Barton Biggs made his name as the “sourpuss” (as one journalist put it) lead investment strategist at Morgan Stanley over a period of 30 years. A value-oriented investor, Biggs was a killjoy during the Great Buying Panic of the 1990s, and the New Paradigm cohort loved it when his curmudgeonly writing in the twice-monthly Morgan Stanley Investment Perspectives turned out wrong. Of course, nobody in the investing game is always right. (Biggs, however, is on record in 1999 comparing the Internet boom to the speculative mania that gripped biotech stocks in the early 1990s.) Biggs has done well, making himself and others who have invested with him over the years plenty of money (before starting up Morgan Stanley's research department, Biggs ran a hedge fund in the 1960s, another popular time for the investment vehicle).

But in 2003, at the age of 70, he chucked it all to launch another hedge fund, the global/macro Traxis Partners, only two years after saying that “hedge fund mania now grips the U.S. and Europe” and “is rapidly assuming all the classic characteristics of a bubble.” In his book, Hedgehogging (John Wiley & Sons, 2006), Biggs not only describes what the trials and tribulations of launching a hedge fund (raising money on road-show tours is no fun; yes, even legends must tour to raise money), but he also takes readers on an opinionated journey across the investment world. The book is written as an informal memoir, with vignettes from various phases of his life. Interestingly, it is all the new hedge funds opening up by “new, naïve, trigger-happy crazies, long on aspiration and short on experience” whose losses may expand the “alpha pool” for crusty veterans like himself. In this short excerpt, which is typical of the style of the book because he describes an expert friend's investing strategy, Biggs describes what to look out for when examining hedge funds.

Think of Returns Net After Fees and Taxes

Another evening I had dinner with Sam, an old friend, who some 15 years ago sold his company and walked away with a big smile and some serious money. Since then, he has worked intensely at both his golf game and at enhancing this fortune. He has been very successful in both. Along the way, he has come to some interesting conclusions about how tax-paying Americans should manage their money.

To summarize Sam's philosophy, all returns should be looked at after carries and, above all, after taxes. Returns are reported pretax and thus they are an illusion, because achieving high after-tax compounding is what the exercise is all about. Liquidity and transparency of the investment vehicle are crucial. An investor has to have the right to change his mind and get his money back. My friend likes to keep it simple, and, as a result, he doesn't do much in real estate or oil and gas deals: “Too complicated, too illiquid, and the carries are too big. Besides, it's almost impossible to calculate the returns, because they pay the money out over ten years.”

Sam doesn't use private wealth management firms to run his money. Their best talent, he says, either invests funds or institutional accounts, and the individual gets short shrift even if he has big bucks. Besides, in the present environment, the best and the brightest inevitably will migrate to hedge funds. He maintains that no major firm, either in Europe or the United States, has its act together on private wealth management. As a result, he has concentrated on hedge funds. He doesn't use funds of funds because he feels he knows as much about hedge funds as they do, and besides their fees take a huge bite out of returns. On the other hand, he concedes they do make sense for less knowledgeable people.

Hedge funds are glamorous, Sam says, and when you are in one that is flying, spectacular top-line (gross) returns can make for great cocktail party conversation. But a tax-paying U.S. citizen must look at the returns after the general partners extract their 20 percent fee and after taxes on the gains. He invests in hedge funds that have active strategies, that go for it. He is willing to live with the volatility. Market-neutral stock pickers have no appeal for him.

What has worked for Sam is finding a handful of great, enduring funds, knowing the managers well, concentrating on them, and staying with them. Over the past decade, the three great hedge funds in which he has amassed his money have delivered a pretax IRR after carry of 25.4 percent per annum versus 11.1 percent a year for the S&P 500. The three great ones had a volatility of 21 percent over that period versus 15.8 percent for the S&P, which means 10 percent declines in a month will occur from time to time. After taxes, the IRR to him, as a tax-paying investor in the United States and California, shrinks to 16.3 percent as 71 percent of their gains were short term because they trade a lot. Of course, the S&P 500 return also is before taxes. He finds that as a higher percentage of their funds become tax-exempt institutions, the general partners tend to become even less conscious of taxes.

My friend looks for large funds with stable management that will outperform in up markets and protect your capital in bad ones, which is all you can ask for. You shouldn't expect them to make money in down markets, and you have to recognize that they are going to deliver you a big tax bill. Obviously, for tax-exempt institutions it's an entirely different matter, and Sam thinks hedge funds are the perfect vehicle for medium-sized foundations with unwieldy and ignorant investment committees. Because they don't pay taxes, the compound can be fabulous.

Hedge-fund selection and timing require research and hard work. Entry points are crucial. “Nobody talks about the high failure rate in start-up hedge funds. Just because the managers say they are going to run a low-risk fund and will always have a lot of shorts doesn't mean they can't lose a lot of money. Sometimes the longs go down and the shorts go up.” Sam also is very leery of U.S. stock pickers who, “puffed up with success,” think they can do macro — international markets and foreign exchange plays. “Currencies and Japan have killed some of my best friends,” he says sadly. He also points out that many hedge funds that opened in the late 1990s were really leveraged, long-only funds, and a lot of them got beaten up badly or wiped out in the bear market.

My friend will seed with a million dollars a start-up fund that has credible operators “just for the look.” He wants to get to know them better, read their reports, go to their partners' meetings, and understand their style. He will call on them in their offices. If, over a couple of years, he likes what he sees and they do well, he will raise his stake. However, he points out that his results away from his big three funds have been mediocre.

