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.