There is a common myth among investors that hedge funds are run better if they are left to specialised and often overpaid professional hedge fund managers.
The harsh reality is that if these fund managers were as good as their brochures suggest, they would be too busy looking after their own money, not other people’s.
In the UK, a commission on banking has heard evidence that City bankers and fund managers can push up their own salaries if they claim that they must pay high salaries to those working under them, to retain talent.
Today, with the internet and very efficient derivative exchanges, sensible private investors can simulate a hedge fund and often do a better job than their “professional” counterparts.
Measurement of risk
When you manage your own funds, you pay close attention to risk. You don't have to worry about compliance and regulatory procedures since you alone suffer the losses if you get it wrong. Nor do conflicts of interest cause a problem.
On the other hand, if you manage other people’s money, you think and behave differently. For instance, you are tempted to ignore the measurement of risk if your investors don’t ask questions.
Also, spending more time on compliance, though time consuming, will keep you out of court.
Professional hedge fund managers, if they are being honest, are often more loyal to the compliance rules than to the needs of their clients.
What distinguishes hedge funds from straightforward traditional investment funds is their sophistication and flexibility.
For instance, in a boom period when stock markets are racing ahead at an irrational rate, hedge fund managers may use derivatives to reduce their exposure or even change direction by “shorting” the market – ie, making profits when the markets fall.
If you feel the stock market is going to stabilise or decline, you can use derivatives to profit from its fall.
Traditional investment funds are usually “long-only”, which means that they only profit in a rising market.
Eliminating risk
Another advantage that hedge funds have is that managers can tailor their risk profile.
Suppose you feel that the risk of US corporations going bankrupt will increase because the US Fed’s monetary policy is very inflationary (ie, the Fed is effectively printing money).
A long-only investment fund might simply buy some US corporate bonds. A hedge fund manager will probably realise that quantitative easing is inflationary and may cause the dollar to fall against the euro and, of course, the US may be forced in times of inflation to push up interest rates.
A European hedge fund manager will therefore buy US corporate bonds and “hedge” the interest rate and foreign exchange exposure.
In other words, the hedge fund manager uses derivatives to eliminate the interest and foreign exchange risk that is inherent in the bond.
The idea is to simply pinpoint the exposure that you want and eliminate (or hedge) the rest.
As with all forms of investment, the correct pricing of risk is essential. That means deciding on a risk level and then making sure that you are adequately compensated for that risk.
A unique investment style helps. If you follow what everyone else is doing, you end up in an overpriced market and the rewards for the risk you take diminish – think of the Irish property market.
Professional hedge fund managers tend to follow strategies adopted by other hedge funds. If you manage your own funds, you will try to do the opposite – focus on areas that the professionals are not interested in, the underpriced sector.
The biggest conflict of interest that professional fund managers face is the fee structure. Normally, fund managers obtain an annual fee of 2 per cent. On top of this, it is quite normal that they are entitled to 20 per cent of the profits.
This encourages high leverage. Hedge fund managers are happy with high leverage because their commission is much more valuable if the value of their portfolio swings by large amounts than small amounts. If their bets are profitable, they get 20 per cent of those profits.
Overleveraged
But if they make losses, they pass them on to the investors of the fund. In essence, because they can walk away from losses, hedge fund managers are tempted to turn a safe conservative fund into a highly leveraged gamble and ignore risks.
Long Term Capital Management was a famous, sophisticated hedge fund that collapsed in 1998, nearly bringing down the US financial system. Studies show that it was very much overleveraged and therefore vulnerable to market emotions.
With today’s technology, it is easy to set up a hedge fund. And, without the conflicts of interest or compliance costs, it is easier than you think to outperform the professionals.
The key to a good investment manager is to understand how to price risk – and to make sure the rewards justify that risk.
Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options.
