Hedge Funds – Are We Missing Out?

by Mike Holman

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I had lunch with a friend recently and he mentioned that he thought that hedge funds and private equity funds are the best places to make money. I disagreed with him and said that I don’t think hedge funds do anything any different than a normal investment fund except that they don’t have any constraints on their investment activities.

Most people who want to invest in managed assets are generally restricted to retail mutual funds. These funds usually have mandates which prevent them from investing outside their core area ie an American bond fund would not be able to invest 40% of its money in Mexican bonds. They also have restrictions against things like options, leverage, private investments. So in other words they will generally just buy publicly traded securities which fall under their advertised areas.

Hedge funds on the other hands can invest in the same type of securities as mutual funds but they can also buy option, use leverage, purchase private companies, trade currencies. All of these options can increase their diversification but also increase their risk.

As a fairly hardcore passive investor I don’t believe that anyone can pick investments that will outperform the “norm” for any length of time. When I hear friends tell me that hedge funds can “outperform” because….of some sort of hedge fund magic – I say that I think the people running the hedge funds are doing perfectly normal economically sound investments (they are smart people after all) and the reasons that people think they are doing so well are as follows:

  • Secrecy – most hedge funds don’t say a word to anyone about anything.
  • Performance presentation – mutual funds have to keep up-to-date performance returns so everyone knows how good or bad they are doing. Hedge funds don’t have to so no one knows how good or bad they are doing.
  • Recent history – The last five or six years have been very good for equities. I don’t care how you invested or which brand of dartboard your analysts utilized – it was pretty hard to lose.

My personal opinion on why hedge funds have done so well in the last five years or so is because the markets have been strong and because of a lot of leverage. Hedge funds are renowned for their use of leverage and while I personally don’t have anything against leverage (I use it myself). The reality is that pretty much anyone could have invested in anything over the last several years and done well. If they used a lot of leverage then they would have done exceptionally well.

Compensation

The typical hedge fund compensation scam…err scheme is 2/20. 2% of assets regardless of how good or bad the fund performs. This part is similar to mutual funds that charge a fixed percentage of assets for their management fees. The 20% is 20% of the profits past a pre-determined level. I don’t know what the typical hurdle rate is but the biggest problem with this compensation is that it encourages the managers to “swing for the fences”. Since fund managers make virtually all their money on the upside and 2% of the assets on the downside (enough to pay for the Rolls), why worry about risk management? Go for the big returns – if they work, the managers are rich. If they don’t, then the managers end up making not much less than if they were conservative to begin with.

My opinion on leverage is that it should be used to increase the risk level of your portfolio if desired. Some investors like to increase their risk by investing in riskier securities. I like to buy safer investments and use leverage on top of that.

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{ 17 comments… read them below or add one }

1 Canadian Capitalist

I don’t think you’re missing out. People like Warren Buffett are derisive of hedge funds – they question if these funds are suitable for anybody other than the fund managers.

2 Leslie

I love reading about stuff like this. The emotional and thinking process that goes into rationalizing there’s a investment vehicle out there that will produce more returns than anything else. Always go back to the maxim: only invest in what you understand. Does your friend understand how hedge funds work and make money? Does he understand that like any financial product, it is designed to make money first & foremost for the people who sell it? There’s a whole bunch of financial blogs that regularly post profiles of the ‘average’ millionaire. I don’t think any of them got there by investing in hedge funds. Except of course, if it’s the hedge fund manager him/herself. Canadian Capitalist makes a good point.

3 Mr. Cheap

I haven’t looked into Hedge Funds much,but from what you’ve written I wouldn’t be attracted to them either.

That being said, if mutual funds CAN’T use leverage and Hedge Funds CAN, they might make sense if you believe in the “great man” fund manager (which I don’t). Magnifying the returns (and risks) would make sense if you believe you have an edge over the marketplace.

I guess you could do the same thing by buying the mutual funds themselves on margin…

4 Kyle

In general, hedge funds underperform plain-vanila mutual funds. You may a chart floating around the internet showing that an index of hedge funds match the market return with much lower risk. That chart is incorrect because it doesn’t include all the hedge funds that went out of business during the period reported. And hedge funds go out of business a LOT. Sure, if you happen to find the right one you can win big, but it’s a crap shoot. How do you pick the winners ahead of time? Traditional hedge funds are relatively uncorrelated with traditional mutual funds, so they can be a good diversifier to a more standard portfolio, but that really only applies to the hedge funds that actually hedge. It doesn’t apply to the ones who leverage up to make 1 or 2 huge bets and either make a fortune or go bankrupt.

5 ThickenMyWallet

Thanks for the link. Hedge funds should be “fun money” products- you are not upset if you lose your investment. They should never form a core holding of a retail investor.

