Accidental Money Manager

Accidental Money Manager

By Francis X. Gilpin

Associate Editor

Joseph B. Galbraith manages a small hedge fund. But the 34-year-old Safety Harbor resident is reluctant to admit it.

If asked his occupation, Galbraith says he works in finance. Galbraith isn't secretive for the usual reasons of hedge fund managers. In his blessedly unrefined social circles, Galbraith jokes that mentioning hedge funds could lead to offers of lawn maintenance work.

Joe Galbraith is Middle America all the way.

A son of Independence, Mo., Galbraith entered the exclusive world of hedge funds through the backdoor. Unlike many hedge fund managers, Galbraith never ran a mutual fund. He didn't leave a big investment house. He didn't covet all the management fees.

Yet a flirtation with personal investing in the late 1990s has become a lucrative new enterprise for Galbraith. Lately, though, he has had at least one thing in common with his more celebrated peers in alternative investing: His results during the past year aren't as good as they have been.

Galbraith grew up in Harry Truman's hometown, where his father counseled troubled youth and his mother became a nurse. He displayed few early tendencies of a Type-A personality, the prerequisite in some minds for a career in high-stakes investing.

"The way I grew up, I wasn't trying to get into Harvard or anything," he says.

At Central Missouri State University, known for turning out future teachers, Galbraith studied applied mathematics. He concentrated on actuarial science, along with computer programming and statistics, after hearing the insurance industry paid math majors the best.

The computer programming and statistical analysis have proven invaluable.

Consulting not for him

Galbraith won a scholarship to the University of Connecticut, squeezing a two-year master's program into one year while teaching undergraduate algebra. "There were no jobs for actuaries in Kansas City," he says. "I had job offers from the day I stepped on campus there."

In 1996, at Deloitte & Touche LLP in Hartford, Galbraith quickly realized insurance consulting wasn't for him.

"They throw you into a hole, and they give you a stack of papers to crunch into a spreadsheet," he recalls. "You're just entering numbers all day long, mindlessly."

Galbraith, who had married his college sweetheart and brought her to New England, decided that he could only work for himself. He looked into a franchise business. But he couldn't understand how to earn back 20%, with all the fees and overhead.

Seeking that kind of return, Galbraith started reading personal investment magazines. He came across an article that referred to a Duke University professor's research.

From 1986 to 1994, Robert E. Whaley reported, shares of companies added to the Standard & Poor's 500 equity index rose sharply between the announcement and the actual enrollment of the stock.

Galbraith initially found Whaley's claim preposterous. "I was so miffed by it that I went and looked the paper up," he says.

Whaley was right on the money. "I couldn't believe how good the results were," he says. "I recreated his research."

Barbara L. Galbraith watched with alarm as her husband started playing with real money - their entire savings at the time of $8,000. "My wife thought I was insane," says Galbraith. "I was going to blow all of our money on a stupid gambling trick."

At the instant of any announcement, Galbraith bought the stocks of companies coming into the S&P 400, 500 or 600 indices, while shorting those being dropped. "Buy the adds, sell the deletes, when you could, and make a fistful of dollars," he says.

Galbraith was on his way to running a hedge fund (see box).

The S&P 400 was the most consistent for Galbraith. Nine out of 10 trades were winners. In November 1997, instead of studying for an actuarial exam, Galbraith made about $15,000. He bought new S&P index entrants in time to sell them a week or two later to mutual fund managers, who had to have the suddenly more respected shares.

Galbraith continued working at a $50,000-a-year insurance job while racking up a $275,000 trading profit in 1998. He made $1.1 million the next year, when he decided to invest for his own pension plan.

In 1999, he contributed $52,969 to the plan, according to federal income tax returns. By year's end, the plan's value had soared to $365,136.

Between 1999 and 2002, Galbraith contributed $181,469 to the plan. It was valued at $2.6 million as of Sept. 30, 2004, when Galbraith opened his own hedge fund.

Galbraith says he stayed away from Internet stocks. "I didn't want to take that much risk," he says. After the crash, he cautiously used futures contracts to protect against rapid declines.

"For me, where I grew up from, I'd gone all the way," he says. "I could have the same cars and the same home I grew up in and never work another day."

