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How to Invest Like a Hedge Fund
By: Alan Earls
Although hedge funds are generally focused on the needs of larger investors, the approaches to the market they use can be useful reference points for mainstream investors.
Winning is Everything
Hedge funds, after all, are about winning. As a class, hedge funds often undertake a wider range of investment and trading activities than traditional investment funds. As the name implies, hedge funds often seek to hedge some of the risks inherent in their investments using a variety of methods, notably short selling and derivatives. But, in practice, a lot of hedge fund thinking boils down to some very common-sense ideas.
For instance, Alan Snyder of Shinnecock Partners in Los Angeles, who has managed two hedge funds for more than 20 years, says the first rule he uses in investing is to “never short-change due diligence. Investments should not be undertaken casually," he adds. "Don’t be swayed by the latest bright shiny object."
His second rule of thumb is a bit trickier: You must carefully evaluate risk, volatility and return against your investment time horizon. In other words, he explains, volatile, high-return executions demand longer time periods to invest because entry and exits are impossible to precisely set over time. “You could be investing at a peak,” he warns. By contrast, he argues, “Slow and steady does win the race... [and can] give the investor the most flexibility for entering and exiting, and the best peace of mind.”
“Never forget: A 50 percent decline, like many experienced in 2008, requires 100 percent bounce-back just to get even and that does not consider the time-value of money,” he adds.
Great Leaders, Great Investments
Joel Shulman, Associate Professor of Entrepreneurship at Babson College, Boston, and operator of a hedge fund that focuses mostly on technology stocks, has a more domain-specific approach. He likes to find great entrepreneurs.
“The barriers to entry in a lot of technology industries are fairly low, so you really have to look for the differentiator provided by savvy entrepreneurs,” he says. He looks for great teams or great leaders, and his model is Steve Jobs of Apple. “He isn’t just in it for the money, he is a steward for his company and he cares about the company and its image,” says Shulman. A second characteristic Shulman likes – and one that is often linked to strongly entrepreneurial companies – is low selling, general and administrative (SGA) expenses. “Good entrepreneurs keep their companies lean so they can survive in tough times,” he says.
On the other hand, Shulman has an aversion to companies that grow through acquisition rather than organically. “On the long side, hedge funds in general, and ours in particular, like great companies with great leaders that keep their teams together and leverage their intellectual property to keep growing.” These are the companies that put money back into the organization and craft strategies that enable them to expand their margins, he says.
Diversity is Key
Finally, Larry Connors, CEO of the Connors Group and co-founder of TradingMarkets.com, says the best and most successful hedge funds consistently make money in all market environments through the use of a range of strategies. Translation: balance. Connors suggests investors consider applying some of these methods on their own: trading shares of stocks and exchange-traded funds, monitoring trade mean-reversion (the concept that prices return to the mean or average) and trend-following (attempting to earn gains through an asset’s momentum in a particular direction). And, of course, he recommends trading on both the long and the short side of the market.
“These combinations are critical for building a balanced portfolio that can participate in bull markets, taking advantage of strategic opportunities in bear markets and earning money when markets are range-boud," he says.