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Hedge Fund Investments & When They Make Sense

ILB 5 | Hedge Fund Investments

The final category of passive alternative investments that the ultra wealthy leverage is hedge funds. The larger and more sophisticated the investor, the more they like hedge funds. This asset class is often used by institutional investors to protect against volatility, while also achieving diversification and high returns. So join us as we pull back the mystery of hedge funds, and look at the major strategies they use and their advantages.

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Hedge Fund Investments & When They Make Sense

In this episode, we are going to be diving into the world of hedge funds. We’re in a series where we are covering the big three alternative investments. We’ve already covered real estate. We did private equity in the last episode and now we’re doing the final one, which is hedge funds. This is probably the one that’s least understood by individual investors. What’s cool is your background. You ran a hedge fund for a period of time before Aspen. You have a great perspective on what the landscape is like. Obviously, there are a lot of movies about hedge funds, headline billionaires from hedge funds. People know that it can be a great strategy but how’s the performance? What is the role of it in a portfolio? In this series of broad stroke overviews, we want to hit on what are the definitions? What are the strategies? What are the structures? How do you invest in these? How should you think about these?

On the alternative investment continuum, which we’ve talked about in a lot of episodes, this is level four. As you get more sophisticated, you have a higher net worth. We see most investors going up this continuum, which is starting with stocks, bonds and mutual funds, go into level two of real estate, get some private equity and hedge funds. We talked a lot about other past episodes of how the ultra-wealthy are investing and hedge funds are a portion of that. It’s usually a smaller portion, at least in years. It’s still something that the ultra-wealthy, the billionaires are looking at as a good place to get volatility protection, as well as diversification and return.

In general, the larger the investors and the more sophisticated, the more they like hedge funds. We want to pull back, look at the mystery, see what the major strategies they’re using, what the advantages? What is a hedge fund? A hedge fund is basically you can do anything you want. That’s the whole point about a hedge fund. They’ll do long equities, which is buying stocks and short, which individual investors rarely do to make money when a stock goes down and do things like swaps, interest rate, currency, stock. Also, credit default swaps, which are very complicated derivatives and instruments, commodities, everything goes.

It’s very sophisticated. Some of the smartest people in the financial world work for hedge funds and some of the smartest mathematicians. Let’s take a look at this a little bit as we dive in. The average hedge fund in 2020 returned 11.6% but the S&P 500 gained 16%. The hedge fund, the smart guys, did worse. Since 1994 to 2021, through bull and bear markets, the passive S&P 500 index outperformed every major hedge fund by over 2.5%. The hedgies are basically getting creamed by the plain vanilla investors.

There’s always been this argument of active versus passive investment in the public markets of, “I’m going to invest passively in an index,” and this is what hedge funds have to justify because they’re charging fees, generally higher than a passive mutual fund or an index fund. They have to justify those fees by getting better performance but they haven’t been able to do that.

Maybe you’re ready to tune out now but please read on because there’s a reason that’s irrelevant. The chart here shows during the decade of the 1970s, ‘80s, ‘90s, 2000s and 2010s how hedge funds performed relative to the broader market. During the ‘70s, ‘80s and ‘90s, hedge funds did very well or slightly better. In the decade of the 2000s, hedge funds massively outperformed the market. In the next decade, it massively underperformed the market. What I want to point out, the decade of the 2000s, you had both the dot-com crash and you had the 2008 crash. When equities are likely to crash, the hedge funds did very much better. On the other hand since 2010, while we’ve had a one-way bull market, that’s one way straight up, hedge funds have underperformed that.

That gives a lot of insight into how hedge funds work and when it makes sense to invest in hedge funds. Here’s the saying, “Hedge funds deliver equity-like returns with bond-like volatility.” The idea is to get close to equity returns but at far less risk and volatility than the stock market. In fact, that’s been largely true throughout the 1980s, 1990s. As we go into the strategies, you’ll see why it’s like this. In this market, it may make sense to start looking at hedge funds again.

Hedge funds have been declining in popularity during the last few years generally because of this. When the stock market is going up so much, why not put it in the S&P 500? It’s hard to compete with that. If the stock market is overvalued, I’ve seen arguments both ways and clearly, it is on a fundamental basis override but that’s not to say it’s not going to continue to be overvalued. If it is and in fact, it is ready to be volatile, you want to look at hedge funds because they outperform.

This goes back to the concept of risk-adjusted returns. We’ve talked about in other episodes where you can have two similar opportunities of investment that produce around the same return. One has significantly more volatility, which is the proxy for risk relative to the other. You’re going to want the one that’s going to have less volatility. The stock market historically has had a lot of volatility. Especially later on in a market cycle, it can increase. What you’re saying is the hedge funds look to achieve equity-like returns. A good double-digit return that you’d see in a bull market but without a lot of the risk.

