Chapter Seven
The Ultimate Alternative Investments
Hedge Fundamentals
Having covered conventional investments, plus some alternative investments we don’t love as well as some that we do, we now turn to the alternative alternatives that will be our main focus from here on: hedge funds.
What is a hedge fund? AQR Capital’s Cliff Asness wrote the definition that no one has topped: “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.”
A hedge fund is an alternative investment vehicle available only to wealthy investors, such as institutions and accredited investors presumed to be financially numerate because they possess significant assets (currently defined as those with over $1 million in financial assets or who make more than $250,000 a year). They are not currently regulated by the U.S. Securities and Exchange Commission (SEC), a financial industry oversight entity, as mutual funds are. However, more regulation for hedge funds may be coming.
The popularity of these alternative investment vehicles—first created in 1949—has waxed and waned over the years. Hedge funds proliferated during the 1960s and again during the market boom in the 2000s, but many closed in the wake of the 2007 and 2008 credit crisis. With the decline of private clubs, hedge funds have become the new country clubs.
How do hedge funds try to produce “absolute returns” (a marketing slogan rather than a description of any investment reality) that are disconnected from those in the stock and bond markets? Partly it is because they invest in alternative assets and partly it is because they follow alternative investment strategies. Most stock investors buy shares of companies hoping that the stream of earnings will rise and support a higher price when they sell the stock. Most bond investors are looking for a steady payout over time and a return of principal when the bond matures. If the bond increases in value along the way, so much the better. As discussed earlier, those are the basic ideas behind stock and bond investing.
Hedge funds are more complicated. If they were simple, everybody would be running one—although sometimes it seems like everybody is running one. The idea is not for you to become a hedge fund manager yourself, but to learn how you can use the same alternative strategies that hedge funds use, even if you are not an accredited investor (yet). The downside is that we can’t just tell a few jokes and breeze through this part. If you’re not already familiar with how hedge funds work, you are going to have to put on your thinking cap and follow along. Hedge funds are more complicated than a game of Tic-Tac-Toe, but fortunately they are not string theory, either.
Today’s hedge funds have been made possible by several developments.
1. The ability to go short—bet that a stock price will go down—expanded the fund manager’s domain of operations beyond that of the traditional long-only investor.
2. By being allowed to go long and/or short on similar assets, hedge funds were able to neutralize the overall market risk. Taking the rest of the stock market out of the picture (having a correlation to the stock market of close to zero) put the managers’ own virtuosic skill on display, unlinked to the usual tie-in with the stock market.
3. With the market risk canceled out, managers could more safely leverage their trades. They could borrow money to make more money on each transaction (but, if they were wrong, lose more, too).
4. Computers and stock market databases suddenly made it possible to analyze massive amounts of data in real time.
5. New markets in futures and derivatives made it possible to target precise elements of risk and reward that these models sought to exploit.
6. Computers made it possible to trade super efficiently, executing large trades with lightning rapidity by using direct market access instead of via the usual gang of brokers.
7. Trading commissions were driven down to a vanishing point, which made it possible to execute strategies of borderline profitability, promoting them to acceptable profitability once leverage was applied.
8. As the rewards from investment management went through the roof, the brightest (if not always the best) were drawn into high-paying careers in finance. People who otherwise would have become doctors or engineers started running hedge funds instead.
Essentially, hedge funds exploit small market anomalies, the sea shells left on the beach by the ocean of efficient markets. They find trades where the upside potential appears greater than the downside risk. They buy large blocks of stocks at a discount by coming up with cash (supplying liquidity) when a big sale would otherwise hammer down the price. They take on certain arcane risks that others do not want or cannot take. They trade against institutions such as central banks and others who sometimes act solely for policy or political reasons. (More on this in due course.)
Hedge funds exploit small market anomalies, the sea shells left on the beach by the ocean of efficient markets.
Another feature that cuts across many hedge funds might be called serious research. As we mentioned, these funds are often run by super bright people who put in long hours making pinpointed studies and doing very careful analysis. This gives them an edge. You might watch a DVD and think about buying Netflix. These people have already done the equivalent of a Ph.D. dissertation on Netflix, and they are the ones you are trading against. In fact, they want you to play. Sit down, we’ll deal you in—can we get you a drink?
Ben once met a man who had had the terrible misfortune to be imprisoned and tortured in an Eastern European Communist country. When Ben sympathized, the man brushed it off. “Actually, it wasn’t so bad. The torturer was a civil servant. To him it was just a job. He had a lot of people to torture and not enough time to torture them. My appointment was late Friday afternoon, when he was more interested in getting home to his wife and kids.”
