Justin Newdigate 1987: Graduated with a degree in accounting and economics from the University of Cape Town. 1988: Private client fund manager then institu tional fund manager with Syferts Trust Company in Cape Town. 1997: Transferred to the London office. 1998: One of four partners who founded Thames River Capital in London. TWO YEARS OF CRUNCHING falls there may have been but conventional wisdom has it that investors should stick with stocks for the long term and they will outperform every other asset class. 'History suggests that's right but there are two holes,' said Justin Newdigate, an ardent fan of hedge funds. 'You don't know what the time frame is. You could be underwater for 30 years. That for many people is just too long. By the time they have got back to break even they are dead. 'The other [hole] is volatility does awful things to people's heads, even professionals. What happens when it is volatile is they do things they wouldn't ordinarily do. 'Good investors get shaken out at bad times. I don't think that leaves Mr Joe Average with much of a chance. I think volatility will tend to fry a guy's head.' Mr Newdigate, a director of British boutique fund management house Thames River Capital, has created a vehicle which he believes can keep his clients cool. It is a fund of hedge funds. 'The great thing about a hedge fund is that it can lose a huge chunk of that volatility,' said Mr Newdigate, a South African based in London. 'It may not be sex and violence investing. It is a cup of Horlicks by the side of the bed at night. It is sleep-easy funds. 'While it is not great dinner party conversation, these things have a stream of non-volatile returns which means you can stay rich, you are not going to lose a lot of income.' In strategies such as merger arbitrage both long and short positions are taken, making it possible to make money in both falling and rising markets. The Sentinel Fund is his low-risk flagship but is still intended to bring in double-digit annual returns. Volatility in annual returns is expected at 5 per cent above or below the average. The maths worked out in 2000 with a gain of 13 per cent. This year is below par with a rise of 3.7 per cent expected. The Sentinel Fund is composed of 22 hedge fund managers working for 21 different companies, with no one hedge fund accounting for more than 6 per cent of the portfolio. 'We don't like to be too exposed to any one manager,' said Mr Newdigate. 'If something ugly happens to a manager we want the portfolio to be as error resistant as possible. We are assisted in that by having a wide number of managers.' All the hedge fund managers are based in the United States though Mr Newdigate is scouting for talent in Asia and elsewhere to add to the portfolio. There is US$35 million in Sentinel and US$65 million in a segregated account for a Japanese life insurer. Now Thames River is launching a new version called the Mainstay Fund which investors in Royal & Sun Alliance savings plans can access. 'The time is right for this particular fund in a volatile, difficult period. It is not everyone's cup of tea but more people should like it,' Mr Newdigate said. '[Even] bonds have always been seen as a non-risky asset class. You could have done your boots buying the US long bond. It has been a volatile asset class.' Another strategy used by hedge fund managers in Sentinel's portfolio is convertible bond arbitrage, distressed securities and derivative arbitrage. Part of Sentinel's poor performance last year can be explained by a reduction in deal flow for merger arbitrage hedge fund managers to work with. 'Corporate managers were less gung ho about adding new businesses. There are still deals being done but far fewer. That is a problem for merger managers,' said Mr Newdigate. Merger arbitrage managers normally make money by betting that a deal will go through. They buy the target company and short the acquiring company. In tricky market conditions, some resourceful managers were even reversing the normal process and betting the deal would break down, Mr Newdigate said. 'Conversely while the atmosphere has turned negative for merger arbitrage it has turned positive for distressed securities,' he said. The US economic downturn has sent droves of companies to file for Chapter 11 bankruptcy protection. There the bottom fishers in the distressed securities hedge funds find rich pickings. Companies going into bankruptcy proceedings might be oversold relative to their assets and revenue flow, Mr Newdigate said. For example, a high yield fund manager might have to dump the debt of a company going into Chapter 11. 'If the company experiences some distress, the credit ratings agencies might downgrade the company and it might fall outside the mandate of that portfolio manager,' Mr Newdigate said.. 'As the downgrade happens he might become a price insensitive seller of those securities.' There is more than one way to make money from distressed securities. With accounts receivable factoring, a manufacturer might want to raise quick cash so it sells its receivables book to a distressed manager. He has to assess how many of the receivables will go bad and how long it will take to collect and price the book accordingly. 'The beauty of that business is the guy buys that book, say at 70 cents [on the dollar],' Mr Newdigate said. 'From there on in it becomes dull. You have a bunch of guys with green eye-shades, pencils, ledgers and invoices and the cheques come in the mail, or they don't. 'It is entirely irrelevant if the Nikkei is down 500 points or it is up 500 points. 'From my point of view investing in something like that is very sensible because I want Sentinel to be very uncorrelated with global markets.' Mr Newdigate has a more aggressive vehicle called the Warrior Fund which is 'trying to give equity-like returns with bond-like risk'. It gained 21 per cent in 1999 and 10 per cent in 2000, but final returns for last year are likely to come in at a disappointing loss of 7.9 per cent. So does Mr Newdigate practice what he preaches? 'My predilection is 100 per cent towards hedge funds. I really don't see the sense in having long-only funds,' he said.