There’s a lot to be said for that. Are you willing to give up some of the returns in order to avoid a lot of the downside? If that’s what you want to do then hedge funds are definitely something you should be looking at. The top-performing hedge funds in 2020 were energy and basic materials, technology-focused and healthcare funds. In good years, hedge funds have 50% returns and better. I was looking over the top-performing funds over the last few years and there are many that are over 35% to 40% returns.

ILB 5 | Hedge Fund Investments
Hedge Fund Investments: The investor is a limited partner. They don’t have any say in the investments.

There was one that was returning around 40% per year for the last three years and only had a 5% share in their portfolio on a quarterly basis. Meaning they’re only changing their investments 5% quarter to quarter, which is insane. It’s very low for a hedge fund. That’s probably blowing your cork a little bit and as it should so who is doing this? Typically, it’s the stars. There’s the star phenomenon in hedge funds. Whenever a hedge fund has a good year and a lot of times, that star will go and start their own fund.

If you saw the movie, The Big Short, there were hedge fund guys that made their hay by making the little tiny guys that were stars made this incredible call and got super-wealthy on that. It attracts a large number of investors. There’s a star phenomenon. There are certain people that have the goods that it takes to do this and other people that don’t.

If you’re looking at a broad average of hedge fund returns, that may be misleading if you break it by quartile or quintile or looking at the top performers, the variance is very big in the returns you get across.

If you look at every hedge fund, generally, they’ll tell you who their fund manager is. There’s a celebrity. This is the guy you want to invest with. There’s a reason to do that. Let’s look at the structure. How does the hedge fund generally work? They’re all fairly similar. You find very little variance on this. It’s called the 2 and 20. The idea is they take 2% of the assets under management every year for managing it. If there’s $1 million in assets, they’ll take $20,000 a year off the top and then 20% of profits.

They only make that if they’re making money. If there are no profits, they don’t get that. They’re highly incentivized to make profits. That’s the way it works. It’s generally a general/limited partner. The manager is the general partner. The investor is a limited partner. It means you don’t have any say in the investments. It’s very passive from your perspective. These managers are actively managing. They’re trading their portfolios, buying the swaps, buying the stocks and the shorts, etc. The goal is to generate above-average returns. A lot of times, these are 6 to 7-figure minimum. Especially the bigger bonds, it’s a seven-figure minimum. You got to pay to play. The most important thing in evaluating these is a track record.

I was talking with a broker who helps place money in hedge funds of the day. Everyone’s heard in real estate that the most important thing is location. It’s all about location in real estate. He said the same thing in hedge funds. It’s all about track record. It ultimately comes down to they live and die by their performance. They’re all looking to generate alpha, which is basically above-market returns, above their benchmark. That’s what every hedge fund’s goal is.

Let’s make a quick compare and contrast here are the other two alternative categories we’ve talked about in private equity and real estate, this one stands out because it is in the public markets. That is a very big differentiator here but the way that they’re building these portfolios, strategies and doing hedging can limit the volatility, which is one of the main reasons you go to the private market. You get some of that in the public markets here. It does provide some of the benefits you would get in private but they’re using publicly traded investment tools to do these portfolios.

Let’s look at the seven main strategies that are used. These are seven very big buckets that these strategies can be so diverse, unique and different but here are seven big strategies. Number one is the long-short equity strategy. Seventy-five percent of all hedge funds fall into this category. It’s basically picking stocks and with some shorts. They’ll pick long Apple. There are some popular ones, long Google, some of these taxed. This is the strategy and including some short positions.

They may short a couple of stocks that they think are overvalued. Right there, it tells you why this equity returns with less volatility. As soon as you’re shorting a stock, you’re making money if that stock goes down. If all stocks are going up as they are then your returns are going to be lower. You’ve got some that aren’t.

Your short position is losing money.

The idea with hedge funds is to get close to equity returns but at far less risk and volatility than the stock market. Click To Tweet

You’re making money when it’s going down. If it’s going up, you’re losing money. That’s why but also if there is a correction, they will make money in those. It’s inversely correlated. That is the number one strategy. Not all stock records are the same. Some of these stars are doing this. If you are a true savant and star, what you will do is you’ll start your own hedge fund. That’s what these do. If you want to find a star, they’re not going to sit and work for a fixed wage somewhere. They want to make millions or even billions of dollars. They’ll start their own fund based on their skillset. There are a lot of stars out there and the pickers matter. That’s the number one strategy.

The second strategy is a market-neutral strategy. The idea is to have zero broad market exposure. The idea is if you believe in Apple and you think Google is way overvalued or let’s pick Netflix. Netflix is way overvalued relative to what it’s producing. Apple is a great investment. For every dollar you invest in Apple, you short a dollar of Netflix. The idea is if the stock market goes up, presumably both will go up and down. It’s neutral relative to the overall performance of the stock market.