Professional money managers are a lot like that Communist civil servant. They are doing a job, but not really trading as if their lives depended on it as hedge fund managers do.
However, the purpose of hedge funds is not to do God’s work. It is not to allocate risk. It is not to aid in price discovery or to supply liquidity. It is not to narrow price spreads or smooth discontinuities or reduce market inefficiencies. The purpose of hedge funds is to make money.
The Secret Sauce
Most sensible investment writing necessarily focuses on what not to do. The big casino of Wall Street wants to lure you in, divert and amuse you with invest-o-tainment, keep you stupid, and get you playing. In this environment, all the good advice is defensive. Don’t play. Don’t drink. Don’t pay attention to them. Buy an index fund and get out of Vegas.
Phil’s nephew Chris DeMuth, Jr.—manager of Rangeley Capital (the only hedge fund both your authors own)—points out that using hedge funds takes us from a passive ducking-for-cover to an active stance. Instead of just keeping our heads down while other investors get picked off, we look for opportunities to exploit and fire back.
Where do these opportunities arise? From various obscure corners and back alleys of the market. One common source is the “agency” problem: the fact that agencies acting on behalf of others tend to put their own interests first. Consider the initial public offering (IPO) of a new closed-end fund.
Closed-end funds are simple baskets of stocks or bonds. They exist primarily because they provide a one-time money-making opportunity for those selling them. The brokers get paid an 8 percent commission. Their clients are patsies who end up paying $25 for exactly $23 worth of securities. Because no one has any interest in touting these products after the IPO has passed, they usually drift even lower in price, to discounts of 20 percent or more to the net asset value of the underlying securities. This is when hedge funds buy them from the now disgusted buyers, who simply want the pain off their statements. Where agency problems abound, hedge funds are there to capitalize on them. (Don’t try this at home. It only works if someone has enough money to compel a liquidation.)
Another source of opportunity is the “narrow mandate” problem. For example, there is not much mystery about which stocks are going to be added to the Russell 2000 index of small U.S. companies each June. Being added to the index means the stock will get a pop, since all the funds licensing the index are forced to add it to their portfolios. Since everyone is clamoring to buy a thinly traded stock at the same time, the price is artificially bid up. The index investors overpay, foolishly handing money to the hedge funds who bought these stocks on the cheap before the announcement. The world has institutions who sometimes must act for policy reasons rather than for economic advantage, and hedge funds lie in wait to take the other side of these trades.
A third source of opportunity is simply when people need cash. If you need cash today, you will sell at a discount to get it. When people need to unload blocks of securities for any reason, hedge funds are there with deep pockets to help them out—at a price. (We’re going to talk more about this later, but there are merger and acquisition funds and these often can be gold mines.)
These are the kinds of actions hedge fund managers can take that you probably can’t, unless you are a hedge fund manager yourself and this is your specialty.
Since we’ll be talking a lot about these alternative strategies in the chapters ahead, we need to start by clearing the air. A lot of ridiculous myths have grown up around hedge funds. Believe it or not, many otherwise intelligent people still believe these abominable lies.
Myth: Hedge Funds Charge High Fees
Good grief, man, do you know what a 500-foot yacht costs these days? What about important paintings by Van Gogh and Pollock? How about renting Versailles, as hedge fund manager Ken Griffin did for his wedding?
Then there’s the high cost of entertaining. Hedge fund manager Stephen Partridge-Hicks chartered a jet to fly 150 of his closest friends to Morocco for a James Bond-themed party. A particular highlight was staging a movie scene featuring himself (who else?) as 007—complete with fire eaters, dancing monkeys, a submarine, and a fly-by from Russian MiGs. This kind of tailgate party doesn’t come cheap.
You can’t expect a fund manager to swim in these waters if he gives away his services for free. Throw in a private jet, mansions in Greenwich designed by world-renowned architects, sports cars, polo ponies, trophy wives, dogs, and supermodel girlfriends, and it adds up. When J.P. Morgan died in 1913 and left an estate worth $80 million, John D. Rockefeller observed, “And to think we thought him a wealthy man.” Remember that what seems expensive to you, dear reader, may only be pocket change to a fund manager, who, at the absolute top of the pile, can make $5 billion in a single year—a multiple of J.P. Morgan’s entire estate in constant dollars.