Sam's basic strategy is to have 75 percent of his hedge-fund money in four or five core, established funds that he feels he knows inside and out. He then has the rest in his “farm team” of around ten rising stars. Size is the enemy of performance, he admits, but the funds in his core group are big. World-class reputations attract money, and a fund has to have a certain critical mass to buy the best young talent and trading coverage. With all of them, at the first signs of hubris or fading intensity, he starts cutting back his stake. A bad year or a big monthly drawdown, and volatility, doesn't trouble him, as long as he is convinced the managers are staying focused. He wants his hedge-fund managers to be obsessive, self-absorbed, somewhat obnoxious people. It doesn't bother him in the least that the best ones are often very hard on their employees and not popular with Wall Street salespeople and traders because they don't suffer fools. He likes grumps.

The rising stars are attractive because their assets are not so big, and thus they can take meaningful positions in small and medium-size companies. They also can move positions more easily than the giant funds, which is a huge advantage if something goes wrong. All things considered, he thinks hedge funds are the best investment vehicle for wealthy individuals, but they require constant attention and some know-how.

In general, Sam believes in being an owner rather than a lender, and, as noted, he is very tax conscious. As a result, he doesn't have any use for taxable bonds or Treasury inflated protected securities (TIPS), because the taxes eat you alive. “TIPS don't work for individuals,” he says, “because you are paying taxes on the inflation component so the real return is almost nothing.” Real estate investing is tricky, and the funds he has looked at are compensated through transaction and management fees rather than sharing in the profits generated for their investors. In other words, the promoters' interests are not aligned with those of the investors. Oil and gas investing is the same story. The deals always sound enticing, but almost invariably end up with the operators and the general partners getting rich while the investors don't.

Sam has two-thirds of his money in hedge funds. He does think every wealthy person ought to have a lifestyle reserve in high-grade tax exempts. How big should that reserve be? It depends on the age and wealth of the individual. “Ideally,” he says, “it ought to be enough to support you in a basic, affluent lifestyle if the stock markets crashed and stayed busted.” His concept of a basic lifestyle might be a little exalted, but the concept still makes sense. “Such a dire outcome is unlikely,” he adds, “but why take any chances? Besides, tax exempts are relatively cheap now.”

Select Hedge Funds with Skeptical Care

It's crucial to get in the right hedge fund, too. Over the five years ending March 31, 2003, the spread between the twenty-fifth and the seventy-fifth percentile in all hedge funds tracked by the TASS database is 9.5 percentage points (plus 12.7 percent per annum versus 3.2 percent, with the S&P 500 down 3.8 percent per annum over the same period). As you would expect, the volatility of the hedge-fund universe funds is much lower than that of the private equity classes: 15 percent for hedge funds versus 21 percent for the S&P 500. As for hedge funds of funds, the spread is smaller: 5.3 percentage points (plus 9.2 percent per annum versus 3.9 percent, with a volatility of 12 percent). Of course, hedge funds are much more liquid than private equity and usually more transparent ….

Sam also has a good perspective of what is going on in the hedge-fund industry. He says the really big-time legitimate hedge-fund operators with good long-term records are being flooded with money. Because they already have more than they can run fast with, they are laying off much of the new money. They basically put into business young guys who smell like winners. The big-time operator tells his clients that he has this new Emerging Managers Fund with five of the smartest young guys he has seen in years. He reminds them that young guys with no fear and imagination can shoot the lights out, but young guys without fear can also do crazy things. So he, the big-time operator who has seen everything, is going to watch them as closely as a hawk watches mice. The investors eat it up. It's the best of both worlds for them.

For example, Sam says, there is this guy named Jimmy located in Newark, who is a wild trader and has a great record. In his glory days, Jimmy charged 50 percent of the profits and no fixed fee. Jimmy is not dumb. He knows he can't day-trade billions the same sly, slimy way he ran a couple of hundred million. So he has decided he wants to build a hedge-fund empire, and he has changed his fee to 30 percent of the profits and 2 percent of assets. As long as he keeps his golden touch, the money will keep pouring in despite the outrageous fee. To handle the inflow, he is putting kids into business right and left. The story is that last week he took a hot kid from another older hedge-fund guy and gave the kid $300 million. The terms work out to be 15 percent and 1 percent to the kid and the same for Jimmy. That kind of money can turn even a good kid's head. On the other hand, over the next year it could give the kid an early ulcer or migraines, because Jimmy is notorious for being a fast hook. You had better perform if you are running Jimmy's money, and if he does hook you, don't expect a golden parachute. Anticipate nothing but public bad-mouthing. As far as Jimmy is concerned, he has never made a bad decision on stocks or people. Any bad performance is because guys let him down.

The funds of funds version of craziness also is looming. Charlie Munger recently remarked, with his ancient tongue firmly in his cheek, that he liked the idea of a fund of funds of funds. Says he, “If a second layer of fees is good, then a third layer must be better.” Alas, it is already happening. A London-based $3.8 billion fund of funds, in order to take diversification to the next level and cut risk, is creating a fund of funds of funds, which will invest in 11 underlying funds of funds …

History shows a well-managed fund of funds over a period of years at least keeps up with the S&P 500 in good markets, preserves your capital in down markets, and does this with lower volatility. This is no inconsiderable achievement. For the boom-bust five years that ended March 2003 the S&P lost 3.8 percent per annum and the median fund of funds gained 6.3 percent. The seventy-fifth percentile fund of funds returned 9.2 percent and the ninety-fifth showed 15.7 percent. Funds of funds make all the sense in the world for all but the Sams.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from Hedgehogging. Copyright (c) 2006 by Barton Biggs.