Monday, June 30, 2014

Hedge Fund 101



LTCM, with two Nobel-prize winners, best supporting team and best technologies then, ran their hedge funds into the ground. A lot of hedge funds are closed due to frauds.

The primary purpose is supposed to ‘hedge’ your investments from market plunges / dips. Since 2008, the government prints so much money (Chapter 51), the market recovers and the hedges (shorts, derivatives, etc.) deteriorate. In reality, most hedge funds do not hedge.
Hedge funds get tons of press coverage as the Holy Grail of investing. The media need the advertising from this $2.5 trillion industry. It is similar to a mutual fund but most tend to take more risk for better returns. Most require higher minimum investments and more restrictions (such as longer periods to withdraw the funds).

It could be the worst deal: 2% average up front and 20% average on your profit. It is more acceptable to me if the 20% is on profit over the S&P 500.

Well, if they make a lot of money for you, it is not too much to ask for. However, most risk your money by betting big recklessly. When they win, they get 20% of your profit and they use you for advertising to lure other suckers. When they lose your money, they do not lose a penny. It encourages them to take big risks. I do not know any hedge fund (HF) manager who pays you back your losses. 

You have better return by investing in no-load index funds or other diversified ETFs than an average hedge fund. To calculate the average hedge fund performance, you need to include those hedge funds that are out of business. 

There are many failed hedge funds most likely due to poor performances and/or outright frauds. To them, they just open another hedge fund (if they do not go to jail due to frauds) and give you all the excuse for losing your hard-earned money. Some lose their reputation but you need to check them out.

In 2011, the hedge fund industry did not beat the S&P 500 index fund [SPY also termed as the “market” for me for easy illustration] after fees. I bet the hedge fund industry did not beat the market either in 2012.

Some hedge fund managers learn modern portfolio theories from Ivy League universities and apply them in the hedge funds. Often their theories are wrong due to wrong testing procedures or cannot be maintained.

Some use their specialty in certain sectors and that's fine. If they use derivatives, be careful and that's what resulted in our 2007 financial crisis. Derivatives could reduce the risk of the portfolio if they are properly used. If you still want to invest in them, ask for their methods and their historical performance. Very few hedge funds are good. When you find a good hedge fund, most likely it has been closed to new investors or its fees are outrageous.

The owner of a famous baseball franchise lost big money from a hedge fund that concentrated in the oil sector.  Almost every ETF in this sector made good money that year. He still stayed with the hedge fund and had similar miserable return next year. I did not blame his first mistake, but on his sticking with the same hedge fund after a losing year. Some hedge funds give you a hard time to take your money out.

One hedge fund has a performance of 25% every year for a long period. The SEC, take notes and investigate whether they were using insiders' info. There are few hedge funds with consistent performance beating the market. If you find some, stay with them forever.

In 1980, this industry started with really capable fund managers and made good money for their clients. After that, every analyst wanted to open a hedge fund and most did not even beat the market after their expensive fees. Alternatively, just buy the ETF SPY and relax, instead of waiting for the hedge fund to wipe out your savings.  This industry is not properly regulated.

Do not believe in any articles / ads praising how great the hedge fund is without knowing their credibility and their hidden agenda. The hedge fund indexes usually ignore the survivor bias of the bankrupt hedge funds and the early exits of many hedge funds. In addition, it is legal to compare their hedge fund performance to the index such as S&P500 without including its dividends. It could make their hedge funds look far better.

Since the hedge funds very seldom keep the stocks more than a year, their capital gains will be short-term and hence are taxed at higher rates than the long-term capital gains. In addition, most funds have 1-3 year lock-up periods and only allow withdrawals on the first day of fiscal quarters.

Afterthoughts

·         From WSJ, from 1999-2008, the hedge fund industry beats the S&P 500 by 13% a year.
From WSJ, from 2009 thru July 2012, it lagged by almost 8%.

As I stated before, there are good managers using the right strategies in a bull market. When every analyst starts a hedge fund, their performance lags. After the overall maintenance fees 2% (1.4% average for mutual funds and .7% for ETFs) plus 20% fees on the profit, most hedge funds eat up your principals and profits!

In 2011, the average hedge fund lost money when the S&P 500 was flat. In 2012, the average hedge fund earned about 6% when the S&P 500 was up 13%. It is a ‘genius’ to buy an ETF representing the entire market instead a hedge fund.

·         Now hedge funds can advertise.
A pig wearing lipstick is still a pig. No one including Sarah can deny that.

If you run 5 hedge funds, you will advertise your best fund. Advertising industry will benefit and eventually their investors in hedge funds will pay for it.


·         A hedge fund article from SA.

·         Another hedge fund fraud.
http://money.cnn.com/2013/07/25/investing/sac-capital-charges/index.html?iid=HP_LN

·         Gold even managed by great hedge fund manager is down as of 7/2013.

·         A famous hedge fund manager has big losses in JCP and shorting another company. It teaches us to diversify and be conservative.

·         Hedge funds must have a hard time in 2013. Hedging against a rising market is a fool’s game.

·         The average expense for mutual funds is 2% and it is probably more if you consider other fees such as trade commissions. In 50 years, the $10,000 investment will grow to $1,170,000 assuming a 10% return a year. However, about $700,000 will be the cost of the typical mutual fund. It will be better to buy an ETF (far lower fee) and avoid market plunges described in this book.  

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