Hedge funds are the “it’ thing in finance these days. Pension fund managers, university endowments, high-net-worth individuals; everyone is either starting one or investing in one and that is probably a mistake. Many of my clients were hedge funds, and they usually paid very well. Heck, I used to wish I could run my own hedge fund. When I took the reigns of Karagosian Financial Services, most people asked me; “is it a hedge fund?” The answer is “no”, we manage separate private accounts, although I could still apply many hedge fund strategies.
Here are my problems with hedge funds, in general.
1. Many hedge funds do not hedge.
The original Alfred Jones (creator of the modern hedge fund) model was long/short, meaning 50% of the funds you hoped went up in value, and the other 50% was shorted, meaning you hope the investment goes down. If you guess right on both sides, you make double the money, because when you short stocks, it is from borrowed securities. Theoretically, this cancels out market risk. Most managers overweight and underweight based on how well they think the market will do which means they are just leveraging their picks. Others are “long only”, and build up cash if they think the market will tank. Others are simply market timers, and you know what I think of that subject.
2. If you successfully hedge market risk, people think there is no risk.
THERE IS NO SUCH THING AS NO RISK! In a long/short strategy its true that most of the market risk is canceled out, but by shorting stocks, you now have doubled the stock picking risk. Alfred Jones had a fairly successful track record, but even in 1970, he lost 35% for his investors while the S&P 500 returned minus 23%. The lesson here is that when you hedge one risk, you don’t eliminate it, you just shift it somewhere else.
3. They are too expensive and the fee structure makes no sense.
The average equity mutual fund charges about 1.5% of assets under management. The average hedge fund now charges “two and 20” or 2% of assets and 20% of profits. Thats pretty steep. Some hedge funds charge as high as 50% of profits. That means that if a fund does twice as well as an index fund, the investor ends up with the same result of the index fund. Does that make any sense? Warren Buffet and Alfred Jones didn’t charge any management fee, just a percentage of profits.
So why are people paying so much? Because these funds are exclusive and that makes them popular. Individual private partnerships can only have 99 limited partners, so each investor better have at least $1 million to invest. The best way to make a boat load of money quickly which, usually attracts the smartest and most talented individuals, is to start your own fund; and its cheap, only $10,000 vs. $150,000 for a mutual fund to set up. Warren Buffet (second richest man in America) operated a hedge fund (or private partnership as he calls it) which is how he was able to take over a controlling stake in Berkshire Hathaway, his holding company.
Here’s the most sobering question. Why is there an incentive fee of 20% or more? If you charged only 2% of assets per year, would you not try as hard to get the highest returns possible? The incentive fee is what causes hedge fund managers to take out-sized risks which often lead to disaster. An incentive fee with no management fee makes more sense because you don’t get paid unless you perform. One could argue that if you are shorting stocks, which is very difficult to do successfully, one should be compensated for it, thus the 2%.
4. Hedge Funds don’t expect the unexpected.
The fundamental essence of any kind of investing is that you want to buy something that you think will be worth more in the future. But reality doesn’t make this a linear event. Lets look at a few examples.
Company A announces its intent to buy a competitor for $20 a share, a 30% premium to Company B’s pre-merger price of $15.38. The stock now trades at $19 because its not a done deal. That $1 spread equals 5.3% upside and the deal may get done in only 4 months. Looking at studies I’ve read, about 90% of these deals go through, so arbitrageurs, guys who make money this way, buy the stock at $19 hoping they get $20 in 4 months. That’s a 16.8% return annualized. Arbitrageurs feel really confident so they buy on margin and double or triple their exposure. Great, except, funny things happen; like the founder of the company being acquired has second thoughts about handing “his baby” to his old competitor; or Company A has a lot of debt and can’t find a way to finance the deal; or shareholders want more money and reject the deal; or the stock market tanks and Company A doesn’t want to pay the same price; or after doing more due dilligence the accounting seems a bit shady for Company B, etc…. you get the point. And if the deal doesn’t go through, whats the down side? 30% downside vs. 5.3% upside?
Buy good companies that are cheap and short bad companies that are expensive. Sounds easy and it probably works most of the time. Lets take the periods of the internet and real estate booms of 1996-2000 and 2003-2008. During 1996 to 2000, the mention of any dotcom company led to an enormous increase in stock price. The justification was that there was future value and one had to act NOW! Meanwhile, good companies got cheaper because they were “old economy” stocks. Fundamentals went out the window.
History shows us that smaller companies have greater growth potential than larger ones but are inherently riskier and more volatile, yet in 2008 during the economic downturn, the Russell 2000 (small company index) was down 33.8% versus the S&P 500’s (large company index) negative 37%. Many hedge funds also got creamed during this time because of these logical assumptions. Even more dangerous are the quantitative funds who use historical statistics to make buy and sell decisiions. Mathematical models tell managers that certain negative events are 3 or 4 standard deviation events or in plain English it is 3x or 4x the variability from the average of the historical data. Three standard deviations covers about 99.7% of all known possibilities and 4 standard deviations is 99.9937%, so smaller than 0.03% and 0.0063% probability. So hedge fund managers borrow as much money as possible to make small gains, because the down side is so improbable, according to their calculations. Good odds, ….until sh*t happens. According to the National Weather Service, the probability of getting struck by lightning over 80 years is about 0.01%……but it still happens to an estimated 400 people a year in the U.S.
Below is an example of how one of the most famous quantitative hedge fund managers thinks.
“In statistical terms, I figure I have traded about 2 million contracts, with an average profit of $70 per contract (after slippage of perhaps $20). This average is approximately 700 standard deviations away from randomness.”
He didn’t have one hedge fund blow up, he had two! More about this in the next post.