As my interview with Mr. Wilson stated too, careful about lumping hedge funds into one big group. There are 300,000 hedge funds. Some die quick and terrible deaths and others do quite well (if you can handle the risk).

The mutual fund model is dying but I wouldn’t shift to hedge funds as a replacement.

6 Zach

I think you have to be careful about making assumptions regarding the entire hedge fund class. To say that hedge funds are risky is akin to saying that mutual funds are conservative. The risk will actually be related to the strategy employed by the manager, and within the mutual fund world as well as the hedge fund world there are conservative and very risky managers.

There is not a very good widely accepted definition of “hedge fund” but many refer to a fund that is compensated based on performance to be a hedge fund. To compensate a manager for performance gives him an incentive to perform well for his clients (although I agree the 2 and 20 model can be excessive). Mutual funds are often able to receive roughly the same payment regardless of performance. This has the effect of creating an incentive to concentrate on marketing the fund to get more investors rather than concentrating on a strong investment program.

You are right in that people should only invest in what they can understand. I would never put hard earned capital into a fund that did not disclose how they made money. However, there are hedge funds out there with transparency and more reasonable fees. I have worked for a company that charged no management fee and only a performance fee (although this is rare in the industry).

Your post definitely inspires good thought on the matter. I just believe there is room to allow for a well managed, properly disclosed, ethically run, hedge fund community.

7 Four Pillars

Hi Zach – when I checked out your site the other day I thought of this post. :)

Zach runs a hedge fund so he actually knows what he speaks of – check out his site if you are interested.

You and TMW are correct that the entire class of hedge can’t and shouldn’t be lumped together.

Kyle – good point about the survivorship bias. (And another great blog).

I might have been harsher than I intended with this – the main idea behind the post was that I don’t believe that hedge fund managers have some kind of “magic” which allows them to outperform regular mutual funds or individual investors. A lot of people (like my friend) believe in that magic.

Mike

8 Praveen

One area that non-hedge fund investors may miss out on are small cap growth funds.

Because of compliance costs with Sarbanes-Oxley (which, ironically, was passed to “protect” investors – never mind that the Enron, etc. fraudsters were prosecuted successfully under the old laws), a lot of companies are delaying going public.

This means that, for example, if Microsoft was starting out now, itmay not have gone public at the point that it did, so public investors might not have had the same opportunity for return.

9 Praveen

Sorry, I meant small cap growth companies.

10 Alex Givant

Check “The Big Investment Lie” by Michael Edesess – he has couple of chapters about hegde funds. I specially like his comparison of hedge funds to tobacco companies, check it out.

11 Brian Poncelet, CFP

Hello 4P,

The real story with hedge funds is, there is some good funds and great hedge funds and some ugly ones. Like a excellent golf club you need to know someone to get in.(read excellent hedge fund). Next is a good hedge fund, a high cash amount is needed to get in. The rest … as low as $25,000 or less to get in.

There is no rules to set up a hedge fund, you and your best friday night poker players can get into this game.

regards,

Brian

12 Four Pillars

Brian – got any extra money you’d like to invest?

The Quest For Four Pillars Hedge Fund is now open for business.

13 Brian Poncelet, CFP

Hey 4P,

The other point I forgot was the hedge fund managers have a large part of their personal wealth in their own hedge funds, and will disclose this freely. (but read my “golf club” point, you need to know them to get in.)

regards,

Brian

14 Richard Wilson

I full agree that hedge funds are not all risky and mutual funds are not all risky. Hedge funds have their place, and that is usually within the portfolio of an institution or ultra high net worth individual who may allocate 8-20% of their portfolio to a few selected hedge funds that they may be most comfortable with based on their track record of investment process. I think it is crazy though how often hedge fund are framed to appear as mostly billionaires or poor-performing frauds. The average hedge fund manager is neither. Here is a video that discusses what a hedge fund is and compares them to mutual funds: http://richard-wilson.blogspot.com/2007/11/what-is-hedge-fund.html

Thanks for the recommendation to read the interview above!

- Richard

15 Four Pillars

Richard – thanks for the comment!

appfunds – I really don’t think that the ability to form an opinion makes me “prejudiced”. My opinion is always flexible if new ideas, information come to light.

Some of the comments I’ve received made me realize that the hedge fund definition is quite broad so my analysis doesn’t apply to all funds.

Mike

16 Richard Wilson, Hedge Fund Blogger

I think this last comment is 100% spam – his name is “online advertising” and his URL is targeting the keyword – “Online Advertising”… just an FYI

R

17 Four Pillars

Thanks Richard – you are absolutely right!

Mike

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