Hedge Funds - The Big Bad HF's (Part 1)

Readers have asked me to answer the following questions about Hedge Funds:  

• What are they? 

• Why their bad reputation? 

• Why are the best money managers running Hedge funds? 

• What are some Hedge Funds' strategies - from simple to very complex.

While answering the questions, I’ll take advantage of this presentation to define some of the words used in Asset Management (in “italics”). Those of you who have listened to investors talk with their peers about know that it can be difficult to follow mostly because of the industry jargon. 

Note: For convenience, “He” is being used instead of “He or She”.

What are hedge funds?

They are not “Traditional Investments” which comprise: 

• “Publicly traded” stocks (or “Equities”) meaning being bought and sold in the Stock Exchanges (vs. “Over The Counter - OTC when an financial institution makes the trade one to one, so-called behind their counter like a store). The investor either buys the Index, i.e. a package made of the largest stocks of any developed country such as the S&P500 in the US, or specific stocks in those regulated Stock Exchanges or Stock Markets, at times abbreviated using just the word “Markets”). 
• Top quality bonds (or “Fixed Income”) issued by the governments of the largest developed countries or by the best companies that are graded as safest investments. They are named “Investment Grade”. Those bonds are given a grade or “rating” ranging from AAA, to BBB., which are the best quality.

Traditional investments are “directional”, which means they move in the same direction of the Markets. This correlation is called “Beta”. 

Hedge Funds are “Alternative Investments”, but hedge funds are one of the many alternative ways to invest money. Alternative investments include: 

• Directional investments in all sorts of assets:
• Bonds with lower rating than Investment Grade starting with BB, B+, B, B-, down to the lowest rating C- They are named “High Yield” since they need to offer investors a higher remuneration for them to accept taking the extra risk. The ones with no rating are the “Junk Bonds”. 
• Commodities such as oil, gold, other metals, corn, etc.;
• Stocks of private companies i.e. not traded in regulated public Markets, either existing companies (“Private Equity”) or in new ones (“Venture Capital”). 
• Real estate – land, office, commercial and residential buildings or units, either ownership or mortgages.
• Also collectibles, insurance, etc. you name it - you have it.

• “Non-directional”, which means not related to the direction, positive or negative, of the price of any asset, including stocks and Investment-Grade bonds. Since the antonym of the word “relative” is “absolute”, the non-directional investments are also named “Absolute Return”. If the performance is not correlated with the gyrations of the Markets, it has to come from some more or less complex strategies and how much talent the manager who devise and implements them. The measure of the manager’s talent is named “Alpha”. 

Hedge Funds belong to the B. 2. category: They are Alternative Non-directional/absolute return investments. These funds apply so many different strategies they cannot be easily regulated, even there have been numerous attempts. 

Why are they called "Hedge" Funds? 

1. Why “Hedge”? Historically, the hedge funds started by being managed by being very much protected from the variations of the Markets, similar as garden hedges which protect a property, but they now include some of the B. 1. strategies i.e. directional, therefore not hedged at all!
2. A Fund is a legal structure or “Investment Vehicle”, into which money coming from many investors are commingled (vs. a “Private Account” being owned by one single investor). The manager of those funds, most of the time a management company and not an individual, is the “Hedge Fund Manager”.

Why do Hedge Funds have a bad reputation? 

For many reasons, here are some of them:

• They often have been sold by the marketers using deceptive arguments, presenting them as having the potential of making money all the time instead of explaining that they still take of risks (stock selection in our example) and indeed they can lose a great deal of money.

• As discussed above, these funds apply so many different strategies they cannot be strictly regulated, so-called “lightly regulated”. Some of the very complex strategies can’t be understood by non-specialists and it is human it creates uneasiness. 

•  While the average hedge fund is generally less speculative than a long-only traditional fund, there are many aggressive ones. The majority of the good ones explicitly and methodically pursue consistency of returns and/or preservation of capital. Of course this is not sensationalist or sexy, so this aspect of hedge fund finance seldom sees the light of day within the media. 

• Their fee structure is outrageously high, which is fine when they make a ton of money since they still deliver handsome after fees returns, but scandalous when they lose money. A classic fee structure is made of an annual “management fee” equal to 2% of the money they manage, plus an “incentive fee” of 20% of the annual profit – named the “2 /20 or the 2 and 20 fee structure”. 

