TOP VIEW Madeleine Albright, Richard Breeden and Ron Insana are just three of the luminaries to join the hedge fund industry recently. While observers debate how their power and influence may translate into investor returns, they could all learn something from Otto Spork, a self-directed investor whose new hedge fund gained 117 percent in its first 12 months. Anyone who has considered starting a hedge fund must realize that alpha is becoming increasingly elusive in a market with 9,500 competitors, but high performance is possible if celebrity managers find financial masterminds to leverage a specialized niche.

Breeden has no previous experience as a large-scale investor, but today a hedge fund manager need not be a derivatives trading prodigy. Madeleine Albright started an emerging markets hedge fund in January through her investment company, Albright Capital Management, backed by $329 million in seed money from Dutch pension fund PGGM. In September, veteran CNBC anchor and Emmy-award nominee Ron Insana announced his plan to establish a fund of funds, apparently based on the relationships he developed with the leading lights in the hedge fund industry through his television career. Because of SEC restrictions against marketing while their hedge funds are raising capital, Breeden, Albright and Insana all declined interviews for this story.

Last October, two former U.S. treasury secretaries joined existing hedge fund firms: Larry Summers, who served in the Clinton administration, became a managing director at the $25 billion D.E. Shaw Group, while John Snow, who served in the current Bush White House, became chairman of $16.5 billion Cerberus Capital Management; former vice president Dan Quayle is chairman of Cerberus Global Investments, a division of the same firm.

While these names grab headlines and send financial columnists scurrying to their keyboards, only time will tell if these hedge fund newcomers will be able to post market-beating returns. While power, influence and contacts attract capital and open doors, successful hedge fund managers need far more than a reputation. They also require superb financial skills, especially in today’s crowded market for alternative investments.

"I wouldn’t be giving my money to Madeleine Albright unless I knew who was trading," says Randy Shain, a vice president with First Advantage in New York who has helped oversee investigations into the backgrounds of 2,500 hedge funds and 4,500 managers on behalf of prospective investors. "The real issue is that she has no qualifications. Obviously someone else is doing the trading; who is that someone else? That someone else has nothing to do with her history," he says. "You still need to check that person just as rigorously as you would someone else. The fact that she’s put her stamp on that person means nothing to me."

Triple-Digit Returns
In March, Warren Buffett called the fees hedge funds charge investors (typically a 2 percent annual management fee and 20 percent of any gains) "grotesque." Many investors have become as exasperated as Buffett, and have perhaps considered joining Breeden and Albright as hedge fund founders. One of them is Otto Spork.

Warren Buffett has called hedge fund fees (typically a 2 percent annual management fee and 20 percent of any gains) "grotesque."

In February 2006, Spork, a former dentist, launched Toronto-based
Sextant Strategic Opportunities Hedge Fund. In its first 12 months of activity, Sextant’s returns reached 117 percent. According to the Toronto Globe & Mail rankings, Spork’s was the best-performing fund in Canada for that period. Few have ever heard of Spork, and fewer still have ever heard of his investment strategy, and that’s precisely the point. At the end of 2006, nearly 9,500 hedge funds existed worldwide, nearly quadruple the number 10 years ago, according to industry data provider Hedge Fund Research. Today investors and managers alike are desperate for unique strategies that eschew the lethargy of the bandwagon effect.

Spork started his fund with a focus on Private Investment in Public Equity (PIPE) offerings from industrial metals companies, along with his own proprietary hedging strategy, a term he’s trademarked as Hybrid2Hedge. This technique involves the use of futures, options and exchange-traded funds to hedge long private-placement commodity exposure on a seasonal and cyclical basis.

Spork, 57, expounds not like a shareholder activist, nor a foreign policy wonk, but like someone born to be a hedge fund manager. "I’ve been trading stocks since the age of 15, and I was doing technical analysis and trading my own portfolio all the way through university," he says. But at one point Spork took a detour and became a dentist. "I got caught up in the competition and the prestige of getting into dentistry. However, I loved investing so much that I stayed with it, learning about it and trading and analyzing it."

His fascination with trading led him to buy his own seat on the Toronto Futures Exchange, where he spent a large part of the 1980s as a floor trader when he wasn’t busy with his dental practice. "That was the Wild West of trading, and people really lived and died by their abilities," he says. Many of the most volatile names on the exchange were mining and other commodity-related companies, so Spork started to develop an expertise in analyzing these firms. He gained more experience by moving to off-floor trading, where he began to take positions in foreign exchange, commodity futures, index futures, options and equities. In 2003, he received his Canadian Investment Management designation.

Spork looks for companies that he believes will vastly outperform. He is generally bullish on uranium. Last year he met with the management of a little-known Toronto-based company called Yukon Resources (now Uranium Star), a uranium exploration company with assets in Quebec, Arizona and Finland. Their capabilities impressed him, and in September he negotiated taking a private placement in the company at 50 cents per share—while the company was trading around 75 cents. As part of the deal, Spork also bought options to increase his stake. As of late March, Uranium Star was trading at $1.50 per share, tripling Sextant’s cash position in just six months. Spork says the value of his options has increased 400 percent.

