Tuesday, April 27, 2010

An Unflattering Thousand-Foot View of Hedge Funds

Hedge funds are a murky area of investing for me. They are often characterized as only being suitable for sophisticated investors with large portfolios. This gives the impression that hedge fund investors are having a party making lots of money while the rest of us are going to work every day and making little on our savings.

However, I don’t see why it takes much sophistication to hand over a fat cheque to a hedge fund manager. Combine that with the fact that hedge funds as a whole don’t seem to outperform the market generally, I don’t think that hedge funds deserve their reputation.

From what I learned about a few different hedge funds, here is my own (possibly flawed) view of the typical hedge fund:

1. Some very clever guy develops a trading strategy with a good chance of outperforming the market and a small chance of going bust.

2. This clever guy doesn’t want to risk his own money because of the possibility of going bust.

3. He has the bright idea to start a hedge fund to use his strategy and collect fat performance fees if the fund does well.

The great thing about this approach is that the hedge fund manager doesn’t lose any of his own money if the fund goes bust. The manager takes a big slice of the upside and leaves all of the downside for the chumps investors.

This model works well for the manager even if the fund’s expected return taking into account all possibilities is less than the market’s expected return. Even if the fund blows up after a few years, the manager will get his fees up to that point.

No doubt this isn’t a fair characterization of all hedge funds, but I certainly wouldn’t invest in a hedge fund until I was fully satisfied that it didn’t match this general description.


  1. You should be more open minded about hedge funds. While there are many dogs, many are great way to invest in the capital markets and earn steady returns. Without getting into a long debate, I will make a few points.

    1) Many hedge fund managers have almost all of their money in their fund. They are highly aligned with me, especially on the downside.
    2) Because they take a large cut of the upside, the smartest and most astute investment professionals flock to world of hedge funds where they can earn a lot of money. If you want to invest with the best, it will cost more. In my experience, it has been worth it.

  2. @Anonymous: Telling someone to be more open-minded is almost guaranteed to start a fight. It amounts to a personal attack. I prefer to stick to the facts and not let this get personal. I endeavour to analyze all facts rationally.

    Because hedge funds as a whole do not seem to perform well, we must have some reliable way to choose better than average hedge funds. You suggest a method which is to choose hedge funds where the managers have the bulk of their net worth in the fund. I'd be interested in whether this can be determined reliably and whether hedge funds with this property have outperformed the average hedge fund. If so, this would be interesting news.