Another Sacred Cow Becomes Kebab: Hedge Funds

crispydoc Uncategorized Leave a Comment

As part of the process of losing a loved one, I’ve made myself available to help a widow get through the tedious and at times overwhelming process of dotting i’s and crossing t’s in ensuring the timely legal transfer of assets into her name.

During this process, we had occasion to discuss finances in a fleeting fashion. She and her late husband have had a decades-long relationship with their financial advisor, and they pay (it hurts me to say it) 1% AUM in fees. This knowledge causes me emotional distress. She further informed me that they are also heavily invested in hedge funds. This knowledge causes me physical pain. I am not going to challenge a widow on the wisdom of investing in hedge funds in her moment of hurt. Instead, I’ll vent my pain and distress here.

Most hedge funds operate on a two and twenty compensation structure. You pay them a flat rate of 2% for the privilege of entrusting them your money to invest. Lose money? You still pay them 2%. Make money? You pay 2% PLUS 20% of any profits earned. Remember the kid in kindergarten who ran around screaming, “Heads, I win, tails, you lose!” He went into finance.

A hedge fund is a private, unregistered investment pool dealing only with accredited investors (folks presumed to be sophisticated based on their having a significant income or a large amount of cash in the bank). Unlike mutual funds, which are required to register under federal securities laws and abide by anti-fraud regulation, hedge funds are freed from this burden and unregulated by the SEC. If this sounds to you like the investing equivalent of buying an expensive sports car from a shady dealer while forfeiting the right to have your mechanic inspect it beforehand – you get it.

Hedge funds try to “hedge” their market risk by taking an opposing position such as shorting a stock to reduce their risk. Mutual funds are not permitted to take short positions. So they can buy stock A, and if it goes up in value, great, they get their 2% fee plus that 20% haircut off your profits. If stock A loses value, their losses are mitigated by their short position on stock A.

In a short position, an investor expects a stock’s value to fall over a certain period of time. He borrows stock from a brokerage firm over that period of time, paying a certain interest rate as a fee. He then sell these borrowed stocks on the market, predicting that the value of the stock to go down. He buys the stock back after the price has dropped, returns the borrowed shares to the brokerage house, and pockets the difference.

For example, Hedge Fund A decides to take a short position on Widgetmaker. It buys 100 shares of Widgetmaker at $10 a share, paying 10% interest for a 12 month borrowing period. Hedge Fund A then immediately sells these shares for $10 a share earning $1000. 12 months later share prices of Widgetmaker have dropped to $5 a share, and Hedge Fund A buys back those 100 shares at a cost of $500. Hedge Fund A returns the borrowed shares to the brokerage. Hedge Fund A made $1000 minus the 10% interest fee of $100 and the $500 share buyback cost, for a net profit of $400. Makes sense so far.

Problem is it makes two huge assumptions. First, that hedge funds can accurately predict the future (spoiler alert: their crystal ball is as cloudy as yours). Second, that hedge funds will beat the market by such a significant amount that investors will come out ahead even after paying hefty fees.

Yet another problem is that hedge funds seem to tout amazing returns…which are extremely distorted by survivorship bias. An estimated 15% of hedge funds fail each year. A hedge fund will start up multiple small funds at once, and promote the inevitable outlier as proof of their valid strategy. The underperformers are quietly folded, with assets sometimes transferred to a surviving fund with a better track record.

The most spectacularly memorable failure of hedge funds came in 2007 when Ted Seides, a typical brash and overly confident hedge fund manager bet against Warren Buffett that the former’s hand-picked group of hedge funds would outperform Buffett’s preferred low cost S&P 500 index fund over the ensuing decade. Buffett tolerated all kinds of taunting when the Great Recession of 2008 caused a 50% drop in the S&P 500, but stuck to his strategy…and won the bet by an enormous margin.

Hedge fund managers will argue that it’s unfair to compare their cost and performance to an index fund, when their objective is to mitigate risk in volatile times. In fact, hedge fund popularity soared after the dot com crash of 2000, when hedge funds outperformed most other asset classes. To which I would answer: a well-diversified portfolio with adequate fixed-income allocation and a long investing horizon can accomplish the same objective at significantly lower cost.

Which leads me back to the widow and her advisor. She lives out of state, and her financial advisor is going to attend meetings with her estate attorney and hopefully assist in transitioning all invested assets to her name. This presence of boots on the ground by a trusted advisor is clearly valuable to her and alleviates stress, and I am not trying to diminish the very real benefits she will obtain from the advisor in her time of transition.

A close friend works at a hedge fund, and I wish him nothing but happiness and success. But would I want this widow to invest with him? To borrow from the wisdom of Elvis Costello: Hedge funds were a fine idea at the time. Now they’re a brilliant mistake.

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