L.A. hedge funds basking in glow of excellent results.

Now may not be the best time to be looking for publicity in the largely unregulated hedge fund industry, which has come under increased scrutiny by the Securities and Exchange Commission.

Regardless, several hedge funds in the Los Angeles area are basking in the limelight of strong returns.

Dorchester Capital Advisors LLC, which runs four separate fund-of-fund hedge funds, generated a compounded annualized return of 23.5 percent in 2003, compared with 28.7 percent for the S&P 500 and 4.1 percent for the Lehman Bros. Bond Index, according to Mark Zucker, one of Dorchester's principals.

Through June 30, the firm's compounded annualized return was 4.6 percent, compared with 3.4 percent for the S&P 500 and 0.2 percent for the Lehman Bros. Bond Index, he said. Dorchester returns do not include management fees.

Hedge funds use aggressive strategies that include short-selling, program trading, swaps, arbitrage and derivatives that are not available to mutual funds. Moreover, hedge funds are restricted by law to no more than 100 investors per fund, so they set high minimum investment amounts, typically starting at $1 million.

The funds are lucrative for their managers, who often receive a fee of 1 percent to 2 percent and collect as much as 20 percent of the profits.

Like their counterparts in the mutual fund industry, fund-of-fund hedge funds reduce the risk further by spreading clients' investments among a number of funds. Fund-of-funds managers typically earn an additional 1 percent fee and 5 percent of the profits, on top of the fees of their constituent hedge funds.

Growth of fund-of-funds

While Los Angeles has always had a handful of high-profile hedge funds, including ones run by MW Post Advisory Group and Canyon Capital Advisors, it has relatively few fund-of-funds.

One of the only other local fund-of-funds, Mosaique Capital Management LLC in Beverly Hills, is affiliated with Bear Stearns & Co.

Zucker and another Dorchester principal, Michael Halpern, met while attending University of Pennsylvania's Wharton School in the early 1980s and both learned the ins and outs of the industry while running their own hedge funds in the late 1990s.

Zucker's Anvil Investment Partners, in Los Angeles, did not have much success. Halpern, who worked for David Murdock's Pacific Holding Co., launched his own hedge fund in 1992 but shut it down in 1999 because he was uncomfortable about the run-up in the markets.

Both found they had an eye for picking hedge fund managers and preferred scouting the top players in the industry to merely running a fund. Dorchester currently invests with 44 different hedge fund managers.

"A lot of our relationships and our investors, who find us by word of mouth, come out of working in investment banking in New York," said Halpern, who began his career in the mergers and acquisitions group at Goldman Sachs & Co.

Despite the high fees, wealthy investors became enamored of hedge funds several years ago when the stock market tanked and many sought to protect their capital.

"The reason why people are attracted to hedge funds is they understand the principle of trying to grow your money without losing it," said Zucker, a co-founder of high-yield bond firm Libra Investments, which was sold to U.S. Bancorp in 1999.

In 2002, for example, the S&P 500 was down 22.1 percent, but Dorchester's combined funds posted a 4.5 percent gain, Zucker said.

The publicity has also helped draw investors. Dorchester's assets have skyrocketed to $407 million as of Aug. 1 from $33 million in January 2002. Recently, the firm was featured in a Barron's article, and London-based research firm InvestHedge named it as the best "global multi-strategy firm" in 2003.

Hedge funds tend to keep a low profile because they are restricted from advertising and by law may accept investments only from those with annual incomes of $200,000 or net worth exceeding $1 million, excluding home equity. That narrows the playing field to about three percent of the U.S. population, although many Los Angeles residents fit the profile.

"The industry is growing like gangbusters," said Dave Smith, president of Coast Asset Management, a $2.5 billion-in-assets hedge fund in Santa Monica that has a small fund-of-funds component.

"A lot of it had to do with when the stock market got smoked in 1999 to 2002," Smith said. "At that time, everyone thought they were going to make 25 percent to 30 percent returns every year. Now, of course, they realize there's an awful lot of risk in the stock market after all."

Up, down markets

One allure of hedge funds is their ability to produce returns regardless of which way the stock and bond markets are moving. They can make a profit on the fluctuating "spreads" in merger arbitrage plays or between long- and short-term interest rates, for example.

Because most hedge funds have a distressed or high-yield debt element, those in Los Angeles often have a connection to the former junk bond outfit Drexel Burnham Lambert.

Lawrence Post, founder of high-yield bond fiRM MW Post Advisory, served as co-director of research at Drexel. Canyon Capital, another high-yield bond firm and hedge fund, was founded in 1990 by Chris Evensen, Josh Friedman and Mitch Julis, all former senior members at Drexel.

Smith, a former fixed income trader at Oppenheimer & Co., believes hedge funds are misunderstood and receive bad press because they are unregulated.

"If you look at diversifying a traditional portfolio of stocks and bonds, and you add hedge funds, the rate of return goes up and the volatility goes down," he said.

SEC Chairman William Donaldson has pressed for more regulation of the industry, claiming the amount of capital invested in hedge funds, now estimated at close to $1 trillion, requires oversight because of its overall impact on financial markets.