You have probably heard of hedge funds, which are investment funds somewhat similar to mutual funds in they pool together money from different investors, but with the very important difference that they have virtually no limitations on what they can invest in, and also have no requirements to disclose their holdings.
In order to invest in a hedge fund, you are usually required to be an accredited investor, which means that you either have a net worth of at least $1 million or have made at least $200,000 each year for the last two years (or $300,000 joint combined). Supposedly this is to show that you are savvy enough to navigate these loosely-regulated waters, but to me it seems like they just want you to be able to lose a ton of money on these sexy-sounding investments and not make a big fuss about it.
I was reminded of this when reading about the most recent big-name hedge fund failures:
Investors in two troubled Bear Stearns Cos. hedge funds that made big bets on subprime mortgages have been practically wiped out, the Wall Street firm said yesterday, in more evidence of the turmoil in this corner of the bond market.
Bear said one of its funds was worth nothing and another worth less than a 10th of its value from a few months ago after its subprime trades went bad, according to a letter Bear circulated and to people briefed by the firm. The Wall Street investment bank — known for its bond-trading savvy — has had to put up $1.6 billion in rescue financing.
Oops! I guess they didn’t hedge their credit risk exposure very well. For more reading, just run a search for Long Term Capital Management or see the Wikipedia entry:
Initially enormously successful with annualized returns of over 40% in its first years, in 1998 it lost $4.6 billion in less than four months and became the most prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.
Here is an example of hedge fund fraud:
An Atlanta hedge fund manager under suspicion of defrauding a group of investors that included several NFL players now faces criminal charges in connection with the collapse of funds that investors believed held up to $180 million.
While I plan to meet the requirement to become a accredited investor, and wouldn’t mind working for a hedge fund, I’m pretty sure I’ll never sink a penny into one. I just don’t see the need to take such risks.
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Not all hedge funds are bad, the ones that do well just don’t make for good news stories. Hedge funds do have some advantage over mutual funds in that normally the fund manager only gets paid if the fund performs well (they take a cut of the gains) where as with mutual funds the fund manager takes a percentage of your total dollars invested regardless of fund performance. But of course the million dollar questions (or $200k for the last 2 years question) is where do you find a good hedge fund if you did want to invest your money that way.
It should be noted that the definition of an accredited investor is going up – so your hopes to become one may take a little longer! You can google it, but it is something along the lines of 2 or 3 million dollar net worth NOT INCLUDING YOUR MAIN RESIDENCE, and 500K liquid. These regs haven’t been passed by the IRS, yet, but are in the works.
Hedge funds will also only accept investors putting big bucks into the funds.
Risk? What risk? These funds get bailed out by their cronies in gov’t, don’t they? “Heads I win, tails you lose.” I read that the fund managers still managed a 17% annual return after the bailout.
Robert – Most active MF managers are paid on performance. Think about what you said. If they take a certain percentage of the funds value do they make more or less if it goes up? They’re also paid bonuses based on alpha.
^that’s the LTCM fund in the 1st paragraph
The biggest problem with Hedge Funds is lack of internal oversight. Long Term Capital Management and the two Bear Sterns (what the hell is a company like that getting into hedge funds anyway?) both had the same problem, though, and that was betting it all on ONE thing. There are hundreds of hedge funds you don’t hear about that make billions the right way: little bets here and there that they can make very good money on. By little bets I mean less then 1/10th of what the hedge fund has under it’s control.
The problem is finding those funds.
“A hedge fund is just a pool of capital with a lucrative compensation scheme.”
The risks you mentioned similar to those found in mutual funds. There are plenty of risky mutual funds out there. Those mutual funds which have had great returns have also collapsed in the past. Also, fraud is unfortunately everywhere. Granted, there is a lot less liquidity in hedge funds.
Still, the incentives for managers of hedge funds (percentage of profits) is far superior to that of mutual funds (percentage of assets, and NOT profits).
Ted Valentine: LTCM was bailed out by a group of major wall street banks, not by the government. That point aside, though, you’re right that they did make a decent return after the bailout — on the new funds invested by the major banks. They had already lost that $4.6 billion in four months and most of it didn’t come back.
Ted Valentine: LTCM was bailed out by a group of major wall street banks, not by the government.
Yes, but the bailout was arranged by the Fed and implicitly backed by the government. Not the same thing, obviously, but the government had a great interest in arranging some sort of orderly resolution.
In my mind, hedge funds and their highly leveraged derivitive positions are the biggest threat to US finance right now. In essence, a lot of what they’re doing is finding combinations of assets where asset A goes up while B goes down, and arranging derivative “bets” that will make money regardless of whether A goes up or down, as long as B does the opposite. Usually there’s not a lot of percentage profit in these, so you have to put on your best suit and get the banks to lend you enormous amounts of money to put as much leverage as you can on it.
