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A company teetering on bankruptcy doesn’t sound like a great investment opportunity, but in many instances it can be.

Investing in distressed securities allows the investor to limit the downside of his investment by effectively buying $1 for 50 cents. This usually results in consistent returns to competent practitioners, the specialized fund managers of the strategy.

Distressed securities are stocks, bonds, and trade or financial claims of companies in or near bankruptcy or financial distress. Investment managers who specialize in researching distressed securities and who understand the true risks and values can scoop up these securities or claims at a discount, seeing the glow beneath the tarnish.

Many institutional investors, like pension funds, are barred by their charters or regulators from buying or holding onto below investment-grade bonds (BBB or lower). So they may sell at steeply discounted prices that have the effect of lowering prices further.

How do distressed debt funds know when the distressed company is worth investing in? For one thing, they study the events driving down the value. Maybe the company over-expanded but still has a strong core market. In short, this may be a viable company whose price slide doesn’t reflect its real worth.

According to a study by New York University’s Salomon Center and the Georgetown School of Business, newly distributed stocks emanating from Chapter 11 proceedings during the period 1990−2003 outperformed the relevant market indices by over 20 percent during their first 200 days of trading.

Distressed securities investing has little stock market dependence or correlation. This is a useful way to add value to a traditional investment portfolio as it offers a counterbalance to volatility in equity and bond markets. One way to invest is with a multi-manager who will combine several managers within one fund. This can be particularly attractive for investors, offering investor’s added diversification.

Successful funds of funds managers typically derive their “edge” through the quality of their ongoing due diligence and analysis of the underlying fund managers and their strategies.