Hedge fund thrills now tempt the little guy

It had to happen sometime, and sometime is now. Hedge funds have invited peons off the street, up the paneled staircase and into the tabernacle of leverage, derivatives and arbitrage.

And why wouldn't they? Hedge-fund managers rake off 2 percent of the assets and 20 percent of the profits. Mutual funds, by contrast, are often considered expensive when they charge 2 percent of assets, period.


In that light a hedge-fund dollar invested by Joe Schlub is as good as a dollar from Bill Gates - maybe better! Come in, Mr. Schlub. The butler will take your coat. The other butler will take your wallet.

The pesky problem was that the government, knowing hedge funds to be unregulated, Glitter Gulch investments that occasionally shoot the moon and occasionally hit the wall, made it hard for the outfits to take small-guy clients.


Individuals typically had to have $1 million to sink into a hedge fund. With that kind of dough the Securities and Exchange Commission figured you could take care of yourself. But now the entry barriers are falling, and the SEC is worried.

Some mutual funds - highly regulated and available to the masses - have begun employing hedge-fund techniques such as complex derivatives and short-selling, which is a bet that asset prices will fall.

Last year Greenwich, Conn.-based Lake Partners estimated mutual funds consistently employing hedging techniques managed $8 billion in assets - not a lot, but double 1999's level. Many small investors are exposed to hedge funds indirectly through pension plans.

And a few mutual funds now invest directly in unregistered hedge funds and accept investments as low as $25,000, such as the Rockville-based Rydex Sphinx Fund. The Sphinx Fund, designed to track the Standard & Poor's Hedge Fund Index, introduced in 2002, has grown from nothing to $175 million in assets since starting a year ago.

"It demonstrates the broad appeal of the story," said James Erceg, director of investment products for Rydex. "And there's a lot of excitement from the adviser community regarding the product."

Well, of course there is. For peddling the fund, investment advisers get a sales commission - from your pocket - of up to 3 percent. That's on top of the 1.95 percent Rydex gets and the 2 percent management fee the hedge funds gets along with the 20 percent of the profits. You'd be excited, too.

To be fair, we should note that the Sphinx product is a hedge-fund blend that cuts the risk of buying one or two vehicles by investing in 40 different funds with varying strategies. One outfit might bet on a stock market fall; one might try to seize on price differences in similar Treasury notes; one might snap up debt in a bankrupt company or buy a firm's bonds and simultaneously sell its stock.

But lower risk means lower return. The conflicting strategies in the Rydex fund tend to cancel each other out, removing the opportunity for a big score.


"The investment goal is to achieve, after all expenses, a mid to high single-digit-type return, like 7 percent, say," says Erceg, who adds that the S&P; Hedge Fund Index performed far better in the stock-market collapse of 2000-2002 than other investments. "It's designed to hit singles. It's not designed to hit home runs."

So what's the point? Home runs are one reason people buy hedge funds. If you're an individual, and you want single digits with low volatility, buy and hold good bonds with varying maturities.

Counting the sales-load commission, the Sphinx Fund would have returned 0.06 percent from its June 2003 birth through May 31, slightly beating the Lehman Aggregate Bond Index, which lost 0.24 percent. Without the load, which is sometimes waived, Sphinx would have returned 3.16 percent.

So you would have gotten hedge-fund prestige and Treasury-note returns, at best. Given other scenarios of what can happen in Hedgeland, that might not be a bad deal.

But the risk door could open wider. Even though Sphinx Fund's investment minimum is far less than traditional hedge-fund antes, Rydex limits investors to the relatively well-off who would otherwise qualify for unregistered hedge funds.

The SEC worries that other marketers of "funds of hedge funds" won't be so careful. The history of U.S. finance is the story of small investors moving into financial products once limited to the wealthy - stocks, credit-card debt, money-market funds.


But maybe it's time to stop the trend.