In a great burst of optimism, Spork opened two new funds last November. One is an offshore version of the metals fund available to investors outside Canada, the other a fund that seeks opportunities in the global water industry. Spork does not have deep knowledge of the water industry, but he surrounds himself with a board of experts. Initially, the water fund will primarily take long-equity positions in companies involved in the exploration, filtering, monitoring, distribution and treatment of water, and the technology and services related to water consumption, again with a focus on PIPE offerings.

The way Spork sees it, starting a fund without a track record is an all-or-nothing effort. "If your returns are mediocre for the first year, if you are down for the year, or you have a very big draw-down, you are out of business," he says. But even if the fund enjoys triple-digit returns, the business will bleed several million dollars of overhead in the first few years. Spork believes starting as a garage entrepreneur is not an option; hedge fund managers need a solid image to build credibility. His firm has a staff of 10 that includes Robert Levack, a fund manager with 20 years’ experience, as portfolio manager and chief compliance officer, and Patrick Raffalovich, a former broker who previously ran his own technical analysis firm, as a senior strategist and manager of technical research. Though Spork’s phones have been ringing much more often since the Globe & Mail ranking appeared, he says he doesn’t feel he has reached "the magic inflexion point where money starts chasing you."

Mouthpieces and Masterminds
Certainly little chance for glory exists among hedge fund founders like Spork. They must live with constant risk that they will go long with the wrong default swap and wake up one morning with investors baying at the door. Fulfilling a lifelong goal and earning the 2-and-20 fees from outside investors present some incentives. But perhaps more important, hedge fund founders prevent their wealth from being eroded by not paying these fees to others.

A boldface name on company letterhead may bring potential investors to the door, but celebrity counts only if the "celebrity" can offer the fund some unique expertise. Finding an unfilled investment niche demands priority over a star managing director. Albright’s niche, according to various published accounts, is her access to the government officials in emerging markets—leaders who can open doors for foreign investors. But industry veterans John Yonemoto, formerly with Franklin Resources, and Gregory Bowes, previously with Fairfield Greenwich Group and RBS Greenwich Capital Markets, actually manage the investments. Albright is more of a well-connected figurehead, on hand to provide credibility and present potential investors with a sense of security.

As with Spork, few investors have ever heard of James Casper or Alex Waldman. But the two are convinced their backgrounds will make their startup hedge fund successful. In February, they launched Olive Tree Capital in Jerusalem. Casper previously owned an online foreign exchange trading business, FXUC Solutions, while Waldman runs a diamond manufacturing and distribution company, Waldman Diamond Group. The partners have started small, with only $5 million in seed capital. With Olive Tree, Casper plans to use mathematical algorithms to systematically monitor and identify trading opportunities in liquid markets. (See "Unlocking Alpha")

"My FX business was successful, but I decided to sell it because I wanted to get into the quantitative strategies market," Casper says. His fund is registered in the Cayman Islands. Along with his experience in gems, Waldman has been investing in hedge funds for 25 years, Casper adds.

Casper says that his love of mathematics, combined with his foreign currency background, made setting up a multistrategy algorithmic fund a natural next step. His niche expertise comes from screening hundreds of algorithms, finding the ones likely to be successful profit generators, then tailoring those to suit the risk parameters of his fund. "We’re looking for algorithms that trade purely liquid instruments, and we want to be putting on short-term trades only, generally with no longer than 10-day holding periods," he adds.

Breeden, too, hopes to leverage a niche he knows well—most likely proxy fights as only he can stage them. He has started with the Applebee’s International restaurant chain. Breeden Capital Management owns a 5.24 percent stake in the casual dining company, and in the first months of 2007, launched a proxy fight to install four of Breeden’s friends on the board. (The vote was scheduled for May, after Worth went to press.) In January, Breeden Capital Management filed a letter with the SEC criticizing board members for allowing Applebee’s CEO to use the corporate jet for personal beach vacations. Breeden’s partner in his fund is friend Steven J. Quamme, a lawyer who, in recent years, bought out Taco Bueno, Bertucci’s and Papa John’s.

Although the fund has so far raised only $500 million of its $1.25 billion target (most of it from the California pension fund CalPERS, which committed up to $400 million), the most recent data from CalPERS shows that Breeden Partners, the parent of Breeden Capital Management, gained 7.3 percent in the fourth quarter of 2006 with very little investment activity. Double- and triple-digit gains, however, will rest largely on the partners’ ability to turn around companies where Breeden sees management driving share prices down to a level that makes these businesses sufficiently undervalued.

John Ferry is an Edinburgh, Scotland–based financial journalist and a senior correspondent for Worth.

Additional Information
 Founding Your Fund: A Step-by-Step Guide