Works great, until A goes down and B goes down because of something you didn’t anticipate, and then you’re in the hole and in an awful lot of crap because you’ve borrowed billions and billions to do this. You haven’t got billions and billions to pay back, so you’re going to default on it. Also, you’ve screwed other hedge funds who were counting on you being good on your obligations (counter party risk), so now they’re in trouble because their A’s and B’s are not doing what they’re supposed to. Now they’re in the same trouble. So are the banks, too.
Ever made those triangle things with popsicle sticks, where each stick is pressing hard against another one, and take one stick out? The whole structure blows up all over the room. That’s what we’re dealing with.
that’s wrong about hedge fund compensation, the standard fee is “2 and 20”, meaning a two percent expense ratio and then 20% of the profits (that is, over zero, not over some benchmark)…all funds have some variety to that model. Sometimes they change it for really big investors (pensions, Calpers, etc…). The long short model can be a great diversifer, if you know how to pick mangers. Nevertheless, it’s almost never a good investment for individual investors, because of the expense ratios, and the inability to spread risk among many funds.
I used to work at a relatively small hedge fund. They wouldn’t consider taking any investor on unless they were putting up at least $1,000,000. Times were good for a while, but it turns out a fund manager was doctoring the books, and they had to write it off as a complete loss.
As far as getting bailed out… didn’t happen. Lots of money was lost… Nothing is different here than in other economic markets. Potential reward is proportional to risk.
From a Money article I think, they recommend hedge fund investing only after you have more than 3M, because they are not correlated to the other types of investments that you would have accumulated up until then.
Most hedge funds don’t hedge, they (over) lever. Just another financial fad that I hope burns out soon. I have never seriously looked into one myself (even the ones that allow exceptions to the accredited investor thresholds), but I’d bet that many of the new players in this (faddish) niche still charge a nominal % fee on assets under management (just like regulated mutual funds), in addition to that performance fee on % of gains (or % of gains over some dubious benchmark).
Ted Valentine: think about what *you didn’t* say. Sure you can say that the %-assets-under-management incentive model is performance based when the fund outperforms. But what happens when a fund underperforms (whatever benchmark you use for measurement)? Manager still gets paid. What happens when a fund *loses money* over some period? Manager still gets paid. I would only trust a money manager who was confident enough in her/his abilities that he/she would only arrange to be paid if he/she *out*performed some established measurement. (She/he would get a cut of that outperformance of my account.) Underperformance does not deserve compensation when it comes to money management. I can underperform just fine all by myself, and I don’t charge any %-assets-under-management fee against my account.
In my opinion, %-assets-under-management is the most insidious, institutionalized scam ever perpetrated against savers and investors. “It’s just the way it is.” is the answer many people give and most people accept outright. I am certain there are hard working, skilled money managers out there, but the pervasive %-assets-under-management compensation model attracts a throng of mediocre money churners. It’s just really easy money. I’d wager that over 90% of the money managers out there aren’t worthy of touching your money because they are in their field only on the basis of their herd membership.
Lucky for me, that worry is a long way off!
“Hedge funds do have some advantage over mutual funds in that normally the fund manager only gets paid if the fund performs well (they take a cut of the gains) where as with mutual funds the fund manager takes a percentage of your total dollars invested regardless of fund performance.”
If I were running the hedge fund, this is exactly why I would take the same risks as they did and use lots of leverage. If I fail, I move on. If my bet pays off, I just made millions of dollars and I’m retired at 29 🙂
The compensation scheme is exactly why such funds take such big risks, and why there are such spectacular failures. I will admit that this carrot is also what attracts the smart and ambitious people as well.
I’m not saying there aren’t any bad mutual funds, but can anyone name a mutual fund that went to zero in 4 months or less?
“Hedge funds do have some advantage over mutual funds in that normally the fund manager only gets paid if the fund performs well (they take a cut of the gains) where as with mutual funds the fund manager takes a percentage of your total dollars invested regardless of fund performance.?
I don’t agree with this statement because Hedge funds usually charge 2 types of fees. Management Fees which range from 1- 2% annually of your invested capital regardless of whether the fund does well or not and then the performance fees which is usually 20% of the profits.So whether the fund does well or not the managers are getting paid from the Management Fees.
On the other hand Mutual funds only charge Management fees and there is no performance fees assoicated with mutual funds so if you take expenses into consideration, I think in my opinion mf come out better then hedge funds.
