Hedge Fund 101

LTCM, with two Nobel-prize winners, excellent supporting team and best technologies then, ran their hedge funds into the ground. Many hedge funds are closed due to frauds and/or poor performances.

The primary purpose is supposed to ‘hedge’ your investments from market plunges / dips. Since 2008, the government prints so much money, the market recovers and makes the hedges (shorts, derivatives, etc.) unnecessary. 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 mutual funds but take more risk for better returns. Most require higher minimum investments and more restrictions such as requiring longer periods before withdrawal.

It could be the worst deal to most of their customers: 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 or any relevant yardstick to the specific hedge fund. Why should I pay you 20% of my 10% profit when the market rises by 15%?

Well, if they consistently make a lot of money for you, it is not too much to object. 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.

An average mutual fund charges about 1.5% management fees. An average hedge fund charges 2% that would cover the expenses to run an office, market the products and research expenses. The real compensation of an average hedge fund depends on the average 20% of the profit.

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

After a hedge fund has failed, most fund managers 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 after fees. I bet the hedge fund industry did not beat the market after 2011.

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 they cannot be sustained in real life.

Many invest in new companies and small companies where they would have big profits swing. They need to learn the business of the company they plan to buy the stocks, interview the owners, read between the lines, and double check whether the owners are telling the truth by talking to their competitors, vendors and customers. It explains the high cost of their research. We just look at the transaction of the insiders and/or use a low-cost subscription to have similar research. There is no need to travel to visit the company unless you want to. 

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 the following year. I did not blame his first mistake, but on his sticking with the same hedge fund after a losing year. It could be the hedge fund gave him a hard time to take his 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' information. There are very few hedge funds with consistent performance beating the market after their hefty fees. If you find some, stay with them forever. One hedge fund was rated as the top fund and the next year it was out of business due to poor performance.

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 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 funds are without knowing their credibility and their hidden agenda. The hedge fund indexes usually ignore the survivor bias of the bankrupted hedge funds and the early exits of many hedge funds.

Since the hedge funds very seldom keep the stocks more than a year, their capital gains would be short-term and hence would be 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 each fiscal quarter.

Update as of 1/2016

Hedge funds have not been doing fine since 2009 as there are nothing to hedge in a rising market. Only a very few are doing great. Learn what and why they are doing great. The reasons are obvious by now. The successful ones unloaded energy stocks and Chinese stocks after the crisis but before the big losses. Some correctly shorted these problem sectors afterwards.

However, I still advise not to buy hedge funds for the average investor:

·         The better ones are not open to new investors or ask for a king's ransom.

·         On the average (including the closed hedge funds), they're not doing well after the high fees.

·         Even the good one last year could be a bust this year as they're betting high. Examples abound.

To make money, you need to depend on yourself. To start, play simple market timing. Buy value stocks when the market is not risky. Be patient. Evaluate your owned stocks every six months (prefer 3 months if time allows) and act accordingly.

Following these simple 'techniques' (or common sense), you should at least beat the market (or SPY) in the long run. It has been proven and being practiced by many successful retail investors among us.

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The above is an abstract from my book "Complete the Art of Investing" which is available from Amazon.


I challenged to have the best-performed article in Seeking Alpha history, an investing site, for recommending 5 or more stocks in one year after the publish date. The concepts for that article are discussed in this book.