Hedge Funds: What are they & How to Avoid a Bad Hedge Fund
The top hedge funds are stellar investments, but the rest are mediocre investments. So how do you avoid investing in a bad hedge fund?
If you have some money to invest, chances are the stock market has not been kind to you. From 2000 to the present, stocks have provided a piddling return, and to achieve this return you would have had to endure the gut wrenching volatility of not one, but two, stock market crashes of more than 50%. After living through a period like this, you are probably wondering is stocks are the right place for your retirement money and if you will even be able to retire at all, since the prospects of the stock market are murky, at best. Hedge funds might seem like a panacea. After all they promise to make money whether the stock market goes down or up.
But before you invest in a hedge fund, you should learn as much as you possibly can about them. The top hedge funds are stellar investments, but the rest are mediocre to disastrous investments. First, we will cover exactly what a hedge fund is and isn’t. Then, after you have a solid understanding of what a hedge fund is, we will cover the factors that make most hedge funds pathetic investments.
After all if you can’t tell which hedge funds will be poor investments, you won’t be able to avoid investing in the poor performers and invest your capital in the top performing hedge funds which will power your portfolio to new heights.
What is a Hedge Fund?
A hedge fund is an actively managed pool of investments run by a hedge fund manager. It is typically set up as an onshore or offshore limited partnership whose general partner is the hedge fund management company and whose limited partners are the accredited investors whose combined capital is managed by the hedge fund manager.
Most hedge funds are unregulated or lightly regulated investment vehicles that are setup as private investment partnerships that are limited to a small number of accredited investors who have to put up substantial sums of investment capital. Most hedge funds are highly illiquid and require lockup periods of several months to several years.
Because hedge funds cater to sophisticated accredited investors their investing and trading activities are less restricted by regulation than other forms of registered investments. They are allowed to take leveraged long and short positions in asset classes that other types of regulated funds simply cannot touch.
Hedge funds can invest in foreign and domestic markets and they can shift billions of dollars a day from one country to another at nearly the speed of light.
Unlike a mutual fund manager or other regulated investment advisor, the goal of virtually all hedge fund managers is to generate a positive return in all market climates. Whether the market goes up or goes down their goal is to always make money.
Most hedge fund managers are only compensated on absolute returns, not relative returns. Usefully the get paid a percentage of the profits that exceeds the previous high water market. So if the hedge fund investors do not see their investments making a new high, the hedge fund manager doesn’t get paid at all.
But the big problem is that most hedge fund managers do not rely solely on performance fees to be compensated, and this can create conflicts between you and a hedge fund manager. This can in fact cause unscrupulous hedge fund managers to line their pockets at your expense. When this happens, the hedge fund wins and your portfolio loses.
Why Most Hedge Funds make Poor Investments
There are quite a large number of reasons why many hedge funds despite having the potential to be incredible investments fail to live up to their promise. The biggest problems probably stem from what is known to most economists as the principal-agent problem. In hedge funds where the incentives for hedge fund managers are not set up properly this problem rears its ugly head and can end up hurting you the investor.
The principal-agent problem arises when a hedge fund manager’s incentives are not well aligned with the incentives of his investors. There are a number of ways that a fund manager’s incentives can be misaligned or poorly aligned.
Not enough skin in the game
The first is when a hedge fund manager does not have enough skin in the game. All hedge fund managers should have a significant portion of their net worth in the fund that they manage. If they do not, this should be a huge red flag for you, because a fund manager in this scenario will be tempted to take excess risks with your money. If their wagers turn out good, they stand to make a lot of money in performance fees. But if their trades go south, they simply don’t make money, but they don’t lose any money at all. Your portfolio ends of taking the brunt of the losses. When you find yourself in a situation where the hedge fund manager doesn’t have any skin in the game, it is like making a deal with a compulsive gambler where you pay for his wagers and if his wagers work out, he keeps a portion of the winnings, but if the wagers don’t work out you bear all of the losses and he walks away no worse for the wear.
