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If you think your portfolio has experienced a lot of volatility over the last two months, consider the case of Sowood Capital, a Boston-based hedge fund. They lost more than 50 percent of their assets in just the month of July.

This debacle came through a massive collapse of their positions that were tied to the falling bond and credit markets. If they had not been able to sell the remainder of their portfolio to Citadel Investment Group LLC, and were forced to liquidate the remainder of their holdings, they might have experienced a near-total liquidation.

This was only one of several very large, well-known hedge funds that ran into trouble in the credit market collapse. Goldman Sachs Asset Management, Bear Sterns and several other very large firms all had serious problems in affiliated hedge funds. What is interesting about this, at least to those who were not invested in the funds, is that these staggering losses came in investment vehicles that were supposed to help sophisticated investors reduce their overall portfolio risk.

My favorite comment, in the financial press, about this event was when another investment manager described this debacle as “mind boggling.” I guess that is one thing you can call it when a group of supposedly sophisticated investors loose up to a third of their portfolios’ value in just 10 days. This event alone may not be sufficient to reshape public perceptions of hedge funds risks, but it is a start. What is important to understand is that this type of event is not an exception to the rule; this is the normal course of occurrences. While I doubt these specific events might not repeat themselves, the history of financial markets demonstrates that these types of events always repeat themselves.

In the past similar difficulties with investors like Drexel Burnham Lambert, Long Term Capital Management, BNP Paribas, and hosts of others have forced central bankers to take aggressive actions to prevent a global meltdown. After each of these near disasters regulators believed that they had a better understanding of how to monitor, manage and control risks so that it would not happen again. Unfortunately this did not work and the lessons were soon forgotten. Today central bankers are again forced to take aggressive actions to prevent a global meltdown.

Some of the more recent unexpected collapses we suffered through were the dot-com bubble, the junk bond crisis, the peso crisis, the savings and loan crisis, the Russian crisis, and the Asian flu. This time the collapse in the credit markets is impacting the subprime mortgages, low-grade bonds, housing, and other financial assets. Similar types of problems, different time period, different financial instruments.

Isn’t it ironic that a great amount of this wealth destruction has come about through investments in bonds? These instruments are what prudent investors fall back on for safety. How could one of the safest investments been the cause of this much wealth destruction? By changing the nature of these products from one of a risk reducer to one designed to earn excess returns, their characteristics were distorted. Overzealous financial engineering of these instruments by hedge funds has caused many of the current problems in the financial markets.

Let’s see how this can happen. A typical hedge fund strategy in the fixed income market involves borrowing at a cheap rate in one market and then lending at a higher rate in another market. This can be done by low-cost borrowing in the Japanese markets and depositing the borrowed sums in a much higher-yielding foreign market. Or, you would borrow (if you have the credit) at T-bill rates and invest (lend) in the high-yield bond markets, thereby pocketing the difference between the two rates, called the spread.

This seems like a whole lot of work to go through to earn a few percentage points. Well, for most investors, it is. But for many hedge funds this is the stuff of which dreams are made. You see if you are a hedge fund you can turn a two-point spread between different quality bonds into a business. It works like something like this.

First you find an attractive spread between two different markets, one that historically has a nice expected return. Say, for example, in this case that the spread shows you can earn 4 percent on this trade. Then you need to back test it for robustness. This is simply a mathematical process to see how this strategy would have performed looking at historical data. You are trying to see what would have happened historically with this trade, sort of like a big game of what if. When you are satisfied that you understand how this spread works, and the risks are manageable, you can turn it into a business.

Since you can’t attract investors to a strategy that earns only 4 percent, and still makes you money, you need to add a little something extra to boost the returns. That something extra is leverage. If your spread earns 4 percent, and you leverage it 5-to-1, all of a sudden you have engineered a strategy that earns 20 percent annually. If you market this as a hedge fund, keep 2 percent for management and 20 percent of the profits for your efforts, your investors still have an expected return of 14 percent. Since stocks have earned about 11.5 percent historically investors will beat your doors down for this opportunity.

