H is for Hedge Funds

The letter H in our investor’s alphabet covers one of the most mysterious areas of all. Where fortunes have been made, mainly by the managers, and where eye watering fees in return for mediocre performance have become the norm. H is for Hedge Funds. They are often thought of as an invention of the ‘greed is good’ nineteen eighties, but they actually date back to nineteen forty nine.

There’s a clue to how they operate in their name – they seek to hedge their bets in order to ensure god returns in any market conditions. So they might have a long-short strategy, where they buy shares in a company hoping they’ll go up but at the same time go short on the stock meaning they make money if the price goes down. Hedge funds also make extensive use of derivative products like futures and options. It’s all about leverage, so for a small outlay you can get control over a significant volume of assets. Equally, they lend money over and above investors funds to further amplify the results of their chosen strategy.

Of course, as anyone who’s opened a spread betting account knows, leverage works in two directions. If your hunch is right, your returns relative to the amount you’ve invested are spectacular. And if you get it wrong, the losses can be tragic. Indeed, unsophisticated investors can leave themselves exposed to unlimited losses if they set things up the wrong way. Hedge funds employ some very clever people with brains the size of the planet called Quants to analyse the best strategies to game the market. They’re kept in darkened rooms, food is passed under the door and they are never allowed to see the sunlight or to meet clients. There are scores of different strategies including long/short, arbitrage, event driven, And still they can get it horribly wrong, as we learned in nineteen ninety eight with the collapse of Long Term Asset Management when their sophisticated models failed to cope with the impact of crises in Asia and Russia.

Hedge fund managers have become some of the wealthiest people on the planet, mainly as a result of their success fees which start at twenty per cent of the gains they achieve for clients. If you have a billion pounds under management you’ll receive maybe two per cent as a management fee, that’s twenty million quid for starters. Let’s say you achieve a fifteen per cent return, a twenty per cent success fee means you trouser another thirty million making fifty million for the year. That should buy a few hundred acres of gentleman’s farm in the Scottish highlands. We’ve talked before about the discrepancy between the best and the worst fund managers, reaching a conclusion that for many investors they are better off in a tracker fund or an ETF.

In the world of hedge funds, the differences are even more stark. According to Zerohedge, ninety per cent of big name hedge funds have failed to beat the performance of the S and P five hundred in recent years. In twenty fourteen the best performer gave a return of twenty two per cent, the second best a return of fourteen per cent. Good, but not great given the risk profile and volatility that go with hedge fund investing. Many made double digit losses, often after making solid gains the year before. Some of twenty fourteen’s worst performers are topping the tables in twenty fifteen, reinforcing the volatility of hedge funds as an asset class.

My own view is that there are a tiny number of hedge funds worth investing in if you are a high net worth or sophisticated investor and you take the time to do some serious research. For the vast majority of people watching this video, I urge you to make use of my favourite investment tool – the ten footy barge pole.