It’s easy to forget that, despite all the money sloshing around their bank accounts, these hedge fund managers are plain folks like you and me. According to one newspaper story about the housing market in the Hamptons, due to the recent widespread hardship, “There is tremendous pressure on the part of those people who could write a check and buy a [weekend] house for $15 million to $20 million not to do it at this point in time.” Another article on vacation travel emphasizes that when hedge fund managers take time off (perhaps on the featured $300,000 one-week trip to Paris), “They want to get back to basics.”
Where does all the money come from to pay for these luxuries/necessities? Why, from the high fees they charge, of course. While an S&P 500 index fund might charge 6/100ths of a percent in management fees, hedge funds famously charge “2 & 20.” That is, they rake off 2 percent of your money every year for expenses (coffee, pens, printer cartridges, etc.—in some cases, research), and they also take a mere 20 percent of all profits above some hurdle rate as a performance fee, like the “Royal Fifth” of all the gold the Conquistadors took from the Indians and paid as tribute to the King of Spain.
Then, in addition to charging generous fees, hedge fund managers get to keep more of what they rake in. Do you perhaps pay federal income taxes at high marginal rates? You fool! They don’t. Since their performance fees are structured as a percentage of the fund’s profits, much of their income is taxed as long-term capital gains. Not only do they earn more than we do up front, most of their income is sheltered from marginal IRS tax rates.
Yes, it’s pretty cool to be them.
Myth: Performance Fees Pit the Interests of Hedge Fund Managers against Those of Their Own Customers
Critics claim that the asymmetrical nature of the performance fee distorts the incentives of hedge fund managers. Managers share in the profits—but not in the pain—of their customers. They take 20 percent off the top, but, strange to say, are not volunteering to give 20 percent back in a down year.
Say you are a fund manager and it’s December 15th. Your fund is below its hurdle rate for the year (the amount below which no performance fee is granted). This means Santa Claus isn’t going to be depositing a fat bonus check in your stocking. And all your wife can talk about is how well her friend’s husbands (all hedge fund managers) are doing. Have you lost your mojo, she wonders. That tenderness like before in her fingertips? It’s gone, gone, gone.
Then, a hugely risky deal crosses your desk. If it pays off, it could redeem your whole year, especially with enough leverage. The bonus check will come in after all. You’ll be able to hold your head high at the New Year’s party, while your wife shows off her new diamond and emerald drop earrings. You’ve brought back that lovin’ feeling.
Of course, there’s an even bigger chance the whole deal will blow up in your face. Time for a Hail Mary. If you lose, it’s not exactly your problem, now, is it? Sure, your investors will be mad, but even if they want out, their money is locked up, and by the time they can get it back you will probably have turned things around so they won’t leave after all.
You sit at your desk, weighing the choice: a possible big bonus, or the certainty of no bonus. Are you a player, or just . . . a loser?
Believe it or not, critics have been insulting enough to suggest that a hedge fund manager, confronted with these circumstances, might roll the dice on a risky deal just to get his bonus—mere money. This completely overlooks the selfless, altruistic side of human nature. Look at Gandhi. Look at St. Francis. Who’s to say that, behind the security gates at his Greenwich compound, your hedge fund manager isn’t wandering naked through the garden preaching peace and love to the birds and squirrels?
Myth: Hedge Fund Operators Abuse “High-Water” Marks
Some hedge funds have a “high-water” mark, which means that managers don’t collect a penny of their performance fees unless the fund is over its previous high level. This seems like a fair shake for investors.
Yet, some peevish faultfinders suggest that this sets up the same perverse inventive that we saw above: It just shifts the goal line from the hurdle rate to the high-water mark. It rewards reckless behavior rather than prudence.
These critics are wrong. There is no need whatsoever for a hedge fund manager to swing for the fences when he is below his high-water mark. Why should he, when it is far easier to just close the fund and open a new one? Presto—the high-water mark disappears.
For example, when John Meriwether’s hedge fund Long Term Capital Management exploded, he opened JWM Partners. This fund closed when it was down 44 percent. His solution? Start a new fund, JM Partners. The high-water marks present no obstacle to success for the audacious hedge fund manager who is willing to try, try, try again.
Myth: Hedge Fund Performance Isn’t What It’s Cracked Up to Be
As we mentioned, hedge funds are structured as limited partnerships or offshore corporations so there is presently no reporting requirement. Databases exist, but since reporting is voluntary, critics argue that there may be a slight tendency to overreport the good news and bury the bad.