This is a very simplified description of the types strategies employed by many of the quantitative funds that have gotten into so much trouble recently. They found relationships between various assets that they thought were relatively stable and then they leveraged their strategies to enhance returns. Since they owned one asset (were long) and borrowed another (were short) they felt very confident in marketing themselves hedge funds.

Here is what they forgot when they concocted these strategies using bonds. When you invest in bonds and absolutely everything goes right, when they come due you get your money back. Unfortunately they learned the hard way that many of the bonds that they invested in were never going to return their monies and the ones they borrowed wanted their monies back.

All of a sudden these relatively stable spreads they discovered were no longer stable and the leverage they employed accelerated their losses. These lessons, while important for funds, are crucial to individuals. Unlike large institutions if you make a mistake in your own investment portfolio there is no federal reserve waiting in the wings to bail you out.

This does not mean that you should avoid fixed income securities. Bonds are an important part of all well-diversified investment portfolios. When properly used they are great diversifiers, have a large measure of safety and provide cash flows to your portfolio. When you put a substantial portion of your investments into fixed income you usually do it to help reduce your portfolios volatility. When the markets are in disarray you want your bonds to help cushion the blow not implode with your other holdings.

Here is what you should know about investing in bonds to help protect your portfolio. When you invest in bonds for safety you need to invest in very safe bonds. If armies of Ph.D.s, CFAs, and MBAs with extensive access to research, equipped with impressive computing power can lose half their money trading risky bonds how can you expect that the same will not happen to you?

Following these three simple rules about bond investing will help you minimize any unpleasant surprises. First, keep the maturity of your bonds relatively short. Invest for long periods of time but only lend for shorter periods. Second invest in only high grade or insured debt obligations. Third, make sure that your bond portfolio is well diversified.

Generally speaking if you keep your bond maturities to less than 10 years, with an average closer to five, your bonds will have a good trade off between risk and reward. You have a very high probability of recovering your principal. When you loan money over longer maturities changing market conditions often cause a great deal of volatility in your portfolio.

Long-term bonds often increase portfolio risks at very little additional reward. Current investors only receive an addition three-eights of a percent for investing in a 30-year Treasury bond over a five-year bond. This is not a lot of additional compensation for tying up your funds for an additional 25 years.

If you limit your bond investments to the highest-grade issues, either individually or in funds, you remove many of the risks that hedge funds have run into in their bond dealings. Treasuries, agencies, high-grade municipals and high-grade corporate bonds all work well in reducing risks. You should be investing in fixed income for safety and not to enhance returns. When you start to take risks with the credit quality of you bond portfolio you introduce a huge amount of complexity into the equation. These are the types of risks that the hedge fund managers thought they could control, can you?

Finally, try to get a reasonable amount of diversification in you fixed income holdings. Unless you are managing a very large portfolio you might have to invest in bond municipal fund, exchange traded funds or unit trusts to achieve enough diversification. This is particularly important for investors with large portfolios of municipals obligations. Often investors concentrate their monies in only a few municipal issues or a single state. While the odds of something happening to any one issue are slim you should not be overly concentrated in you holdings. If giving up one-tenth of a percent in after tax yield is what it costs to get greater diversification it might be the cheapest insurance you ever find.

Short-term, high-quality bonds protect your portfolio when you really need the protection. Don’t compromise their ability to help dampen volatility by taking unneeded risks through extending maturities, buying lower-grade credit issuers or concentrating you portfolio in just a few issues. You should leave the risky bond strategies to the pros, although after the past several months I think many investors will be reassessing whether or not the hedged strategies are really worth the unseen risks.

WILLIAM Z. SUPLEE IV is the president of Structured Asset Management Inc., a financial planning and investment advisory firmlocated in Paoli, Pa. He may be reached at 610-648-0700 or [email protected] .

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