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I'm Winning. Now What?

If I were up 100%, I would stick a good chunk of my fund's assets in cash. But I'm not up that much.

My hedge fund had a bad year last year. So far this year, it has a double-digit percentage-point lead over the market. That's a substantial advantage, but it's not an insurmountable one; it could easily disappear by December 31. So what is a voice inside my head whispering? "Sell everything and put the money into an S&P 500 index fund."

That is a new thought for me. But that's because running a fund plays games with your head. Maybe you can explain away one lousy year. ("I was heavily medicated." "My dog died." "I watched too much Cramer.") But in the hedge-fund world, you run the risk of client defections if you suffer two bad years in a row. So, rightly or not, I feel as if I must beat the market this year. And so the voice adds: "If you lose your lead, you won't be able to live with yourself. Index now!"

Games funds play. A recent Wall Street Journal article suggested that the practice I'm describing is more common than you might suspect, especially for hedge funds -- and mutual funds -- that enjoyed a huge first half. After all, if you're up 60% and the market is up 5%, you'd be nuts not to take steps to protect that advantage. But there's a big difference between trying to reduce volatility and fleeing entirely for the shelter of an index.

A former hedge-fund operator tells me he knows a lot of managers who resort to indexing after a big first half and then "lie to their clients about it." After the second quarter, he relates, the managers would liquidate all their positions and take cover in index funds. During the third quarter, they'd describe to clients their Potemkin portfolios, never admitting how they were actually invested. Then, right before the next reporting period, they'd reverse the process. The subterfuge would be repeated in the fourth quarter.


Disgusting? Kind of. But the logic of the hedge-fund biz is so warped that such chicanery is understandable. In a normal world, an investor would care most about a manager's long-term performance. But most people who allocate money to hedge funds are obsessed with short-term performance. And this can drive people like me crazy.

In the past few weeks, I've become aware of the conflict of interest inherent in running a hedge fund. Clients pay me to beat the market, something I've done handily since 1996. They're not paying me to hug an index. But in addition to managing money, I am trying to run a successful business. So, I would gladly sacrifice some additional returns for the certainty of beating the market.

Ah, the safety and warmth of an index! But I can't -- and won't -- go that route. If I were up 100%, I would stick a good chunk of my fund's assets in cash. But I'm not up that much, so I won't. Instead, I've taken some prudent and what I hope are morally defensible steps to increase the odds that this year ends well.

I have trimmed one micro-cap position from a 10% weighting down to 5%. I have made less-dramatic cuts in allocations to other tiny companies. With the proceeds, I have purchased some large-cap stocks -- Goldman Sachs (symbol GS), Express Scripts (ESRX) and Vodafone (VOD) -- that are unlikely to implode. Although I invest in companies of all sizes, I am astonished to own seven stocks with market caps of more than $85 billion. That's unusual.


I have also paid more attention to sector weightings. I remain overweight in technology and health care, but I have trimmed financials and boosted my meager holdings in energy and materials stocks. Even after all this, my ten biggest positions account for 39% of my portfolio. You can't accuse me of hugging the S&P 500.

Have I done the right thing? Am I still trying to do right by my clients while trying to protect my own interests? I think so. The proof, in my mind, is that all that tinkering has left me only slightly less petrified that my lead will vanish before the year ends.

Columnist Andrew Feinberg writes about the choices and challenges facing individual investors.