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'Short-bias' hedge funds rise on market woes

NEW YORK — In a year when making money investing in stocks has been tough, hedge funds that "short" the market, or profit when prices fall, have posted big gains.

Through Sept. 30, the most recent data available for the secretive hedge fund industry, "short-bias" hedge funds were up 16.2 percent, vs. a 0.2 percent gain for the Standard & Poor's 500 and losses for the Dow Jones industrials and Nasdaq composite, says hedge fund consultant Hennessee Group. Short funds sell borrowed shares, hoping to buy them back later at a lower price.

The success of short funds this year highlights a key selling point of hedge funds: By virtue of their freedom to execute a wide array of investment strategies, their returns do not closely mimic the returns of mainstream asset classes, such as stocks and bonds.

These largely unregulated investment vehicles geared mainly to the rich have become wildly popular in the past few years, in large part because they can provide downside protection and post positive returns when the broader stock market is declining or flat, says Charles Gradante, managing director at Hennessee Group.

As of January, hedge fund assets totaled $795 billion, more than double the $324 billion of 2000, Hennessee estimates. In that period, the number of funds increased from roughly 4,000 to 7,000. Most hedge funds charge an annual fee of 1 percent of assets plus take 20 percent or more of the profit.

The hedge fund industry has been working to improve its image after a few high-profile fund blowups, fraud committed at some smaller funds and concerns about the dearth of information they provide to investors. The Securities and Exchange Commission is considering whether hedge funds should register with regulators, which would allow greater oversight.

The performance of all types of hedge funds compared with the broad stock market this year has been far less stellar. The Hennessee hedge fund index, which tracks 23 investment styles, was up 2.6 percent through Sept. 30, 2.4 percentage points better than the S&P 500.

Hedge funds caught the attention of investors during the three-year bear market that ended in 2002. While the S&P 500 was on its way to losing half of its value, Hennessee's hedge fund index made money, posting gains of 7.6 percent in 2000 and 4 percent in 2001, and losing just 3.5 percent in 2002.

But implementing a short-only strategy is risky because it is unlikely one style of investing will outperform for long periods of time, says Mort Cohen, chairman of hedge fund firm Clarion. Last year short funds lost nearly 23 percent as the broad market rallied.

In general, hedge funds tend to underperform the stock market when prices are in a clear up trend. In 2003, for example, when the S&P 500 was up more than 25 percent, hedge funds of all types tracked by Hennessee gained only 20 percent.