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Pulling Back a Curtain on Hedge Funds


Published: October 10, 2004

IT seemed like a good idea.

Two Wall Street refugees would set up shop in a dumpy office over an arts store near Silicon Valley. Their plan was to invest money for the superrich, becoming wealthy themselves in the process.

But these two men, Andy Kessler and Fred Kittler, didn't foresee a number of quirks along the way when they created their company, Velocity Capital Management, in the mid-1990's. The lessons they learned are recounted by Mr. Kessler in a new book, "Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score" (HarperBusiness, $24.95).


Some of the stories in the book deal with personalities. One is about a billionaire who begged them to reconsider when he was shut out of a deal - which involved a company that ended up being called Netscape.

Another describes how the managers were asked to put their money into developing software intended to allow anyone to play the piano perfectly. The inventor's primary credential was that he was an Elvis impersonator.

The bumps along the path to riches, as described by Mr. Kessler, give the book a seemingly endless string of humorous stories about hedge funds - sophisticated, unregulated mutual funds that have generally been open only to wealthy investors.

"The first rule of investing is never to buy something because someone else tells you to," Mr. Kessler writes. "Of course, I spent 10 years of my life as a Wall Street analyst telling people they should buy stuff," he adds. "God, I hope no one listened." He says he and his partner came at their decisions from another angle, spending much of their five years at the fund visiting the management of companies in which they were considering investments.

In fact, the book's tone is so engaging and the stories come so fast that they almost obscure what Mr. Kessler has accomplished here.

First, he pulls back the curtain on the world of hedge funds, in which a minimum investment of $1 million is often required and the fund managers, in lieu of fixed salaries, annually receive 1 percent of the money under management and 20 percent of the profits. He also lays out a rational framework for long-term investing, and provides context for the technological revolution's place in economic history.

The investment strategy is particularly interesting because Mr. Kessler's fund was an aberration. It was intended to hold stocks for a long time - in a world where his competitors would buy or sell equities based on moves of a quarter-point and would engage in currency swaps and anything else to increase returns.

This relatively conservative approach was one way for the fund to differentiate itself from the pack. Another was its choice of investments.

Given Mr. Kessler's background, the focus of the fund was on technology stocks. In the early 1980's, he spent five years at Bell Labs as a chip designer and programmer before becoming an electronics and semiconductor analyst at PaineWebber and, later, Morgan Stanley.

But instead of finding companies that had created breakthrough technology, Mr. Kessler's goal was to find companies that could exploit it.

That is where real wealth has been made throughout history, Mr. Kessler writes. It wasn't James Watt, the inventor of the steam engine, who became very rich from it. It was the people who figured out how to use the engine efficiently to power steamships, railroads and factories.

Money can be made in betting on the commercialization of new ideas, Mr. Kessler says, whether you are running a hedge fund or investing for your retirement.

His fund made successful investments in Inktomi, the search company eventually acquired by Yahoo; RealNetworks, the maker of media-playing software; and Silicon Image, a digital media company.

Equally important, from the perspective of its shareholders, Mr. Kessler and his partner decided to go out of business just before the technology bubble burst. Unlike most investors, they sensed that the valuations were absurd.

"We'd just seen the list from the folks that track hedge funds - our 377 percent gain in 1999 made us the fourth-best hedge fund for the year," he writes. "We are on our way to being up 40 percent for the first quarter of 2000, our sixth quarter of big gains in a row. It is just too bizarre to be believed."

As a result of their decision to start closing the fund, they produced 55 percent annual returns - and all the war stories - over the fund's life.

STILL, the book does have its flaws. Because the narrative constantly jumps forward and back, it is hard to get a clear understanding of how quickly the fund grew. (It eventually had $1 billion in assets that could be invested.)

Terms are not always defined the first time around. In the first half of the book, for example, Mr. Kessler discusses why his fund doesn't "short," a fairly common hedge fund strategy in which managers bet that a given stock will decline in price.

When you "go short," you borrow shares and sell them, hoping that you can replace them later at a lower price. The difference between what you received for selling the borrowed shares and what you have to pay to replace them, is your profit. But shorting is not explained until the second half of the book.

And if you don't already have a deep grounding in both the Industrial Revolution and the technology boom, you may find it hard to keep up with the discussion as the book tries to describe how the current technology revolution is consistent with what has come before.

But none of these things distract from the central point. Mr. Kessler has written an entertaining business book, in which it is more than possible to learn something. That is a rare combination.

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