• Let’s imagine a gunslinger manager who achieves a “gross return” (before fee) of 22% on Year 1 on $100 investment i.e. $22; the manager would receive $2 management fee and $4 of incentive fee, i.e. $6 and the investor would be left with $16 of the profit, i.e. a “net return” after fee of 16%. On Year 2, the manager loses 22% on the $116 left at the end of Year 1, i.e. a loss of $25.5. The manager still receives his 2% management fee on the $90.5 left at the end of Year 2, i.e. $1.8 but of course he does not get any incentive fee since there is no profit, but he is not going to give back the fees he received on Year 1. Therefore, within those two years, the investor is left with about $88.7 out of his original $100 investment, i.e. a loss of $11.3, but the manager would have cashed $6 the 1^st year plus $1.8 the 2^nd year, equal to a total profit of $7.8 !!! No wonder why hedge fund managers are not liked when some of them are lousy and/or unscrupulous by taking too much risk with their clients’ money hoping to get lucky at no risk for them.

• Last but not least, there are the crooks. Crooks are everywhere and some long-only managers are also caught doing “insider trading”, i.e. getting an unfair advantage by using private information to trade before it is known to the general public, but the lightly regulated hedge fund industry allows many creative ways to be a criminal, Madoff being the legendary genius evil. Since it makes juicy stories, journalists love writing about it and this is what the general public remembers, extrapolating to all hedge funds.

Why the best managers are running Hedge funds? 

Short cynical answer is in 2.c. above. A long-only manager charges a maximum of 1% management fee and no incentive fee, compared to the 2/20 charged by hedge funds. The good managers survive and gather enormous amount of money to manage and make huge wealth. 

What are other Hedge Fund strategies - from simplistic to very complex?

One of the simplest strategies is the Long/Short Equity Market Neutral, logical name now that you understand what it’s done.  There are a myriad of other strategies, betting on any asset which trades, even some rather illiquid ones with very little trading volume/liquidity. I do not believe that at this time it is worth getting into too much detail. Suffice to say they employ a wide range of trading strategies but classifying them is difficult due to the rapidity with which they change and evolve. However, hedge fund strategies are generally said to fall into four main categories:

• “Global Macro”: trying to predict how currencies, interest rates and financial markets will behave; 
• Directional: in theory not hedge funds since they do not hedge but they invest in specialty stuff where the manager believes it’s so cheap there is no need to protect the downside;
• “Event-Driven” taking advantage of special situations such as companies merging or acquiring others or going into bankruptcy; and
• “Relative Value” when, like in our example, the manager tries to be long the cheap stuff and short the expensive stuff, and this applies to all sorts of stuffs. 

These four categories are distinguished by their investment style and each have their own risk and return characteristics. It is possible for hedge funds to commit to a certain strategy, or employ multiple strategies to allow flexibility.

Alternatively, hedge fund strategies can be classified by the level of manager discretion.  There are hedge fund strategies where investments can be selected by managers, known as "discretionary / qualitative", or those strategies where investments are selected using computerized systems, known as "systematic / quantitative".

What's an example of a Hedge Fund?

The more a Hedge Fund's strategy is complex, the more the hedging is. In order to have some flavor of what it is to hedge, let’s use as an example a simple hedge fund strategy named “Equity long/short market neutral”.  

If your strategy is traditional and you just buy stocks of different companies, your ownership is straight forward, nicknamed “plain vanilla”. But, at the time the Hedge Fund Manager buys stocks, say $100, he also borrows other stocks for the same amount of $100 (lenders are mostly insurance companies and other institutional holders of large stock portfolios). He sells right away the ones he borrows and gets the cash in his pocket. So instead of being short of cash, he becomes short of the stocks, abbreviated as “being short”. Obviously he’ll need later to repurchase in the Market the very same stocks he sold to reimburse the lender. If the overall market goes down, say 20%, most likely what he bought will also go down along with the market. He would have cashed $100 at the time he sold the stocks when he borrowed them but, assuming the portfolio of the stocks he sold lost exactly as much as the Market average, he will only have to disburse $80 when he has to buy them back to reimburse the lender, therefore he would have made a profit of $20 on the “short side” of the deal. Moreover, if he is good selecting stocks, i.e. he has a “positive Alpha”, he’d have selected stocks that are of a poorer quality than the average, those would have decreased even more than 20%, say -30%. If so, he would have to disburse only $70 when he buys them back. In this example his profit would actually be $30. On the other hand, he started with being long $100 and this $100 would lose $20 on the “long side” during this period when the Market decreases by 20% on average; but if he is has a positive Alpha, he would have bought stocks which are of a better quality than the average and he might only loose, say, half of the average, i.e. only $10. Putting the whole portfolio together, during this period he’d actually have made a profit of $30 from his short portfolio, but he’d have lost $10 from his long portfolio = he’d get his money back (i.e. $100), plus a profit of $20, only because he’s a superb stock picker i.e. he has a high Alpha. So, in this example a long-only manager would lose $10 but an outstanding Hedge Fund Manager would actually make $30! 

The exact same reasoning when the Market goes up 20% instead of down 20% will lead to the same profit of $20. 

This means that this hedge fund manager has made money “regardless of market conditions” his portfolio being neutral to the vagaries of the market. 

