From the May 2004 issue of Investment Advisor • Subscribe!

A Matter of Principles

Remember the old saw that timing is everything? In looking back at my personal journey of investing and advising clients on investing, I can testify to the saying's truth. I began my life as an investor in January 1990. The timing couldn't have been worse. The stock market opened at what would prove to be its high for the year and proceeded to fall from there. The S&P 500 index at one point was down almost 10%, and my positions were down much further than that. I had no concept of risk or what I could lose while investing. The U.S. market did come back, of course, and the start of one of the greatest bull markets ever was soon to come. However, Japan's stock market set into a steady and consistent decline; it's down almost 70% 14 years later. How many of us would still be long-term investors in such an atmosphere?

I've come a long way since then. In January 1999, I formed a QEP (qualified eligible persons) limited partnership that combined low-volatility trading and asset-based lending. Later, we formed a multimanager, multistrategy hedge fund of funds called the All Weather Fund designed to provide a specific return regardless of overall market conditions: We grind out a return and look for absolute performance.

But getting to that point wasn't easy.

I wound up losing much more than money in those early years--I also lost confidence. I started out full of confidence. I had done my research and selected an appropriate private banking firm for my family's money, but that firm sought relative performance, not absolute performance. Using speculative issues and some leverage, failure inevitably arrived. I had given my money and my family's money to an organization that looked very impressive superficially, but which produced dismal results. I cashed out of all my losing positions, shell-shocked.

Finally, I decided to learn how to do this investing thing myself. I devoured every book I could find on investing and trading. I came to realize there are numerous ways to make money, and that I needed to find one that fit my personality. I learned about futures, real estate, and bonds, as well as hedge funds. That research, and my prior painful experience with the private bank, taught me that the most important objective was to stay out of trouble and avoid drawdowns like the plague. Not only are drawdowns financially draining, they're also emotionally draining. There are only four things that can happen when you invest. The two least likely outcomes are big losses or big gains; the two most likely results, however, and the most rewarding over the long term, are small losses or small profits. If I could only avoid those big losses, I thought, everything else will take care of itself. After all, the best offense is a good defense. To make myself available for opportunities in investing, I learned, too, to avoid dogmatism on the markets and to cherish flexibility. There are always opportunities and movement in all markets, not just the stock market.

Now I considered myself an expert, but I was actually setting myself up for my next big misstep. My first mistake was having blind faith in an organization that didn't understand the concept of risk. Now I began to explore hedge funds. As you might expect, my research showed that most hedge fund managers had lackluster returns, but a select few seemed to make money regardless of the performance of the overall stock market. Remember, this was in the years prior to 1995 and the start of the phenomenal bull market. I still found several managers who had tremendous records. I picked a manager who followed a global macro strategy and had a track record of more than 10 years and billions under management. I allocated to him a large portion of my personal net worth. Things went well at first, but several short years later, he ran into serious problems. Once he surpassed his greatest drawdown and remembering my newfound principle to stay away from big losses, I decided I wanted out. That was easier said than done. I could not get out. I didn't know anything about lockups. I could only get out in the next quarter. More losses followed.

From this experience, I formed my second principle: No matter how wonderful a manager's record, it is paramount to understand clearly how the manager achieved those results. Moving forward, I vowed not only to perform strict due diligence on prospective managers, but to diversify among strategies. So I studied the pros and cons of the other trading strategies. They include various forms of arbitrage, in which managers attempt to grind out differentials in anything from fixed income to convertibles, a strategy which avoids being dependent on the fluctuations of the stock market. I learned about distressed debt, high yield, and long-short. They all offered opportunities to meet my need for consistent, low-volatility returns.

If At First You Don't Succeed...

I now knew what I wanted, but I still had problems. The first had to do with the minimums necessary to get into these funds. The most successful managers maintained minimums of $500,000, though more commonly they were from $1 million to $2 million. Then arose the manager problem. It seemed that every time I found a manager who had an interesting, well-performing record and whose strategy I understood--including how he minimized the downside risk--he would either be closing or not accepting any further allocations. I surmounted this hurdle by allocating to groups of managers with diversified strategies, after I conducted my due diligence. I was looking to maintain my wealth, not make it. In essence, I was running a personal fund of hedge funds. I wasn't the only one--I became aware that there were organizations doing exactly the same thing. They would seed a fund with their own money, grow it, and then offer it to their clients. While many of these funds were ultimately unsuccessful, I was able to avoid the drawdowns of 1998 prompted by the Asian flu as well as the recent bear market. I allocated to groups of diversified managers with various strategies as well as cautiously managed money. I also started to invest with a manager who partly invested in asset-backed lending. I was certain I could provide the same benefits to other investors with the strategy I had devised for myself.

However, we experienced problems. Our greatest issue was putting new money to work safely. By 2003, we realized it would be hard to grow without the ability to put out substantial money and we decided to start a fund of funds in which we allocated to diverse managers with multiple strategies.

I found two men who had been in the hedge fund business since the mid-1980s who agreed to help me in my quest to form a fund of funds, which I began to call my "All Weather" fund. One was a founding member of a fund of funds organization started in the early 1990s that now manages several billion dollars. The other is a broker/dealer who maintains a proprietary database of over 2,700 managers. It wasn't their experience that made them most valuable; it was the personal relationships they had with money managers. These relationships gave me and my partners entr?e to managers who normally were closed to new investments. They also assisted us with the legal and regulatory steps. It took us over nine months of due diligence for manager selection and the legal work.

In reviewing prospective managers, I would always ask how they would respond to a worst-case scenario. I was not comfortable with some managers' concepts of risk. Paramount was that the managers had their own personal money in the fund. Others impressed me with their humility. One manager stood out. He was younger than I (41), but was already managing about $1.6 billion. He had been managing money since 1996 and had not only avoided the drawdowns of the bear market, he made money then. Two other managers were brothers with an arbitrage strategy who have not had a losing month since inception. They began their fund with $5 million of their own money and the fund now has $250 million.

While these managers might have good long-term track records, remember the second principle of investing: diversify, especially among hedge fund strategies. Potential clients have told me they wanted to invest with well-known managers who have been around since the 1980s and have billions under management. I remind them that there are absolutely no guarantees, and that we are dealing with risk and the unknown. There are no market wizards. There are managers who understand risk, realize that anything can happen in the markets, have a talent to make money for themselves and their investors, and maybe, just maybe, have the potential to continue to make money.

As financial advisors, being able to offer a fund of funds to our accredited investors puts a unique item into our toolbox. After all, a fund of funds not only provides diversification to the client and can give the advisor a competitive advantage over other advisors, FOFs provide a vehicle that can help retain assets for clients through another bear market.

Andrew Abraham is a partner with Abraham Bedick Capital in Ft. Lauderdale, Florida, and co-manager of the AB All Weather fund. He can be reached at a.abraham@abrahambedick.com.

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