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July 31, 2002

Shelter in the Hedges

By Tom Taulli

Hedge funds, such as Mort Simpson's Bellmore Asset Management, are prospering at a time of financial disaster. But the boom in these alternative investments began before the recent financial storms.

In fact, during the late 1990s, many top portfolio managers left major mutual funds to form their own hedge funds. Of course, the main inducement is financial. A portfolio manager can generate in fees more than 20 percent on the profits of the fund.

A hedge fund also has tremendous flexibility. A portfolio manager and trader like Mort Simpson, besides buying shares, can hedge positions or short individual stocks.

Bear Market

With the bear market, this flexibility has been good for hedge funds. Simpson, who has some 17 years experience in the financial industry, began in the risk arbitrage department at Dillon Read. Simpson has an MBA from the University of Michigan. He worked for legendary value manager Michael Price. Like Price, Simpson's investment process involves determining the intrinsic value of a stock. "If the stock price is at a 30 percent discount or more from the current price, then I'm interested," Simpson said.

Simpson also believes that special events drive value as well. "I want to find stocks at a discount but stocks that also have a catalyst," he said. "If not, a stock can stay flat for a long time. It is with events that there is a narrowing of the gap between intrinsic value and the current stock price."

Simpson uses a variety of information sources, such as Bloomberg and ILX. He is also a tire kicker. "I think the best way to get a sense of the company is to visit it and

talk to management," Simpson said. "We are in continual dialogue with our companies."

Simpson started Bellmore, which has about $30 million under management, in 1998. "It is a long-short fund," Simpson said. "We range from the portfolio being net long 20 percent or net short 20 percent."

Why this approach? Simpson says he is trying to take out as much market risk as possible. This means he can then focus mostly on individual companies.

On the other hand, there are companies that Simpson believes are ready for a fall. Simpson does extensive research on short candidates and tries to anticipate catalysts similar to his approach on his long positions. "Shorts can be tricky," Simpson said. "There are external factors that must be dealt with." A critical element is finding the shares to borrow. For Simpson, this means establishing strong relationships with brokers and clearing firms.

"We also take steps to avoid a short squeeze," he said. A short squeeze is when a stock price surges because short sellers are forced to cover their positions by buying back shares. "As a rule of thumb, we look at the current short interest of the stock and stay away if it is more than three percent of the float. Again, just like in our long positions, we try to eliminate as many trading risks as possible so we can just focus on the fundamentals."

Positive Returns

For Simpson, he wants to have positive returns at all times. Actually, the compensation structure of a hedge fund encourages this. If the fund has no profits, there is no fee other than a small management fee.

Simpson declined to disclose the returns of the fund, citing the private nature of his business. However, he noted that he and his investors are pleased. He expects more money to come into the fund.

"We have structured our fund to make money whether the market is up or down," Simpson said.