How might this exaggeration creep into the performance numbers? Let’s say you start five hedge funds. After a year, four of them have lost money, but the fifth has done well. Which one are you going to talk about when they call to ask you about your returns? Now you have one fund tracked by the hedge fund databases. The following year it does terribly and all your investors leave. What happens next? The fund can be deleted from the database, as if it never existed.
These issues—known as survivorship and backfill bias—are difficult to eliminate. As a result, hedge fund returns are overstated.
To get a better handle on what the actual returns have been, researchers from Ibbotson Associates put the data through a wringer and subtracted the fees from the equation. Their conclusion: From 1995 through 2009, hedge funds had a compound return of about 7.6 percent annually over this period. This compares to an annualized return of 8 percent from the S&P 500 Index.
But why focus on the negative? If you don’t correct for these biases, and you don’t subtract the fees, the returns shoot up to a whopping 15 percent—a much prettier number.
Myth: Hedge Funds Don’t Hedge
Hedge funds first became popular because of their dazzling performances. People invested with them because they wanted to get rich.
Over time, however, it became apparent that not all children in Lake Wobegon were above average. While a few funds grabbed the headlines, most did not. It began to be doubted whether hedge funds in aggregate outperformed even the conventional stock benchmarks, as the Ibbotson study showed. Fortunately, hedge fund managers had a fallback position. Okay, maybe they didn’t outperform, but at least they hedged. In other words, they delivered returns that were meaningfully uncorrelated to those from the stock market. As a friend remarked when he showed us his quarterly letter from his manager, “This is a true hedge fund. It manages to lose money in both good markets and bad.”
Now, critics have begun to dispute even the hedge part. Will they stop at nothing?
Hedge funds returns, they suggest, are positively correlated to the general level of economic activity in society. For example, when stocks are up, that is also when there are a lot of mergers and acquisition going on, which makes a fertile arena for some hedge funds. Then, as volatility falls during a bull market, hedge funds get sidelined from their bets, and are forced into strategies that are more highly correlated with the equity markets. The strategies become crowded, diluted, and less hedgy. As more money flows in and gets compounded by leverage, this completes a positive feedback loop forcing stocks up by the sheer pressure of hedge fund buying at the margins.
Of course, once this luau ends, all these factors get thrown into reverse. The result is remarkably equity-like performance from expensive hedge fund investing.
But, wait! Critics suggest that there may even be something more sinister going on. If you wonder about the price of Microsoft, you can find out to the penny 24 hours a day. Hedge funds, however, take positions in a lot of securities that are priced infrequently. When the end of the month comes and they have to report prices for the portfolio, there may be no recent trades to examine. This is when the professional manager is called upon to exercise his seasoned judgment in determining the prices, and therefore the returns, of his fund. Researchers looking at the Dow Jones Credit Suisse Hedge Fund index from 1994 to 2000 found a correlation to the S&P 500 stock index of 0.52 using the prices that managers reported, but 0.63 using the actual prices as determined later. It is possible that the manager may be subliminally aware that all his investors are counting on him for good results that are uncorrelated to the stock market. Under these circumstances, there may be some slight unconscious tendency toward telling people the prices they want to hear, just to smooth the ride a bit. After all, what’s the harm in using stale or stage-managed prices as long as everyone is having fun?
Ibbotson Associates have calculated that the correlation between the Hedge Fund Research Institute (HFRI) composite index and the S&P 500 index from 1990 to 2007 was 0.70. Looking at the correlations between hedge fund indexes and the MSCI All-World index of global stocks from 1994 to 2009, we again see correlations in the 0.65 to 0.76 range. There is also the looming prospect that hedge fund correlations to the stock market are increasing over time. Hedge fund investors pay a lot for a product that looks like it has derived half its performance from the stock market. Meanwhile, over this same period, Real Estate Investment Trusts (REITs) had a correlation of 0.51 and commodities actually had a negative correlation. Investors could have found lower correlations and better hedges far more cheaply in their own backyards.
Myth: Hedge Funds Are Too Expensive to Offer Diversification
It has been suggested that only rich people can afford the diversification benefits of hedge funds. Poppycock. Since there are basically 10 hedge fund strategies, and most hedge funds will let you in the door with $1,000,000, all you need is $10,000,000 to diversify into each one—assuming that you are comfortable using only one manager per strategy. Probably, three managers per strategy would be better. If you have $30,000,000 to spend on hedge funds, and you further assume that hedge funds comprise 20 percent of your investment budget, you can have a well diversified portfolio with a liquid net worth of only $150,000,000. What’s the problem?
