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How To Build A Poor Man's Hedge Fund

Ultimately unscathed and relatively unregulated in the post-crisis world of financial markets, the hedge fund space remains enormous in scope, risky in appetite and exclusive by design.

Stack of U.S. hundred-dollar bills
Stack of U.S. hundred-dollar bills

Another thing that hasn't changed is exorbitant fees—usually 2 percent for management and 20 percent of the fund's profits.

No wonder then that retail investors are starting to ask—why should I spend that much when I could do it myself?

Given the explosion of ETFs and other financial products in recent years, it's possible to create something of a poor man's hedge fund, which will allow you to diversify your allocation both in terms of strategy and asset classes in order to take advantage of the alternative investment space.

Steve Quirk, Senior VP of trading at TD Ameritrade, says investors are primed to begin creating their own low-cost hedge funds as they become more comfortable using derivatives in their portfolios.

“Before it was considered institutional—but now it’s headed for the mainstream. The only thing stopping people from investing in [derivatives] is a lack of understanding, says Quirk, who should know since derivatives now account for 30-percent of his firm's trading volume.

Size, however, still matters, and your relative size as a small—retail—investor means that there are things you can replicate and others that you can’t.

Here’s what you can do.

Long-Short

The ability to short the market is what hedging is all about. Shorting means that when market sentiment gets bad, you can sell what you don’t own, and make money in a bear market. But shorting stock is not for the faint of heart.

The strategy provides a form of leverage. “The alchemy of hedge funds is being able to buy any securities you want with the leverage you want—that is the secret”, says Michael Livian, founder of Livian & Co, a private wealth management firm.

But shorting stock is not cruise control; it demands close attention. The stock has to be borrowed for a fee, you have to deposit collateral on margin, and you must then monitor the position closely for drops in value. If this seems a bit too labor intensive, why not get the short exposure via a managed fund and pay a small fee for a pro?

Some fund houses like Aberdeen have made long/short funds available in retail sizes. Levels of shorting vary, though most limit short exposure to between 20 percent and 30 percent of the value of the fund. Effectively they sell the parts of the market (sectors or individual names) expected to go down, and then invest the proceeds in their long positions.

Fund houses like Aberdeen Asset Management have made long/short funds available in retail sizes.

“These funds won’t give you hedge fund-like 20-30 times leverage”, notes Livian, but adds that as much as retail investors can access leverage, long-short is a good way to go.

Two examples are Aberdeen Equity Long-Short A and Diamond Hill Long-Short A .

In sum, long-short equity strategies should do well in this directionless, volatile equity market.

Getty Images

Commodities

Typically characterized as “specialty markets,” commodities are considered too complicated for retail investors to understand. After all, it takes a streetwise investor to play wheat futures or oil price derivatives. Take heart, retail investor.

Invesco’s PowerSharesoffers 8 ETFs and 18 ETNs related to heavily traded physical commodities, such as corn, sugar and metals. These vehicles invest in commodity futures and package them into funds for retail investors.

“[ETFs] invest in the derivative contracts that small players cannot,” explains Livian.

With gold currently trading around $1,350 an ounce and many investors anticipating a move to $2,000 or more, ETFs like the SPDR Gold Trust , for instance, give you affordable access to the market. (The ETF is up up 13.4% through Oct 8.)

There's also ETNs, exchange traded notes, which offer exposure based solely on futures contracts with a maturity date.

If you think that global central banks will have their way in devaluing paper money, precious commodities like gold and silver offer age-old value.

Currencies

Global currencies are a trillion-dollar a day market dominated by institutional investors and central banks. But don't let this make you think that you shouldn't get a piece of the market.

Central banks are engaging in devaluation wars. As the old adage goes, you buy when the blood is on the streets. The Bank of Japan, BOJ, recently moved to weaken the yen whose surging appreciation was hurting Japanese exporters. It’s price manipulation, but it works. The hedge funds that were short Yen just before the BoJ moved made a killing.

Your poor man’s hedge fund would have profited by shorting the CurrencyShares Japanese Yen ETF.

CurrencyShares offers US investors nine ETFs that track global currencies.

You can also take advantage of appreciating currencies. Australia, with its large commodity resources is a hot investment area. With large amounts of money flowing into Australia, hedge funds have been buying the Aussie dollar to benefit from its appreciation versus the dollar. You can piggyback on this trade via the CurrencyShares Australian Dollar ETF . Beware, however. “Currency markets are very volatile. Currency ETFs move just as fast as currencies. You're going to have to trade these ETFs very actively," warns Jacques Kugler, Managing Partner of Arcticon Capital.

Trading actively here means getting a good understanding of the countries behind the currencies. Before you take a punt on the Aussie dollar, be sure to research their commodity-based economy.

What You Can't Do

Now that we’ve exhausted the purchasing power of the poor man’s hedge fund, here’s what you can’t do and why:

Distressed Debt

As of now, retail investors cannot get involved in the distressed debt market.

Here’s Why: When a company restructures in emerging from bankruptcy protection, equity investors lose out, and debt holders become the new equity holders. Hedge fund managers have found a way to get in on the action by calling themselves "distressed investors" and amassing large positions in this type of debt.

A 'large position' requires a multimillion-dollar investment in the company's debt, and time for the legal process to unfold. Given that the complex process demands multi-disciplinary expertise, the distressed debt market remains dominated by large hedge funds and private equity players.

High Speed Trading?

The Poor Man’s Hedge Fund cannot emulate quantitative, high-speed trading strategies because they require:

Computer whizzes to program complicated code for trading algorithms; cutting-edge computer hardware that can crunch the code and make microsecond trading decisions, and a very large pool of capital to take advantage of tiny price mismatches. Even fully equipped high-frequency shops estimate they make 0.1 cents per share on a trade. To put it another way, to make $100, you’d have to trade 100,000 shares.

“High frequency traders need to be physically located near an exchange to be able to trade in a nanosecond,” says Livian, Livian & Co.

Hasn’t anyone already tried this?

Yes. The IQ Hedge Multi Strategy Tracker ETFhas attempted to replicate an index of hedge funds by creating an ETF that invests in other ETFs. With meager returns, it is a one-stop shop solution for retail investors looking for hedge fund exposure without doing any of the legwork.

Considering the Index IQ management fee, you might want to think twice.

One of the rationales for using ETFs is the low fee. Index IQ is creating an ETF of ETFs. Thus when you buy this product, you pay all the fees on the underlying ETF (usually between 0.4-0.6 percent) and then on top of that you pay IndexIQ fees of more than 1 percent.

The hedge fund industry thrived for years because it managed to convince investors that its portfolio managers' skills are worth the 2-and-20-percent fee structure, say critics.

The few really talented ones justify their fee by investing in markets out of the reach of retail investors, with large pools of capital and cutting edge technology.

The rest? “Most hedge funds should be out of business,” says Livian.

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