Galbraith says he and his wife lived frugally before moving to Florida in 2000. Their Safety Harbor house, on the shores of Tampa Bay, is worth about $1.3 million today.

Everyone caught on

The index-rebalancing strategy, which Galbraith followed methodically, worked for about five years. "It was a discipline I found in myself that I didn't know I even had," he says.

Galbraith zealously guarded what he regarded as his secret formula, until he opened a trading account at Goldman Sachs Group Inc. "I started getting Goldman research," he says. "They've got guys that spend their full-time job just doing research on this."

Wall Street proprietary trading desks do such arbitrage all the time for mutual funds, in exchange for half of the profits. Galbraith liked those percentages. But he had to find a new strategy to replace his old index-rebalancing act. "Pretty soon, everyone caught on," he says.

So he founded Galbraith Capital Equity Market Neutral Fund LP last year. Accredited investors put in a minimum of $250,000. Galbraith charges a management fee of 1.5% and 20% of annual net profits.

The $6 million fund has an objective of returning 20% net compounded returns annually. So far this year, it is up 6.35%. At least that tops the 5.7% that Hedge Fund Research Inc. says has been the average 2005 industry return.

Galbraith hopes to find new ways to game the markets and stay ahead of rivals. "From a performance standpoint, it's going to get harder," he says. "There's always going to be little inefficiencies that you can take advantage of. But at some point, you're doing the same thing that everybody else is."

Establishing Credibility

How does a 30-something, with no track record, attract several million dollars to start a hedge fund?

Joseph B. Galbraith invited wealthy professionals who knew him, including a few counselors on his early investment success.

More important, after recent scandals, he hired top-notch attorneys and accountants for Galbraith Capital Equity Market Neutral Fund LP.

Akin Gump Strauss Hauer & Feld LLP is a high-powered law firm with Washington connections. Rothstein Kass & Co specializes in auditing hedge funds.

"I went to the best in the business," says Galbraith. "All you have to do is pay."

Galbraith was amazed at the nerve of managers at a Connecticut hedge fund that collapsed last summer. Bayou Securities LLC got $450 million from wealthy investors while using an auditor with ties to the managers.

"I don't even see how they do it," says Galbraith. "I'm a little guy, and I've hired Rothstein Kass and Akin Gump. Those guys are not going to lie about accounting for one little fund."

WHAT IS A HEDGE FUND?

Once upon a time, hedge funds were fairly easy to distinguish from other pools of investor money.

They were generally exempt from government regulation. And their managers typically bought and sold securities both long and short so that, theoretically, they were "hedged" to come out ahead, regardless of market conditions.

But those characteristics are changing.

With certain exceptions, hedge fund advisers will have to start registering with the U.S. Securities and Exchange Commission in February, just like mutual fund managers. That was prompted by the occasional, but usually spectacular, collapse of a mismanaged hedge fund in recent years.

Hedge fund managers are varying their approach beyond the historical leveraging of long and short positions, too. (Buying long means a purchaser actually owns a stock or other financial instrument. Shorting involves borrowing and quickly selling securities or contracts, with the expectation their value declines before the borrower pays for them.)

Recent returns have been flat. The unimpressive results are blamed on the proliferation of hedge funds.

More than $1 trillion was tied up in almost 8,000 hedge funds during the first quarter of 2005, according to Hedge Fund Research Inc. Too many of these managers follow identical investment strategies, possibly dragging down everybody's performance.

That has placed extra pressure on hedge fund managers, who charge hefty fees and lock up investor money for long periods. They must find new and profitable ways to deploy the estimated $640 billion that has poured into their asset pools just since 2003.

Managers are moving into commodity options, exchange-traded futures, foreign currencies and over-the-counter derivatives to keep outshining the competition.

It might work. But more exotic fare could expose hedge fund investors to more frequent calamities. Advocates hope transparency helps the individuals, endowments and pension funds buying into the trendy funds to understand and appreciate the risk.

- Francis X. Gilpin

Galbraith Capital's 2005 PERFORMANCE

% Return

January -2.02

February 5.67

March 0.93

April 0.31

May 0.09

June 3.01

July -3.05

August 0.06

September 0.77

October 0.66

Source: The fund manager