Fund name: Pennsylvania Avenue Event-Driven (PAEDX)

Objective: The Fund seeks to achieve capital growth by engaging in investment strategies related to corporate "events," such as mergers, reorganizations, bankruptcies or proxy fights. It invests in the securities of companies of any size and uses derivatives both as a substitute for investing in the underlying securities, as well as for hedging purposes.

Adviser: Pennsylvania Avenue Advisers, LLC.

Manager: Thomas F. Kirchner CFA, founder and manager of the Adviser, is responsible for the day-to-day management of the Fund. He also serves as the President and a Trustee of the Fund. From 1996 to 1999 he worked as a Bond Trader and Financial Engineer for Banque Nationale de Paris S.A. From 1999 to 2004, he was retained by Fannie Mae, a mortgage firm, as a Financial Engineer. Mr. Kirchner has earned the right to use the Chartered Financial Analyst designation.

Inception: November 21, 2003.

Minimum investment: $2,500 for regular accounts. The fund is available in 23 states but like other small funds (Nakoma and the Manning & Napier folks, for instance), it’s willing to register in additional states as investors express interest.

Expense ratio: 1.50% after waivers on assets of $4 million, 2.90% without the waivers. There is also an "Adviser Class" shares with a 5% sales charge and a slightly higher expense ratio.

Comments: PAEDX is an event-driven fund, a strange and wonderful creature of an opportunistic sort. Sufficiently strange and wonderful that I’ve had a devil of a time coming up with a clear explanation of what it does. An event-driven fund will, at different times, be pursuing very different sorts of investments for its portfolio. The basic rationale of such funds is this: publicly-announced events influence stock prices in predictable short-term ways. If you’re vigilant and move quickly, you can consistently book a series of modest profits. Having booked your profit, you move on.

It also means that event-driven funds tend to be high turnover and relatively tax-inefficient. Indeed, the prospectus warns:

The question is, why would you want to own such a creature? Mr. Kirchner’s answer was bracingly honest: "Our strategy is complicated and hard to explain. It’s best suited to a small part of the portfolio of sophisticated investors."

Okay, so why might a sophisticated investor want to own such a creature? Three reasons. One, it’s a good diversifying tool because it operates with an intentionally low correlation to the stock market. So far, PAEDX’s R-squared has been in the mid-teens. By comparison, microcap funds are typically three times more linked to the S&P than this fund is. Second, it’s more opportunistic than pure-play arbitrage or merger funds. It can pursue merger arbitrage strategies when those provide the best risk-adjusted return, but can switch to a greater emphasis on distressed securities or some other arena. Merger arbitrage and long/short funds typically imagine gains in the high single digits. Mr. Kirchner allows that it’s hard to generate a return objective for a fund with a flexible mandate, though he notes that the gains on the sort of small cap, cash acquisition deals that he’s been able to find are rather higher than what larger funds can find on larger cap mergers. And, finally, it can be pretty profitable. The fund has outperformed the S&P500 in 12 of its first 13 full quarters of operation. That translates to almost 16% annually over its first three years of operation, or about 2.5% better each year than the S&P.

The record for event-driven hedge funds gives some idea of the fund’s ongoing return potential. The Barclay Event Driven Index tracks the monthly and annual performance of over 100 event-driven hedge funds. Here’s there most recent report, with PAEDX and the S&P 500 for comparison:

Bottom line: This is a promising, intriguing option. The fund is growing steadily, which both gives Mr. Kirchner cash to invest and allows him to outsource the back office work so that he can concentrate on the investment side. The manager’s incentives are clearly aligned with his investors (he owns about 10% of the fund’s shares and receives no salary, nor do the directors) and he seems to have the skill to pursue opportunities ignored by most larger funds. All of which seems like a pretty good argument for sophisticated investors and their advisors to take this option as seriously as any of the alternative strategies they might be considering.