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This is the problem: hedge funds have not really had positive returns since 1997. I do believe, from 1946 (starting with AW Jones, Ben Graham, Warren Buffett, George Soros and other early hedge funds) to 1997 that hedge funds had alpha – the ability to quantify an edge and outperform benchmarks and peers. There was just too much of an information gap between the hedge funds and their weaker, less-informed counterparts at the mutual funds or among retail traders.

Mr Buffett would literally go to the hometowns of companies trading for less than their net asset value and hang signs up offering to buy people’s shares. He knew there would be takers because the stocks were just too illiquid back then and these companies traded on disconnected exchanges or in random back alleys and deserted saloons across the Midwest. You want alpha? That was alpha.

After 1997 it was all over and the Long-Term Capital Management crisis in 1998 was the final nail in the coffin. Let us look at what has happened since then. First, in 1998, hedge funds were flat as a group owing to LTCM (I am working off the various indices and published data on hedge fund performance from S&P, Tremont and so on).

In 1999, hedge funds were up as a group but it was a bubble and everyone was up. In fact, the worst investors did the best in 1999 so it is not even worth comparing. From 2000-02 the comparison got even easier. Everyone was down. So it did not matter that hedge funds were only 3-5 per cent up. Heck, they were up! And 2003 was a great year for hedge funds. But they underperformed the bounceback of the S&P and the Nasdaq. And 2004 and 2005 were strictly mediocre, just like 2006 is turning out to be.

So what happened? Why can’t they outperform? One reason they did as well as they did in the 2000-03 period was a matter of three simple words: mutual fund timing. Every fund of funds loaded up on the mutual fund timers. And why not? They were returning a consistent 3-5 per cent a month with no problem, and everyone had a legal opinion from the best law firms in the country that the SEC was going to turn a blind eye towards it. Well, when the game was over on that, hedge funds and funds of funds never recovered and have still, to this day, not figured out a way as a group to outperform Libor minus their 2 and 20 fees on a consistent basis.

Right now, it is very difficult to get an information advantage in these markets. There are, I think, several anomalies in the markets that in general allow you to get little advantages here and there if you are a retail investor trying to fight the big hedge funds and mutual funds. The key is to look at the sandboxes where very few people are playing.

One such sandbox is in the area of closed-end funds. Closed-end funds are publicly traded mutual funds that trade on the major exchanges, usually the NYSE or the Amex. Because they are publicly traded, the price of a closed-end fund is set by the market. Even if a CEF has $100 a share in assets, the price might be only $95 or $90 or even $105 depending on the public’s attitude towards the sector the CEF is in, the management running the CEF and a variety of other factors. Often, because CEFs are not as sexy as owning Google or even as sexy as owning Alcoa, the discount to net asset value that a CEF usually trades at can be explained by nothing more than ennui.

Another important characteristic of closed-end funds is that they usually consist of very low-volatility instruments such as municipal bonds or T-bills. It is rare for a CEF to be up or down 10 per cent or even 2 per cent on any given day. Another aspect is that these stocks are often too shallowly traded for any of the big hedge funds to get involved. The space is capacity- constrained and, hence, shunned by the hedge funds and mutual funds. The lack of volatility keeps out the day traders. And the lack of sexiness keeps out the average retail trader.

In other words, we have all the makings of an anomaly. To take advantage of this, I like to buy CEFs that are trading at a much larger-than-usual discount to net asset value, offer a high dividend yield and typically have some other catalyst that makes me think the discount will narrow.

We are going through a cataclysmic change now in asset allocation as funds of funds, mutual funds, hedge funds and money management firms are all trying to converge on the same business model with little hope of convincing their customers they have an edge. In an environment like this, sometimes the best approach is to lay low and pick up the scraps of healthy food that the drunken partygoers have thrown into the garbage.

james@formulacapital.com

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