Questions and Answers

Patton Funds manages one of the most effective hedge investment strategies in the world — pools of money placed through a proprietary system via a hedge-fund manager to try to obtain, through a mix of investment styles, strong returns with low volatility. Below is an question and answer review about how to choose hedge funds, and why.

Q. What can hedge funds provide investors that they cannot get from conventional investments?

A. Hedge funds offer advantages from their ability to go short, to utilize leverage, and their limited liquidity. The ability to go short provides two advantages: The manager has a larger opportunity set than a long-only manager, who can only reduce a stock's weight to zero if he does not like it, and the manager can construct a portfolio that potentially has a low correlation to a long-only investment strategy.

For example, a manager uses his stock-picking skills to buy stocks he thinks are undervalued and to short stocks he thinks are overvalued. In a strong up market it is likely that the short positions will damage his performance, but in a falling market it is likely that the short positions will help his performance. In an arbitrage trade a manager can take advantage of a difference in pricing between two similar securities by buying one and shorting another and using leverage to obtain an acceptable return and risk. This activity, in general, has very low correlation to the equity and bond markets and offers good diversification.

Q. What percentage of a diversified global portfolio would you put into hedge funds, and how would it vary depending on personal circumstances such as age, risk tolerance and net worth?

A. Although some investors only invest in hedge funds, our view is that hedge funds are an addition to a well-diversified portfolio of stocks and bonds that helps to improve the return/risk ratio of the portfolio. We currently have an 18 percent allocation in alternative investments in our discretionary accounts [that have equal weightings in stocks and bonds], and we would expect this to increase over time. In our definition, alternative investments also include private equity and real estate, although at the current time our offerings are limited to funds of hedge funds.

For our advisory clients we recommend a diversified portfolio of stocks, bonds and hedge funds, subject to client suitability. Clearly a client who normally holds cash deposits and bonds will, in general, not be attracted to hedge funds and may not be offered any of our funds of hedge funds. Clients who are used to investing in stocks will be offered all of our offerings in a greater or lesser amount, depending on how stock-oriented their portfolios are. Our current suggested limit in one of our alternative programs is 20 percent to 25 percent of a portfolio.

Q. When choosing hedge-fund managers for Patton Funds, what factors do you look for and how do you rank them in terms of importance?

A. The principal factors are a sustainable, high-quality investment process and a robust company, financially and operationally. The investment process needs to have an edge in finding and executing investment opportunities and high-quality risk management of the portfolio. To examine this, we review the manager's strategy, the portfolio and individual trades which have made and lost money. We also look at their historic track record under different market conditions.

Q. What percentage of hedge funds would you guess provide risk-adjusted returns, net of fees, that are higher over a multiyear period than the return on a broad global stock index?

A. Your guess is as good as mine. In recent times there have been a number of publications that provide comparisons between hedge-fund returns and stock and bond returns. In general, these show that on a risk-adjusted basis, over a number of years, hedge funds have superior performance to a stock index, such as the Standard & Poor's 500.

Q. The percentage of managers who say they beat the market is probably closer to 100. Given that hedge funds are largely unregulated, how can you trust what a manager says?

A. The vast majority of managers have considerable pride and integrity in their businesses and have highly reputable organizations as their counterparties or advisers, such as auditors. In addition, the administrators of hedge funds, generally independent from the managers, are responsible for production of the funds' net asset values.

Q. Hedge-fund managers are renowned for their inscrutability, when they say anything at all. How can investors pry clear information loose from them?

A. The amount of information given out by hedge funds is variable. Some managers provide all their positions on a daily basis; others prefer to keep their positions close to their chests. However, the ability to place large sums of money with a manager gives extra leverage when obtaining information.

At Patton Funds, we perform continuous monitoring and due diligence on the managers, which is very time-consuming, and clearly we have considerably more power to obtain positions than a smaller investor. We also do not invest with managers who do not disclose sufficient information to allow us to monitor effectively.

Q. Is there a way for smaller investors to get the same information?

A. Apart from reading about the strategies and taking industry publications such as Managed Account Reports, Eurohedge and TASS, no use of leverage is thought to be declining. Were managers chastened by the near demise of Long-Term Capital Management LP, or do they just not need to borrow because stock markets are providing such a low hurdle to clear? Is 1998-style leverage gone for good?

Q. Another reason for reduced leverage is that some celebrated managers of macro funds have closed up shop or drastically curtailed their operations. Are macro funds gone for good, and if so, what effect will that have on hedge funds overall?

A. It is not possible to design an investment strategy that makes money all the time. There will be good times and fallow times, but over the long term a winning strategy is one that has a good return/risk profile. It is certainly true that a number of high-profile global macro funds have had poor performance in recent years. This is partly due to the weight of money invested in this area — making it difficult for managers to move in and out of investments in a timely manner — and partly due to changing market conditions in the macro markets — choppy markets in currencies and interest rates. Whether these changes are permanent or temporary is too early to say.

Q. A number of hedge funds targeting smaller investors have started up. Are there any that you like or that are run by managers you like, and what do you think of the idea generally?

A. We do not advise on individual hedge funds. Due to the risks outlined above, we believe a fund of hedge funds is the best way to make an investment in hedge funds.

We do not advise investors to use hedge funds in their portfolios unless they can afford to diversify across a reasonable number, say 10. Likewise, we would not advise clients to invest all their assets in one stock. The reason for buying a mutual fund is that you can benefit from the pooling of assets to obtain diversification across different stocks. The same argument applies to hedge funds. Until there are fund-of- fund offerings which allow small investments, it is not possible for investors to get the diversification we recommend.