My Thoughts on Hedge Funds

Hedge funds are a lightning rod in the financial industry. The most vocal critics and proponents both offer extreme views that paint a very different picture of the same topic. Some will bash hedge funds no matter what while others rush to their defense anytime they’re criticized.

On the one hand you have the critics who can’t seem to understand why anyone would ever invest money in a group of funds that have collectively failed to beat a simple 60/40 stock-bond mix every single year since 2002 while also charging outrageous fees and locking up investor capital in an illiquid fund structure.

On the other hand you have the proponents who work or invest in hedge funds that point to the long-term track records of legends such as Stanley Druckenmiller, George Soros, Ray Dalio, Seth Klarman, Daniel Loeb, Jim Simons and others who have had enormous success in the markets and built enormous sums of wealth because of it.

I want to give a more nuanced, less biased point of view as someone who has invested in a number of hedge funds over the years and witnessed firsthand the good, the bad and the ugly that these types of funds have to offer. I have some thoughts on why these funds have run into so much trouble and scrutiny over the past decade or so based on my experience in the hedge fund world.

The institutionalization of hedge funds. Once the pensions, sovereign wealth funds, endowments and foundations made it a point to invest in hedge funds it became obvious that the entire industry would become institutionalized. Due diligence is now so focused on operational and organizational risk that the investment process almost becomes secondary. The biggest funds are today’s version of the Nifty Fifty one-decision stocks from the 1960s and 1970s. The have fully-staffed back offices, hundreds of PhDs and the best lawyers in the business who are able to craft a three hundred page prospectus that frees the fund from any potential litigation risk.

Narratives are constantly changing. Institutionalization has also changed the way most funds invest as expectations have shifted. Back in the hey-day of George Soros and Michael Steinhardt in the 1970s and 1980s hedge fund managers were mostly looking for home run returns. As more institutions started to allocate to hedge funds the narrative shifted from the managers who tried to knock it out of the park in any type of environment to stock-like returns with bond-like volatility. Following the dot-com crash value investing staged a huge comeback, so fundamental long/short managers did very well by going long cheap stocks and short expensive stocks. This really increased interest in hedge funds and led to an explosion in the number of funds available.

After seeing solid returns during a bear market investor interest shifted into these long/short funds which next morphed into downside volatility protection and macro funds following the Great Recession. The goal now seems to be that institutions want hedge funds to simply avoid any and all headline risk while earning a steady annual return stream.

The narrative shift is a classic performance chase by both investors and portfolio managers alike. Both sides are to blame here. “Sophisticated” investors tend to fight the last war and hedge funds are more than willing to oblige if it means more assets under management. This is an over-generalization, but it’s definitely a factor for much of the hedge fund industry today as both sides understand how career risk works.

“Hedge Fund” is a misnomer. Everyone wants to make hedge funds an asset class. It’s not. It’s a fund structure. There are so many different types of hedge funds that it’s becoming difficult to keep track — you have long/short, market neutral, managed futures, activist, credit, stat-arb, merger arb, special situations, distressed debt, short bias, event driven, macro and probably a few others I missed. Then there are multi-strategy funds and fund of funds. And this doesn’t even break things down by geography, specialty or sectors. The options and combinations are nearly endless. And the institutionalization of the industry means that most large allocators are trying to pick one of each fund type in something of a hedge fund style box, which is a great way to achieve mediocre returns.

Plus, most funds aren’t really hedging in the way most people use the term. There are very few market neutral funds. Most hedge funds are making directional bets when they go short, not hedging risks in the portfolio. I’m not sure many hedge fund investors realize this.

Competition. It’s insane how many hedge funds there are these days. At my old job we would probably receive 10-15 cold calls or email sales pitches a week from various hedge funds. I was always amazed at (a) the number of funds that managed hundreds of millions or even billions of dollars that I had never heard of before and (b) the number of new funds that popped up out of the blue on a regular basis, usually founded by people who were going out on their own from another fund or bank prop trading desk.

There used to be a few hundred million dollars in hedge funds. Now it’s a few trillion. And as the best funds build impressive track records, money piles in from all corners, which only makes it that much more difficult to keep up the outperformance with more money to manage.

The Yale Model. Every other institutional fund in the world looked at what David Swensen was able to do at Yale and assumed that it would be simple to re-create his due diligence process and pick top flight managers. Not only are there fewer opportunities for alpha available because there are 10,000 hedge funds in the world, but there are also tens of thousands of institutional and high net worth asset allocators who are competing for access to the best funds with the likes of Yale. There’s just not enough top flight funds to go around. And while Yale has access to pretty much any fund they want, it’s not so easy for others to invest with the best of the best.

Fees. This is an easy point of contention for critics to point to, but it’s definitely a huge factor when combined with the over-saturation of funds charging the same high rates. Once you factor in the performance incentive in the 2&20 structure (which is probably closer to 1.8&17.5 now) it works out to a 4-5% annual fee. That’s a huge hurdle rate and doesn’t even include the costs of trading or due diligence that investors are putting into vetting these funds. I don’t know what the correct fee structure should be for hedge funds. But with costs coming down everywhere else in the fund industry, 95% of these funds have no business charging 2&20.

Probabilities. Legendary hedge fund manager Ray Dalio once described hedge funds by saying, “There are about 8,000 planes in the air and 100 really good pilots.” That’s probably pushing it. I know for a fact that there are many really great portfolio managers and teams out there running hedge funds. I’ve seen the track records first hand. Some of the performance numbers in both good and bad markets are nothing short of amazing. That consistency is one of the things that draws investor attention to these funds.

But if there are only a small number of hedge funds that are worth the high fees, then there is an even smaller number of fund investors that are able to (a) identify the best funds in advance, (b) have access to these funds or (c) know when it’s time to exit an underperforming or oversubscribed fund. My guess is the majority of institutional and individual investors in hedge funds don’t really understand the strategies they’re investing in. This lack of understanding has led to unrealistic expectations in what funds can and cannot do for their investors.

I’m not saying it’s impossible, but there are very few teams or individuals who have the necessary expertise to build and maintain a viable hedge fund allocation. Nor am I saying all hedge funds are terrible. It’s just that there is a huge gap between the top decile funds and everyone else. This means investors are constantly trying to pick up-and-coming fund managers, which is probably even harder than identifying those that will stay on top. In a group of funds that are very top heavy, increasing the number of funds chosen over time only makes it easier to be wrong on a low probability bet. And most of the people trying to build portfolios of hedge funds aren’t equipped with the right skills, knowledge, experience or resources to be able to make informed decisions with a legitimate due diligence process in place.

In a future post I’ll share some thoughts on why I think so many wealthy individuals and organizations invest in hedge funds.

Further Reading:
6 Reasons For David Swensen’s Success at Yale

Here’s what I’ve been reading this week:

• Why are bonds a useful diversifier? (Oblivious Investor)
• Regret minimization is a powerful motivator in life (Gary Carmell)
• Is you brain a fortress or a wild bus ride? (Dynamic Hedge)
• The two types of credibility (EightAteEight)
• Philip Tetlock: “What you think is much less important than how you think.” (WSJ)
• Using technology, behavior and design to create the new folklore of finance (The Thought Factory)
• Are you ready for the next bear market? (Fortune)
• What investment term will soon be antiquated? (Abnormal Returns)
• 5 ways to invert your broker’s advice (Malice for All)
• Preparing for volatility in advance (Reformed Broker)
• 13 tricks to appear smart on Twitter (Sarah Cooper)
• The inside baseball of mutual fund rankings (Gordian)