Of course they still get “paid”, just not as much, if their fees are tied to a % of the assets as the Robert pontificated. If the fund’s NAV goes down, so does the pot of money that pays the managers.
President Bush’s approval rating is like 30% and he still gets paid. Hmmmm…there’s an idea…pay politicians for performance. I digress.
I don’t understand the automatic distrust of active managers. In theory half of them beat “the market” every year, so there is a hunk of ’em doing a fine job, right?
Bottom line, people get hired to do a job and they expect to get paid. There’s no free lunches.
Now if you want to hire them that is another story. Many people, right or wrong, do it and some do very well.
Hedge funds are a compensation scheme masquerading as an asset class.
To the person who pointed out that Hedge Funds aren’t so much hedging as they are leveraging, I would agree. For the most part, they are just investing in traditional asset classes, but charging more.
Truth is, most of the great managers have had trouble beating their index consistently by 2% over the years. Now imagine, giving that 2% away in management fees and giving away 20% of the profits and these guys face almost insurmountable hurdles…
If managers charging minimal fees can’t beat the indexes consistently, the solution is probably not to charge HIGHER fees. (I know how we’ll get out of the hole… We’ll dig our way out!)
If you want the “action” (read leverge) of a hedge fund, use a small portion of your portfolio to buy some of the “ProShares” products…
-M
In theory, half of them may beat the market while the other half loses to the market, but that’s before the management fee. And if one only measures the active mgr performance of current managers, one inflates their returns by quietly omitting all the failures (that’s survivorship bias), see Jonathan’s reply above. I have never looked into this methodically myself because I just don’t trust the industry, but the argument makes sense to me (first stumbled into this via Bogle).
Regarding hiring someone to do a job, if the job I just want done is “give me the market return at minimum cost to me”, I’ll buy an index ETF from some guy who operates a bunch of computers and she/he’ll guarantee me market underperformance by 10 basis points.
But if the job I want done is “outperform the market” or “achieve an absolute return of 8% every year”, I need an active manager if I don’t want to do that job myself. If that active manager does not do the job I have hired her/him to do, why would I wish to compensate her/him for their failure to achieve the agreed objective? If an active manager who agrees to performance-only compensation doesn’t exceed the market or some absolute measure of return, I don’t pay them but that doesn’t mean I get something for free. If the manager achieves but does not exceed, for example, some market benchmark, it’s nothing that I couldn’t get for free (almost, 10 basis pts) myself in an index ETF. If the the manager comes in short of the benchmark, she/he doesn’t get paid and I take a hit in my account value. Both sides have skin in the game: the manager has her/his time and effort, while I have my capital at risk.
There should be no free lunch, but there exists one Big Free Lunch: the %-assets-under-management model rewards mediocrity. Why would I ever wish to give someone a free lunch for the privilege of doing what I can do myself at very little cost? Conversely, why would a manager compensated under the %-assets model ever wish to take any risks (and maybe lose investors next year) by aiming too high and failing, when she/he can pretend to be an index fund, keep most people happy with close to market average performance, not look too bad in the eyes of peers, and get paid easy money to boot?
Read an article yesterday regarding hedge funds. The firm (think it was Bear, Stearns & Co.) said their two biggest hedge funds tanked – now there worth $0.09 on the dollar. Exciting. Yes, they will make up the difference for the investors, but only to the amount put in, not the growth that had occurred prior to the bottom falling out. Maybe they should have invested with the “Breck Girl”.
it should also be noted that the term “hedge fund” essentially refers to a pool of invested money (non-equity) that is NOT a mutual fund. Pretty broad. Pointing to LTCM, Bear Stearns, Amaranth and the like as examples of the “evils of hedge funds” would be akin to one saying that the success/failure of a particular sort of public stock is indicative of the performance of the entire stock market.
I would guess that, just like any other investment, hedge funds require savvy on the part of the investor to allocate money to an asset class they understand (distressed lending, special situations, real estate, commodities, heck, even Hollywood films – the list in endless).
The problem is that hedge funds are so loosely regulated that they don’t need to disclose hardly anything – what they invest in (be anything Mike mentions above), nor to they have to even reveal their historical returns to the public. This lack of disclosure is constant across all hedge funds, and contributes greatly to why it is very hard, if even possible, to figure out ahead of time which hedge funds will perform well and which ones will tank spectacularly.
I forgot to add this link. The overall odds of getting superior performance are simply not very appealing:
4 reasons why hedge fund returns are highly exaggerated
The fraud case you mentioned involved many investor’s IRA funds as well as other crucial savings that should never have been invested in hedge funds in the first place. Most people don’t know how vulnerable their IRAs are and it is tough to learn it the hard way.