He can even magnify this profit if he start by borrowing $100 and therefore invests $200 instead of $100. This is called using “leverage” or leveraging the portfolio, 200% adding the longs and the shorts, or “2x leverage” in this example. This leverage will obviously multiply his profit by 2.

As any population sample, you have the good, the bad and the ugly. If the hedge fund manager stinks, his long portfolio might lose more than the Market when it goes down and makes less when Markets go up, while his short portfolio he might lose more when market goes up and make less when it goes down (a “double whammy”). You realize that in that case, the losses are larger than the market loses without leverage and the losses are huge with the leverage. 

Therefore, Manager Selection while always important even for long-only, becomes even more critical for the lightly regulated hedge fund managers who can do pretty much what they want, including adding as much leverage as they want.

Strategic Asset Allocation et Tactical Asset Allocation

I. SAA = Strategic Asset Allocation = une diversification à long terme dans tout ce que l'on peut investir:

1. En fixant en premier le niveau de risque Beta c.à.d.
      a) les risques liés directement aux marchés financiers en investissant dans des fonds qui répliquent bêtement un indice boursier, comme par exemple le "Morgan Stanley World Index" qui reflête  la performance moyenne ponderée de toutes les bourses du monde ou le "S&P 500" qui est egal á la performance des 500 plus grosses sociétés américaines.
     b) les risques pris dans toutes sortes d'investissements très corrélés aux actions, donc aux profits des entreprises ou à la santé des Etats comme le crédit aux entreprises ou aux pays.

Ce pourcentage de Beta est fixé subjectivement bien sûr, mais en se basant sur la performance historique des marchés financiers pendant des périodes similaires à ce que ta boule de crystal te dit. Ta boule se base sur le niveau de confiance que tu as dans l'économie mondiale pendant les années à venir. Vu l'endettement qui va logiquement mettre des années à se résorber, il n'y a pas trop d'enthousiasme à prendre des risques sur les bourses puisqu'en moyenne les entreprises ont du mal à vendre plus, donc augmenter leurs profits, si les consommateurs et les gouvernements sont tellement endettés qu'ils n'ont plus de fric à dépenser.

2. La rentabilité du reste du portefeuille ne peut provenir que d'investissements avec des petits malins qui trouvent toutes sortes de moyens de faire du fric sans dépendre de la performance des bourses (ce que Bob Jaeger déteste et il a raison, mais comme je l'ai expliqué on n'a pas trop le choix). C'est, comme on en a discuté encore et encore ce qu'on appelle le risque Alpha. Il y a des méthodes relativement simples comme spéculer en bourse en même temps à la hausse et à la baisse, mais aussi plein de stratégies plus ou moins complexes. Le problème est que l'on est dépendant de la nature humaine, donc risquer de tomber sur des escrocs au pire, de se tromper sur la compétence de certains qui ont eu de la veine mais très peu de talent, de ceux qui devenant riches changent de style de vie et ne bossent plus suffisamment pour rester au niveau, de ceux qui ramassent tellement de fric à gérer pour se faire plus d'honoraires qu'il est impossible d'en investir autant dans leur niche et donc prennent beaucoup plus de risque pour conserver leur rentabilité passée, etc. etc. La SAA diversifie dans plein de ces strategies et dans suffisamment de managers pour ne pas être trop dépendante de chacun.


II. TAA = Tactical Asset Allocation:

Que le monde aille bien ou mal sur un horizon à relativement long terme, on passe par des cycles courts plus favorables et par des périodes de plus grosse merde. Il faut donc ajuster sa diversification entre Alpha et Beta pour prendre un peu plus de risque Beta  quand on croit avoir une éclaircie et moins si l'on pense qu'une tempête se profile à l'horizon. Egalement certaines strategies Alpha deviennent trop populaires et quand trop de fric chasse des opportunités limitées sur des petits marchés, la période faste disparait. Il faut donc trouver d'autres petits malins qui se positionnent sur ce qui n'est pas encore à la mode et sur des opportunités juteuses mais à cout terme. Tous ces ajustements transforment la SAA en TAA.

III. "Current":
C'est tout simplement le portefeuille de tous les investissements que l'on a à la date où on le regarde. La différence entre TAA et Current s'explique que cela prend du temps d'ajuster  les pourcentages, c.à.d. de désinvestir totalement ou partiellement d'un manager pour investir dans un autre. Tu ne peut donc jamais avoir un portefeuille Current qui reflête exactement ta TAA.



La gestion de portefeuille est bien évidemment plus complexe que ma description plus que simpliste ci-dessus. Quand on cherche à trop simplifier des choses compliquées, on prend le risque de déformer la réalité, mais grosso modo je crois vous avoir donné une explication suffisante pour que vous ayez une vague idée de tous les domaines à approfondir pour arriver à une connaisance de base.