Excessive management fees
Second, when a hedge fund charges excessive management fees, which are based on size of assets under management, rather than performance fees which are based on how much money they make for you, a hedge fund manager tends to focus more on growing AUM rather than generating the highest possible risk adjusted returns. A focus on AUM tends to make a hedge fund manager focus on relative performance, and not standing out from the crowd, rather than absolute performance, which is better for you. The reason this happens is that as long as a hedge fund keeps up with its competitors it will generally be able to hold onto its existing clients and keep growing. A hedge fund that this focused on AUM won’t make unconventional and potentially more profitable investments because it doesn’t want to rock the boat. Rather, it will keep focusing on middle of the road investments instead of outside the box investments that hold the highest returns.
Another problem with excessive management fees in relation to performance fees is that they encourage hedge fund advisors to grow their funds as big as possible and just collect the annuity that the management fees become when they are running multibillion dollar portfolios. When they are running $10 billion a 2% management fee results in a cool $200 million dollars a year just for showing up to work. When they are netting this much money, why rock the boat and try to generate outsized returns when they don’t have to? Furthermore, this leads to managers taking in as much capital as possible to grow the fund as big as possible, even though they may have too much money and too few good investment opportunities to invest that money into.
An offshoot of the principal-agent problem is asymmetric information. Put simply hedge fund managers know more about your money and what they are doing with it than you do. Unless there is a good deal of transparency and the fund is setup properly, you can be at a distinct disadvantage.
This problem can be manifest in a number of ways. One of these ways is in valuation of illiquid assets and another is in outright fraud.
Many hedge funds will invest in illiquid assets that do not always have good market prices as an objective framework for valuation. But valuation is essential in determining NAV and whether a hedge fund manager will be paid a performance fee. So the incentive is for a hedge fund manager to have illiquid assets marked as high as possible so that they can get the biggest performance fees possible. Sure, most funds use third parties for marking illiquid assets, but if these third parties want to stay in the fund managers good graces they are going to be biased toward the interests of the hedge fund managers too. So what can happen is that assets are marked higher than they should be and you will be charged more than you should be charged.
Another problem is outright fraud. The vast majority of hedge fund managers are good and honest people, but there are bad apples out there, and sometimes these bad apples can make off with a massive amount of money as Madoff demonstrated. Fraudsters will often look more credible than honest hedge fund managers, but there are a few simple things that you can do to avoid them.
Extensive background checks of all parties involved with a hedge fund is of course the best way to avoid investing in a fraud. The mere presence of other reputable investors is simply not enough as the case with Madoff demonstrated. Investors in Madoff assumed that since other well known investors were present in his fund that they did all the requisite background checks and due diligence, when clearly they had not. The rule is to always perform your own work, don’t assume that someone else has already done it for you.
How to perform due diligence is beyond the scope of this article and is addressed elsewhere on this site, but at minimum you should make sure that the following functions are performed by independent and reputable parties. Custody should be performed by a highly reputable financial institution and ideally the capital of each investor should be held in separately managed accounts. Audit should be performed by a nationally or globally recognized accounting firm that is completely independent from the hedge fund advisor. In the case of Madoff, these rules where violated and this ended up costing many investors their life savings.
How to Avoid Investing in a Bad Hedge Fund
So if you want to avoid investing in a bad hedge fund, you need to do a lot of your own due diligence. You should never assume that if other well known investors are present in the fund that they have done the hard work. Sometimes other prominent investors fail to do their homework and they can get burned too. For example, when you look at Madoff’s ponzi scheme, there were a lot of prominent investors present and each assumed that the other investors did their homework, so that they didn’t have to do their own due diligence. But we all know how that turned out.
So when contemplating an investment in a hedge fund, make sure that you do your own due diligence. Watch out for the principal-agent problem. Make sure that the hedge fund manager you are thinking of investing with has a lot of their own skin in the game. If they perform poorly, they should suffer a great deal. If they don’t, then they may be taking irresponsible risks with your investment. Avoid funds with excessive management fees. But keep in mind that high management fees are justified if there is exceptionally good performance. Stay away from funds with poor transparency and high levels of asymmetric information. You should have a good idea of what your hedge fund manager is doing at all times. Definitely run away from hedge funds that suffer from low custody and audit independence. Watch out for funds that utilize second or third tier auditors and custodians.
