The Hedge Fund Series

Fighter aircraft

The idea behind today’s post as I had certain questions yesterday with my peers wanted to know more about Hedge funds so trying to put in simple way 🙂

What is a “hedge fund”? It’s a legal category, like “mutual fund”. The “hedge fund” category is basically a “none of the above” legal category, meaning that hedge funds, alone among money management companies, have essentially no restrictions on the kinds of assets they are allowed to trade. To start a hedge fund, all you have to do is be a “qualified investor” with $5 million in capital, or be a “sophisticated investor”. That means that as a hedge fund you can be essentially any Tom, Dick, or Harry, and you can try essentially any strategy. You could have macaque monkeys pick stocks and call it a “hedge fund”. The catch-all “hedge fund” category attracts many of the best ideas in the investing world, but also many of the worst. And there’s a lot more bad ideas than good ones.

Thus, just throwing your money at anything that is called a “hedge fund”, just because you have heard that some “hedge funds” have managed to earn spectacular returns, is an extraordinarily bad idea.To put it another way: Anthony Scaramucci, organizer of the SALT hedge fund conference in Las Vegas, writes: “Mutual funds are the propeller planes, while hedge funds are the fighter jets.” But that’s not true. Some of them really are fighter jets. And some of them are beat-up old pickup trucks covered in papier-mache to make them look like fighter jets from a distance. And you aren’t allowed to get anywhere near the planes to touch them and see which is which. And you forgot your glasses.

Anyway, I’m sure many rich people do invest in anything called a “hedge fund”, but they’re just throwing their money away (fortunately they have plenty to spare). But if America’s pension funds, mutual funds, and insurance companies are doing this, then we have a problem.

In any case, we shouldn’t be surprised that hedge funds as a class have been getting crappy returns of late. In fact, we’ve seen this sort of pattern before. In the 1990s, “venture capital” firms earned amazing returns, and a bunch of people heard about it and started throwing their money at anything that called itself a “venture capital” fund. New funds flooded the field to take advantage of this inflow of dumb money. Returns subsequently collapsed and have not recovered, though the old established firms continued making outsized returns (but stopped taking new investments, because when you get big it’s harder to grow fast). The same thing happened with “private equity” (leveraged buyout) firms, who made a killing in the 00s but have not been doing so well since. And the same thing probably happened with mutual funds, back in the 60s when they became prominent and earned a lot of money.

So there is a very interesting behavioral story going on here. Why do people hurl their money blindly at the flavor-of-the-week money-management company category? Why do they fail to understand that there are good and bad hedge funds, just like there are good and bad architects or doctors or web designers? I don’t know, but it’s a fertile topic for behavioral finance research.

(And as a final note, the big worry when investing in hedge funds should probably be fees, not past performance. Even the best hedge funds may charge you such high fees that the extra returns they earn you get eaten up. So watch out.)


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