Daily Money Tip: Links between mutual, hedge funds

What is the main difference between a mutual fund and a hedge fund? These days, the goodies inside the portfolios are strikingly similar. The only difference might be the wrapping paper.

For instance, which is riskier? A hedge fund holding hundreds of diversified stocks, or a mutual fund such as the popular Fairholme Fund (symbol: FAIRX), which has about 40 percent in one stock - the recovering insurer AIG? An investor's aptitude for risk should be the result of analysis.

To navigate the increasingly blurred lines between mutual funds and hedge funds, we checked in with Brian Portnoy, whom I first interviewed a decade ago when he was a mutual fund analyst for the Morningstar Inc. database.

Since then, he has worked as a hedge-fund allocator, someone who funnels money to hedge-fund managers on behalf of investor clients, and now helps create alternative investment products for his current firm, Chicago Equity Partners.

"Between 2000 and 2002, you could have lost half your money in an index fund and paid very low fees, or you could have made money in hedge funds," Portnoy said.

And yet, during this latest rally from 2009 to 2014, the markets are up strongly, and hedge funds have lagged.

"There's no way when the market goes up like this that 'hedgers' can keep up," Portnoy explained.

Instead, for investors in either a mutual fund or a hedge fund, "the goal over time is to capture a significant part of the upside and avoid the big downside losses," Portnoy said.

The return after fees and taxes - whether mutual fund or hedge fund - is most relevant.

Here are the questions investors should ask themselves:

What does this portfolio manager do exactly? Don't be afraid to ask what you think might be dumb questions.

Can I trust this portfolio manager? "Trust is more than forensic analysis by accountants, lawyers and due diligence specialists," Portnoy explained. "It is tricky."

Portnoy contended it is a psychological engagement to size up others as potential long-term partners with whom we have a clear understanding of interests.

Are these portfolio managers good at their jobs?

Are they the right fit for me?

Note that Portnoy's suggested questions for investors don't ask anything about performance.

"Performance-chasing doesn't work," he said. "Like a sugar rush, great returns feel good for awhile and then dissipate, as a manager rarely and consistently meets or exceeds our expectations."

Portnoy goes into more detail in his new book, The Investor's Paradox (Palgrave Macmillan 2014), outlining his investment and due-diligence process.


erinarvedlund@yahoo.com

646-797-0759

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