors will bring a claim, and they are unaware of litigious trends emerging in the industry," he says.

And unlike brokers that must carry insurance policies, investment advisers are not required by the SEC to have liability insurance.

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