And I will say this again, because it is very important. Do your own due diligence. Don’t get lazy, because other prominent investors are already in the fund. Sometimes, they haven’t done their homework and will get clobbered by fraudulent fund managers.
How Hedge Funds Make Money
Statistical arbitrage, gamma scalping and volatility arbitrage – few people know about these obscenely lucrative hedge fund strategies, but they aren’t as complex as they sound.
We are going to cover some of the secret strategies that hedge funds use to make incredible sums of money. These strategies are not very well known outside of the hedge fund world and hedge fund managers have gone to great lengths to keep it that way.
After all, if you discovered the formula to minting money, would you want everyone to know about it?
So let’s begin.
Statistical arbitrage sounds exceedingly complicated, but the underlying theory behind it is quite simple and easy to understand. For any given group of stocks, you can expect a statistical relationship to exist. In general, if the stock market is up, there is a good probability that an individual stock will be up. If a stock market sector is up, there is an even better probability that a stock in that sector will be up. Statistical arbitrage relies on this probability to generate returns.
For example, stocks in the oil sector are highly dependent on the price of oil. If the price of oil goes up, in general stocks in the oil sector should go up. So let’s say that oil prices have risen and one stock in the oil sector is up, but another stock in the oil sector is down. Assuming that there is no relevant news, a hedge fund would buy the stock that is down and short the stock that is up and rely upon regression to the mean to fix this disparity in time.
Once this disparity corrects, the hedge fund will make a profit and the direction of the market does not matter to them at all.
Gamma scalping has nothing to do with gamma radiation and it is a really simple process used by hedge funds that trade options to generate higher returns and combat the bane of options traders, which is time decay.
Many retail options traders lose money because they don’t know how to overcome the drag on returns that is caused by time decay.
Gamma scalping helps may mute the returns in situations where the market stages an enormous move, but it helps mitigate the losses caused by time decay.
Probably the easiest way to explain gamma scalping is through an example.
Say you are long a straddle on an index like the S&P 500 or the DJIA and the index takes a dive. Your calls will lose a little money and your puts will be up big. You could do nothing and perhaps tomorrow the index will rebound and you will show nothing for your efforts and have lost a little more money due to time decay. Or you could employ gamma scalping by buying enough of the underlying to get back to delta neutral. Then when the index rebounds you would make money on the underlying and you would sell the underlying to get back to delta neutral and lock in the profit. This profit would offset the time decay and you would still have your straddle on to extract even more profit from the next big move.
This process of buying and selling the underlying to get to delta neutral after large moves is what was given the highly cryptic name of gamma scalping. This is just a fancy way of saying that rebalancing trades are made to generate profits and remain market neutral.
Volatility arbitrage can mean different things to different people. In one definition, hedge fund traders look for options with implied volatilities that are much higher or much lower than forecast volatilities. They then buy the option if the implied volatility is lower than the forecast volatilities and then delta hedge the option with the underlying until it expires. If they are right about the forecast volatility, they then make a profit. If the implied volatility is much higher than what is forecast, they simply do the reverse.
Gamma Neutral Volatility Arbitrage
What I just described is delta neutral volatility arbitrage. But being delta neutral is not enough when you have huge option positions because of exposure to gamma, which is the change in the delta with respect to changes in the underlying. Being short gamma can be very hazardous to portfolios, so some traders will practice gamma neutral volatility arbitrages. They will use other options to bring the gamma of the portfolio as close to zero as possible
Stock Index Volatility Arbitrage
Another form of volatility arbitrage exists between stocks and stock indexes. Frequently the implied volatility of the options on the stocks underlying the index will not match up to the implied volatility of the index options. In this case, a true arbitrage exists. Hedge funds are buy the implied volatility on the side of the trade where it is cheap and sell the implied volatility on the side of the trade where it is expensive. The great thing about this type of arbitrage is that there is a defined time limit on when the trade will converge. It will always converge upon the expiration of the options.
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