What you’re playing is the idea that Apple is going to overperform and Netflix is going to underperform. That’s a market-neutral strategy. If everything’s going up, that’s not going to perform well but if the market is very choppy or going down, these can do very well. That’s market neutral. Presumably, you’ve got a superstar that’s making these calls and generally might be pretty good at what they do.

Going back to the data that we showed in the 2000s where hedge funds were very positive while the broader indexes were negative. That was a lot to do with some of these hedges or these other positions that they could. That performed well when the market’s going down.

We get into a whole bunch of arbitrage and quantitative strategies. This is where the best mathematicians in the world are coming in. Arbitrage is basically the way to play minute differences in different investments. The guy who wrote the Flash Boys, Michael Lewis, they’re arbitraging the difference between literary stock trading in Chicago versus the stock trading in New York. In New York, the same stock is trading pennies in difference. They’re buying one and selling the other than buying the other and selling the one and making pennies.

That’s the idea of arbitrage but there are lots of different kinds of arbitrage. There’s merger arbitrage. You’re arbitraging when a company’s ready to buy another company. The differences in those stocks, there’s convertible arbitrage, capital structure arbitrage. For example, a lot of companies will offer stock and they also offer bonds. You can get in situations where the bonds are underpriced relative to the stock. You go long the bonds and short the stock or the other way around. It’s very common. It’s called capital structure arbitrage. There’s fixed-income arbitrage. This is where you’re going long or short bonds relative to treasuries and you’re playing differences in interest rates.

Those are some of the greatest successes and failures that have been in the quantitative strategies of the greatest mathematicians. We’re in these strategies. It is event-driven. This is roughly 10% of hedge funds operating in the vendor space, which is things like mergers, restructuring, shareholder buybacks, debt, exchanges, security issuance or other capital events. They’re playing an event. They’re getting ahead of this event and placing their bets and then post-event collecting on those events. Those are very popular. They don’t necessarily have the same level of long or short exposure that is a pure long-only investment.

The fifth is global macro. This is my hedge fund. This is where you look at economics and you invest based on what you think are economic realities. For example, the emergence of China or the fact that Chinese currency may be overvalued. I had a strategy basically long the Swiss Franc and short the Euro. It turned out to be very right in one instant in time. Based on economic realities, you invest in those. Basically, you make money when you’re right based on global economic trends.

The sixth strategy is short only. This is one, if you’re an Uber bear, what they call PERMA bears. You want to invest in this and these guys can make money when the stocks go down. Shorting is not understood by all investors. Shorting is basically when you borrow a stock. Let’s say Ben owns Apple and I believe Apple is a bad investment. I believe it’s going to go down so we’ll borrow his shares. I’ll borrow 100 shares of Apple. I will sell those. I’ll get cash when I do that.

If Apple falls, I buy those shares back some point later using my cash but now less cash than I sold them for and I’ll return his 100 shares back to him. That’s the mechanics of how shorting works. They’re short-only strategies if you’re a bear. In a market like this, that’s going to be tough to make money in short only.

ILB 5 | Hedge Fund Investments
Hedge Fund Investments: 75% of all hedge funds fall into the long-short equity strategy.

I also think of activist investors a lot of times too, the hedge fund billionaires like a Bill Ackman or somebody who targets a company, basically determines that these guys are fraud, muddy waters. Herbalife was another one I remember he was trying to take down. He would go and publish these extensive researches and try to convince everybody that this was a scam. He’d take a big short position and try to get the market to agree with the settlement.

It’s a lot of research. They go try and find a dirty company or an overvalued company or something with all this hidden dirt under the surface. They’ll go basically accumulate, borrow a bunch of shares over a long period of time from that. They’ll go borrow those and sell them and then they go publish their dirt. Stir up the dirt and muckrake and when that thing falls then they collect it all. It seems like an ugly business.

They are not successful. The other challenge too, is we’ve seen this research where the stock market generally goes up most of the time. I think it’s 70% of the time it’s going up. You’re at a disadvantage from the natural tide in this strategy. It has to be idiosyncratic of a specific company or sector for a short period of time for this to be successful. It takes a lot of guts to do this well but there are investors that are successful in that.

The seventh strategy is the fund of funds. It’s generally where you have a manager who is investing in other hedge funds. This gets a bad rap because typically, the numbers say they underperformed because you’re adding another layer of fees, another 1.5% of AUM fee and another 10% so it’s like a fee on top of the fee. I think it’s a good strategy because what they could do is they’re finding who are the best up-and-coming stars. They can rotate strategies quickly based on macro-economic realities, etc. I think it deserves a look especially for investors that want to get into hedge funds but aren’t as sophisticated as they would like to be and want to get in but let someone else manage the portfolios.

