Hedge--Don't Hog

By James J. Cramer

Did you perspire when you read the stories about the recklessness of the hedge-fund managers at Long Term Capital? Did you check out the mumbo jumbo in the prospectus of your mutual fund to see if it might be using your nest egg as collateral to borrow millions to bet on, say, the 49ers game? Relax. The securities regulators are better than you think. They worry more about you than about the folks who invested in Long Term--the sort who can drop $10 million without having to sell their jets.

Mutual-fund regulations prohibit the kind of leverage that drove Long Term Capital into receivership. The Securities and Exchange Commission also makes mutual funds disclose details of their investments. There are few such restrictions on hedge funds--or protections for their investors--except that the funds may not accept investors with less than $1 million in liquid assets.

So why would anyone want to invest in a hedge fund? Historically, these funds have delivered superior long-term returns--in falling markets as well as rising ones. Hedge funds are so named because they're better able to hedge risks. They are meant to play both offense and defense. They can bet on some stocks to rise and others to fall. Even when they bet on a stock to rise, they can buy a separate position that cuts their losses if that stock falls sharply. And they can invest in any instrument--stocks, bonds, pork bellies--in any country they want.

Most hedge funds use these tools to diversify. But a few, like Long Term Capital, have used them to make huge borrowed-money bets on instruments that can't be found in any newspaper, seeking sky-high returns that can't be sustained. These aren't hedge funds so much as hedge hogs.

As a fairly traditional hedge-fund manager, I use leverage sparingly and don't buy any instrument whose price can't be found in the Wall Street Journal. I bet on stocks that my research shows to be under- or overvalued, not on the direction of the French yield curve or the Thai baht. I play defense by betting against stocks that are too expensive, usually by buying put options--in essence, borrowing shares that I can repay at a profit after the price declines.

Options trading is too complex for the typical investor, but there are other good ways you can hedge risk. The first is to balance your portfolio in a way that lets you sleep at night. You should buy stocks for superior long-term returns, but any money you'll need in the next three years should be in cash or bonds. Bonds also reduce your portfolio's volatility because, as we saw last week, their value often rises when the stock market falls.

Balance your purchases of stocks and stock mutual funds among large, midsize and smaller firms or funds. If you buy stocks, spread them among a variety of industries. You might, for instance, buy shares in a well-run oil-service company, which prospers when oil prices are rising, and in a great car company, which profits most when oil prices are falling.

Above all, don't do what investors in Long Term Capital did. Don't put your money in any fund or company just because it's run by somebody whose press clips call him a genius and who has a Nobel laureate or two onboard. Don't jump in unless you understand exactly how the fund is investing or how the company behind the stock is being managed. Some multimillionaires can afford not to do their homework. The rest of us cannot.

Cramer writes for thestreet.com an investing website, and manages a hedge fund. His fund is closed; this is not a solicitation. Nothing in this column should be construed as advice to buy or sell stocks.