However, we don’t want to forget about the “little people.” Here’s a tip that will get you a diversified portfolio of hedge funds for as little as $250,000 or $500,000. Buy a hedge fund “fund-of-funds.” True, you’ll have to pay another layer of fees on top of the hedge funds fees already in the fund. You’ll also have to do your own due diligence on the fund-of-hedge-fund managers, which is not as easy as it sounds. Funds-of-funds got quite a black eye in 2008 when it became apparent that a number of them were feeders to Bernie Madoff. Until recently, the fund-of-funds approach is the only way ordinary high-net-worth investors could get exposure to a diversified set of hedge fund strategies, and it still may be the only path to hedge fund alpha for most—if you can find a good one. Just make sure your advisor is not investing in the next Bernie Madoff.
Myth: Hedge Funds Are Illiquid
People say that hedge funds are illiquid—that you can’t get your money out when you want it—but that is another falsehood. As a client, all you have to do to get your money back is write a letter to the fund manager three months in advance and you’ll get a check at the end of the quarter. For example, if you want your money out at the end of the year, write your manager by the end of September. Wait until October 1 and you won’t get your money until the end of March. Some funds have variations on this policy. For example, some will only let you take your money out once a year.
Did we say get a check? That’s not quite true. If you are redeeming your entire position, you might only get 90 percent back. They have to hold back 10 percent until the year-end accounting is finished, in April of the following year—even if you redeemed at the end of March this year.
Get cash? Well, that depends. If the fund is liquidating, you may be paid in kind instead—for example, in illiquid securities from bankrupt companies. Who knows? These could turn out to be quite valuable under the right circumstances. Normally, though, you get cash.
If the fund is doing well you should have no trouble getting your money out. However, if your manager is in the middle of some monster transaction and feels it would make the other fund shareholders dyspeptic to liquidate your stakes, he can “gate” your money and lock it up until a more convenient time. This usually only happens during bad times, but you probably didn’t really need it right away. If this happens, you will usually get your money back within one to three years.
People who complain about hedge funds locking up their money fail to consider the opposite case. Far from being illiquid, there are successful funds that have returned money to investors once the manager has struck it rich and no longer wants to carry the other investors on his back. If the fund manager feels that he is making less money because everyone else’s money is weighing down his performance, he won’t hesitate to return your money to you precisely when you don’t want it. Then you can watch from the sidelines as the fund you helped put on its feet takes off without you.
Myth: Hedge Funds Are Risky
What—hedge fund risky? That is like saying nuclear energy is risky just because a few atom bombs have gone off here and there. Hedge funds are lightly regulated the same way that Playboy centerfolds are lightly dressed. Sure, they use strategies that are so arcane only a computer can comprehend them. Sure, they can lever up these strategies 25-to-1. Isn’t it the business of life to be dangerous?
Hedge funds are lightly regulated the same way that Playboy centerfolds are lightly dressed.
These naysayers are probably thinking about Long Term Capital Management. Or Amaranth. Or Peloton Partners. Or Carlyle Capital. Or Bayou Management. Or Marin Capital. Or Bernie Madoff. Notice how they never talk about all the funds that don’t blow up. The ones who don’t trade on criminally obtained information. The ones where the FBI doesn’t knock on their doors. And anyway, Madoff wasn’t running a hedge fund, he was running a Ponzi scheme.
All you need to do is some simple due diligence. A 20-page checklist of questions will get the discussion rolling. You could hire someone else to do it for you, but this begs the question: How do you do the due diligence on them?
As if all this weren’t bad enough, the funds we want won’t even let us in. The famous hedge funds we read about are all closed to new investors. This leaves us like street urchins with our noses pressed against the frosted windowpane, watching the Norman Rockwellesque Thanksgiving banquet going on inside the club.
Talk about bad luck—here we are, wanting to sex up our portfolios, willing to forgive these managers for their sins, and now they refuse to take our money.
Admittedly, it looks discouraging. Is there any hope?
No, there is none at all.
Wait a minute—of course there is.
The Alternative Reality
We might as well concede up front that there are numerous reasons to treat hedge fund investing with a healthy amount of skepticism.
We concede it.
On the other hand, if you are a very high net worth investor with an inside track on a good fund, and you have done your 75 to 100 hours of due diligence, and are willing to take the risks along with the rewards, that fund might be just the thing for you.
If you are not a very high net worth investor, though, there is still a way for you to get some of the same benefits.