To your point earlier, a lot of these minimums for these hedge funds are very high. If it’s a 6 or 7-figure minimum but you want to get exposure to multiple strategies, a fund of funds is a great way to go because you can put in a smaller dollar amount. A lot of times, you have what’s called access funds where they will lower the minimum. They may negotiate with the operator, “We can bring a lot of capital if we can lower our minimum to our investors.”

It might be a good entry point. In fact, a lot of the fund to funds were smaller than the hedge funds themselves. This is what you wouldn’t think about. Far less money is in these and generally smaller funds with smaller minimums. Especially if you wanted to get into it, this is a decent way to take a look. The other way, there’s a number of ETFs that invest in hedge funds. You can look those up on ETF DB or other resources and see if you want to take a poor man’s approach to dipping your toe in hedge funds.

As you can see from our strategies, they’re going to be a lot of smart guys. If you believe the market is going up, you need a reason to invest in hedge funds. That’s not going to be as good. Most of the reason that institutional investors and large investors invest in hedge funds is diversification. That’s the number one reason, to get good returns but reduce risk dramatically and diversify from the market. You want to have uncorrelated or negatively correlated assets. If you do, that reduces your overall risk but it also reduces your overall return potentially.

Could you break down what a perfect correlation or a one-to-one correlation is?

One-to-one correlation means if the general stock market goes up $1, your portfolio went up $1. A negative one correlation means if the stock market went up $1, you lost $1. That’s a minus one correlation, positive and negative correlations. A zero correlation means you didn’t lose or gain. You’re in cash. Correlation is zero is when you stuff your cash in the mattress. What happened? We say correlations go to one. That’s all investors went in the same direction. Everything went up or everything went down at exactly the same time. It’s horrible for somebody who’s trying to get diversification.

If your market outlook is bullish, you need a specific reason to invest in hedge funds. Generally, they will underperform but they have various different levels of correlation. If you can look at this chart from Investopedia, I love this. It shows the big strategies that we outlined, how they correlate to the general market. The long-short is going to be most correlated to the market because they’re in the stock market and a few shorts. You can see all the way down to dedicated short has a negative correlation to the market.

The biggest reason that institutional and large investors invest in hedge funds is diversification. Click To Tweet

This is a good little chart to get you started on thinking about how do I want to want to diversify my portfolio. Most academic studies out there show that hedge funds are, on average, far less volatile than the stock market. You can look up some of those realities yourself. How do you find these best hedge funds and how do you do the due diligence? Most of them are very black boxy and secretive about what they do but start to have some conversations. There’s a website called Hedge Follow. You can see some of the top-performing funds in the last year or the last three years.

Here are some of the questions you want to ask. Who are the founders and principals? What are their backgrounds and credentials? One of my favorite things is to look at some of their thesis decks. These are some of the smartest guys on the planet. I think DoubleLine is one of my favorites. They’re hedge fund managers. They publish a deck quarterly of their investment thesis. Kyle Bass is another one. I can’t remember the name of his fund but these guys are super smart. If nothing else, they will make you think and challenge your presumptions. I like to read a lot of this stuff.

The balance or the truth comes out when you hear all these different opinions and read the data yourself. They’re super smart. That’s a way to get to know their thesis, their investment staff and know what they think is going to happen. You want to look at how long they’ve been in business, what their track record is. You want to look at their ownership and fee structure. You want to understand their basic investment strategy and usually that’ll come out in the PPM and the pitch decks. You want to look at how often are evaluations performed.

These are public markets generally with publicly traded securities. They’re typically valued every quarter. In fact, the bigger ones have to report to the SEC every quarter. What are the lockup periods? What are the liquidity provisions? In summary, hedge funds are probably the domain of the most sophisticated and wealthy investors for a good reason because they get good returns at far less risk than being long only. It’s very star based on a personality or a celebrity, a superstar and usually it’s well served and a lot of different strategies. If you like investing and research, you learn so much by reading about what these guys are doing, talking to them, etc.

In this timing, I think it makes a lot of sense to look at these hedge funds. With the market at these levels, I believe that there’s a lot of downside risk. Personally, I believe because of the incredible amount of liquidity, the stock market’s probably going to continue to rise but it’s going to be increased volatility because the valuations are high. Hedge funds are probably a good choice at this time.

We published some of that economic research where we basically give our sentiment of where we think the stock market is going but expect choppy waters ahead at this part of the economic cycle and given where the valuations are. It is something to consider and we have a few guests that we identify that we are bringing on that are experts in this arena. I’m excited to talk with them and break it down a little bit more and understand how does an individual investor gets more access to these investments. What’s the process of evaluating when that’s a good time and all that? I hope this was helpful and it’s breaking down what this mysterious world of hedge funds is. Thanks so much for joining and stay tuned for some more great episodes coming up.

See you next time.

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