Avoid This Disaster

It's the punch line to a good joke: How do hedge funds make money?

Volume, volume, volume.

Huh?
Typically, these funds rely on making a very tiny amount of money on millions of transactions. First, they try to find trades that have a near-100% certain outcome. Then they leverage to the hilt and buy in. They're confident in borrowing so much, because they think they know the likely outcome of the transaction.

Even after a big deal is announced, such as the takeover of Marvel Entertainment (NYSE:MVL), hedge funds pile in to scrape the last few cents out of a deal. The best metaphor to describe the process might be picking up nickels in front of a steamroller. You're pretty safe … most of the time.

You see, the bulk of hedge funds model their strategies on what's likely to happen in a normal market, or the so-called efficient market. Everything's fantastic, as long as deals are moving and credit is flowing. But when the economy starts to seize up, those normal conditions can go drastically awry. Suddenly, those 100% certain deals explode. The market goes nuts, and there's no way to predict the future.

Witness the fall of 2008, when anything related to financials was tossed aside. Even the best of the best, such as Goldman Sachs (NYSE:GS), were shunned. All conventional wisdom went out the window for months. The hedge-fund industry had its worst year on record, and funds blew up left and right.

The list of closures or blowups in the last few years goes on and on: a pair of Smith Barney funds in 2008, the Old Lane hedge fund of Citigroup (NYSE:C) that same year, and Amaranth in 2006, among many others.

What that means for you ...
For conservative long-term buy-and-hold investors, such periods of irrationality can be a dream come true. Great companies go on sale at ridiculously low prices. But for hedge funds, this mispricing becomes a nightmare. Because they're so heavily indebted, hedge funds have to sell, no matter what price the market is offering. Would you like to have sold Bank of America (NYSE:BAC) at $3.50 in the depth of the market's funk, when it's now trading at near $16? Me neither.

But the pressure of leverage can be a killer. For example, it's not unusual for a hedge fund to operate with a debt-to-equity ratio of 9:1, although the average is closer to 3:1. In the prime of Long-Term Capital Management, that hedge fund sported leverage of around 20:1!

That means for every dollar the fund had in the bank, it owned 20 dollars of securities. Prudent leverage can make you a lot of money on the way up, but it can just as quickly kill you on the way down. For example, at leverage of 20:1, your underlying positions have to move only 5% in the wrong direction for your principal to be completely wiped out. Just 5%. Sure, hedge funds undertake extensive risk management to protect their principal, but even a slight misjudgment can leave the fund leveled by that steamroller.

All that holds true for companies
Just as leverage can burn investors, it can also torch individual companies that have too much debt. Consider the situation at one of the world's largest automotive companies, Ford Motor (NYSE:F).

The company has been saddled with a massive long-term debt load --$24 billion -- which also equals nearly all of its market cap. In fact, the company has more liabilities than it has assets. Based on its book value, Ford is literally worth more dead ($0) than alive (-$10.7 billion).

To try to get a handle on its position, earlier this year Ford engineered a swap of some of its debt for stock in the company. For that quarter, Ford reported a profit, but it was the result of financial engineering, rather than true operational performance. That Ford had to amass so much debt should perhaps be no surprise, given the company's long-term inability to generate cash. In fact, over the last 10 years, Ford's average return on capital hovers ever-so-tenuously above 0%.

Avoiding debt, or at least maintaining a manageable level, is vital in this environment. And that's a key strategy that Fool co-founders Tom and David Gardner employ when evaluating companies at Motley Fool Stock Advisor. Consider these low-debt companies:

Data from Capital IQ as of Oct. 14.

Marvel has been a stunning performer since its first recommendation -- up nearly 1,400% since mid-2002. And eBay has done respectably -- up 37% during a period when the S&P 500 has returned just 3%.

Now, this doesn't mean that all of these stocks will beat the market from here on out, but it does mean that now is a great time to position your portfolio strategically to avoid the mistakes that so many hedge funds make. Let the expert analysts at Stock Advisor help you do just that. You can get the latest guidance, as well as buy and sell recommendations from David and Tom.

You'll also get advice on how to stay in the market for the long term, diversify for the best returns, remain Foolish, and have fun even amid this stressful market environment. If you're interested, we're offering a free 30-day membership with no obligation. Click here to learn more.

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Fool contributor Jim Royal owns shares of Bank of America. eBay and Marvel Entertainment are Motley Fool Stock Advisor recommendations. The Fool has a disclosure policy.