HEDGE CLIPPERS: BUYERS, BEWARE

Hedge funds are one rage in a frothy market. Once bastions of the rich, the unregulated limited partnerships have proliferated, from a few hundred in 1990 to over 3,000 today.

As they become more retail, minimums are dropping. In 1990, the average was $850,000; today it’s $520,000, according to New York industry newsletter publisher MarHedge. You still have to qualify — have a net worth of at least $1 million, or an annual salary of $200,000 for two consecutive years — but many small hedge funds take as little as $100,000 now.

But what if you can’t qualify or $100,000 is still too much? Montgomery Asset Management will sell you shares of its Global Long Short Fund, a hedged international retail product launched in January. Since it’s a mutual fund, there’s no net worth requirement. The fund has attracted $17 million in assets, returning 36% the first four months of the year. Minimum: just $2,000.

Something domestic? There’s Zweig Euclid Market Neutral, with a $1,000 minimum, or Barr Rosenberg Market Neutral, with a $2,500 minimum. They long (buy) and short (sell) U.S. stocks.Montgomery, Zweig and Barr Rosenberg aren’t the only new mutual hedge funds. I found more than a dozen, either in registration or newly minted from firms like Dreyfus, Potomac, Puget Sound and ProFunds.

Why? Until this year, retail hedging operations were virtually impossible due to the Internal Revenue Service “short-short rule,” which said that if more than 30% of a mutual fund’s annual profits were from short-term (less than six months) gains, the fund would be double-taxed. The shorting of stocks (selling without owning, then buying back at a lower price), derivatives, currency swaps, etc., were all classified as short-term transactions — whether a fund held the position less than six months or not.

In its pure sense, hedging is offsetting long positions with short ones. The goal of a conservative hedge fund is to produce steady, positive returns — in up and down markets — with less risk than the market.

A fund like this can be useful, especially if you think the market is due for a correction. But such a fund, run improperly, is risky. Remember David Askin’s Askin Capital Management hedge fund? It bet wrong on interest rates with exotic mortgage-backed securities in 1994, and lost $400 million.

Are the new retail hedge funds worth considering? Depends on who you are. Costs, while mild compared to a regular hedge fund, are high versus a mutual fund. Global and Zweig each carry a 5.5% load and run up annual expenses of 2.3% — cheap compared to a regular hedge fund where, in addition to a 1% to 2% annual expense fee, managers take 20% of profits. But that’s expensive compared to an equity mutual fund. Many good ones can be had with no sales load, and with annual expenses under 1%.

More troubling may be the tax disadvantages. Hedge funds turn over their portfolios, on average, 200% per year while the average mutual fund turns more like 80%. Under the new tax laws, to get the preferential capital gains treatment of 20%, a fund must hold winners for at least 18 months. It’s fairly certain that Zweig, Montgomery and Barr Rosenberg will churn up big tax bills.

How about risk? Montgomery’s Global Long Short Fund “will give you the characteristics of a hedge fund, but not the same aggressiveness,” says Mark Geist, president of Montgomery Asset Management in San Francisco. Montgomery says the retail fund will be tamer than its institutional hedge funds — say, leveraging up 1: 1 for retail vs. as much as 3: 1 for institutional — but Mr. Geist wouldn’t give specific positions within the funds.

That 36% four-month return may be an early indicator. A conservative hedge fund often lags the market in up years, like we’ve had lately, and outperforms in down ones. Global Long Short is leading the Standard & Poor’s 500 stock index — by some 14 percentage points.

“(Thirty-six percent in four months) doesn’t sound like a low-risk, moderate-return fund to me,” says David Katzen, manager of Zweig Euclid.

Katzen is conservative, using the treasury bill as his benchmark. He says he’s beaten it by seven percentage points annually in his private hedge fund going back to 1990 by returning a compound average annual 12%. That’s six points under the S&P 500.

My advice: If you’re interested in these new animals, consider the cheapest funds first. Then check the managers’ previous experience. Many will already have run — or will be running — a similar institutional product, like at Montgomery (Angeline Ee and Nancy Kukacka) and Zweig (Mr. Katzen).

Pay specific attention to how consistently they’ve done with their regular hedge funds. If they were up 30% one year, down 40% the next, up 50% the next . . . be wary. A real hedging operation should produce positive returns, regardless of what index it tracks. Also, remember that regular hedge fund returns aren’t audited as strictly as mutual funds, so be skeptical. You may want to wait a year or so to see how the mutual fund does before anteing up.

Finally, because of potential onerous tax consequences, only consider funds like these for your Individual Retirement Account.

The good news is that the new hedged mutual funds eliminate the usurious 20% manager’s fee regular hedge funds levy. Further, because they are subject to the same scrutiny as a mutual fund, their numbers are more reliable.

James M. Clash is an associate editor at Forbes magazine in New York.