What’s a hedge fund? I interview a hedge fund manager to find out.

In today’s post, I sit down with a hedge fund manager and find out more about this mysterious investment option. 

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An investment only for the rich?

Hedge funds are the private yacht clubs of the world of personal finance.  Shrouded in mystery, they are a type of investment class limited to accredited investors. 

You can be considered “accredited” if you have a net worth of > $1 million (excluding your primary residence). Alternatively, you must make > $200k income annually for the last two years (or $300k for married couples).

But what exactly is a hedge fund?  How do they make rich people money?  And why should anyone, even the rich, consider entrusting their assets to a hedge fund manager?

I have the random good fortune of being friends with a hedge fund manager.  I sat down with her to answer some of these questions. I want to protect her identity, so I won’t go into her background very much.    

I’ve edited and trimmed her responses for clarity.  My questions are in BOLD. Her responses follow. My comments are in italics

Interview starting

What is a hedge fund? 

A hedge fund is an investment management firm that invests client capital and has a very broad mandate.  It has the ability to invest in all kinds of different asset classes, public and private, and has the ability to go long and short.   

  • “Going long” means making money if a stock goes up in value. 
  • “Shorting” means making money if a stock goes down in value. 

It’s generally subject to a more lenient regulatory regime than, say, mutual funds or ETFs (exchange traded funds).  

In theory, hedge funds are trying to generate returns not correlated to the stock market.

How do hedge funds make money for their investors?

For investors, hedge funds make money by timing investments wisely.  For example, by owning assets that go up in value or shorting assets that go down in value. 

How about for the hedge fund owner?

In short, by charging fees.  Hedge funds generally charge performance fees and management fees.  So they charge a fee on returns, and also a fee on the total assets under management.  

A common hedge fund fee structure is to charge 2% of assets under management and 20% of any gains.  Some charge less.

How can a hedge fund outperform a mutual fund?

Mutual funds and ETFs are generally very restricted in the asset class they invest in.  If they invest in, say, stocks, they might invest in a certain sector or in a certain country.  And generally the can only go long in that market.  

So their gains often reflect the overall gains of that asset class.  Most mutual funds that invested in real estate, for example, lost a lot of money in 2008.  

A hedge fund, on the other hand, can generate returns that may not be at all correlated to a specific market.  Some hedge funds made money in 2008.  

What’s the typical size of a hedge fund and what’s the optimal size?

I don’t know if there’s a typical size.  It’s really wide ranging. 

Some of the biggest hedge funds in the world don’t invest at the individual stock level, and the decisions are made by algorithms.  They may have $100 billion in assets, and they’re betting on things like the price of oil or countrywide interest rate fluctuations.  

Smaller hedge funds may invest in individual stocks, and are limited in the capital they can deploy at any given moment by the number of shares available to buy. 

So the optimal size of the hedge fund depends on their strategy?

Yes, you could say that.

What do you make of the studies that show that over time, index funds outperform almost all hedge funds?

The time period you select to look at this is very important.  Hedge funds will look a lot better in times of market volatility, and index funds will generally look better when stocks are calmly rising.

Also, fees play a role.  High fees may make index funds actually a better investment than a given hedge fund.

What differentiates a good hedge fund manager from the rest?

It’s hard to assess hedge fund managers for a lot of reasons.  

Ideally you’d want to evaluate someone’s performance over, say, 10 years.  But over that time span, how they perform is much more dependent upon the overall market environment.  And the average lifespan of a hedge fund is not very long. (It’s about five years.)

But as a rule of thumb, the best managers are ethical and have their investors’ best interests at heart.  They are skilled at taking risk. They’re willing to take risks, but good at knowing which risks are worth taking.  It helps if they’re humble and able to get out of a losing bet. They have to be smart but also imaginative. Finally, the best ones can think outside the box and think creatively about what’s really going on.

What’s the craziest thing you’ve seen as a hedge fund manager?

There have been so many crazy things, but some of my favorite experiences have involved bets.  Hedge fund team members are notorious for making enormous personal bets over trivial things. Think eating contests involving old chalupas or White Castle burgers.

A hedge fund is kind of like a frat house, but with a lot over-confident, money laden people.

Hedge fund manager

What do you enjoy most about your job?

A big part of my job is meeting with management teams.  I assess if they’re telling the truth, and that’s my favorite part of the job.  Most of these guys are really experienced and I love finding out what makes them tick and if they’re honest.

What do you enjoy the least about your job?

The hardest thing is that the only assessment of your skill is your returns.  In the short term, there’s a huge amount of luck. In the hedge fund world, there’s a huge amount of gossip and it’s very competitive.  There’s a lot of keeping up with the Jones’ going on.  

Any closing advice?

Don’t invest in “hedge funds.” Invest with a particular manager that you trust and who has the same investing philosophy as you do.

Ask yourself, “What role do I see hedge funds serving in my portfolio, and which manager and hedge fund meet that role?”

Hedge fund manager

Interview ending

Conclusion

I really enjoyed this interview. Now I feel like I have a better insight into hedge funds.  A few things jumped out at me from this interview.

First, hedge funds managers can invest in whatever they want, with virtually any strategy.  They have a “broad mandate.” Do you want a hedge fund that invests in coffee? There are 31 that are doing that.  How about one that invests in brassieres?  Yeah, they do that too.  

Secondly, when considering investing in hedge funds, she says the driver is more important than the vehicle.  Instead of just investing in “hedge funds,” she recommends you focus on finding a hedge fund manager who meets your risk tolerance and investing philosophy.

Will The Darwinian Doctor ever invest in a hedge fund? 

Certainly not anytime soon. But perhaps one day.

Like individual stocks, I consider a hedge fund investment to be quite a bit riskier than traditional index funds. (After all, index funds are the simple path to wealth.) More specifically, I have nowhere near the amount of investable assets where I’d feel comfortable risking the large amounts that hedge funds generally require. I somehow doubt I’ll ever feel financially stable enough for that.

Finally, I’m too interested in real estate investing right now to think about hedge funds.  But I suppose anything is possible.    

Have a great week.

— TDD

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