Explain to me like I'm a 12 year old the benefit of a hedge fund

slippy777's picture
Rank: King Kong | 1,259

My dad is consistently trying to show me articles how hedgefunds are BS and how they "can't even beat the market". Then proceeds to show countless articles comparing hedge fund performance in the last 8 years compared to the s&p and index funds. I don't know enough about the subject to even respond to him. I know many people say it's bc we're in one of the longest bull markets we've ever seen. Can anyone elaborate further? Completely ignorant on the subject.

Comments (77)

Feb 28, 2018

I presume this discussion with your dad stems from your desire to work at a hedge fund rather than an evaluation of whether hedge funds are a good place to invest money. The reason why the industry has stuck around despite the lackluster returns these articles point to is that hedge funds make money off management fees that are independent of performance. For large funds, this 2% or whatever it may be amounts to a lot.
Moreover, even if on average HFs lose to the S&P there are still some guys like Dalio and Singer who consistently outperform.
As an investment vehicle, HFs benefit from flexibility (they can adopt aggressive strategies like short selling and do not have to be fully invested at a given time).
Thus, for the time being, they're here to stay.

"Truth is like poetry. And most people fucking hate poetry."

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Mar 1, 2018

Thanks for the reply. I don't really have an interest in working for a hedge fund. As for how the discussion comes up, my dad assumes I work for a hedge fund because the word "investment" is in my job title. I remind him how I work in m&a and that we don't invest in anything. I'm shrugged off and he goes on to rant about why anyone would invest in them. So my question is more why would someone invest/is it a good investment. Is it because people have more faith in a particular industry/investment strategy that a fund may focus on? Are they looking and expecting to see returns > other index funds?

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Mar 9, 2018

Hedge funds have stuck around because there is a demand for them. People are always chasing a return and will move from one fund to another based off of previous returns/ strategies. Regardless, there are still plenty of funds that have outperformed the market recently and continue to do so.

Mar 9, 2018

The real answer is that there are a lot of rich people with poor understanding of probability and expected returns, who as a result make poor investment decisions (ie Hedge Funds). Of course there are some benefits to particular funds, but overall the expected return from a statistical perspective doesn't give us any rational answers to why an investor would prefer to put money into a hedge fund. The cold but hard truth about humanity is that a lot of us make decisions disregarding solid rationale. Just because everyone does it doesn't mean there is a good reason for it.

Mar 6, 2018

The reason why the industry has stuck around despite the lackluster returns these articles point to is that hedge funds make money off management fees that are independent of performance.

This makes no sense.

"Not me. Im in my prime"

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Mar 6, 2018

Please explain

"Truth is like poetry. And most people fucking hate poetry."

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Mar 1, 2018

also worth considering that there are a lot of smaller funds that dont disclose their earnings that crush it.

Mar 1, 2018

The best hedge funds outperform in the long run, just looking at some of the track records. A case in point would be the crazy returns Yale's endowment has realized compared to others, largely by leaning towards alternatives and picking the right managers.

Also, many hedge funds employ absolute return strategies that aim to make money irrespective of market conditions - arguably some of them shouldn't even be compared to the S&P (Baupost for example) as they fill a similar role to cash in institution portfolios.

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Mar 1, 2018

Yale's endowment is not a hedge fund

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Mar 1, 2018

That's not what he's saying. Yale has invested in HFs more aggressively than other endowments and has outperformed almost every other endowment over the last decade as a result ( I think second to MIT)

Mar 1, 2018

Yale's returns have mostly been due to their allocation to PE and VC, not hedge funds.

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Mar 11, 2018
Cohle:

The best hedge funds outperform in the long run, just looking at some of the track records. A case in point would be the crazy returns Yale's endowment has realized compared to others, largely by leaning towards alternatives and picking the right managers.

So, an analogous investment strategy, but more risky, would be VC? Plenty of risky investments, with a few but big payoffs.

Apr 2, 2018

what do you mean they fill a role similar to cash?

Best Response
Mar 1, 2018

All of this "beating the market" stuff is literally just completely meaningless. Most equity hedge funds are ... wait for it... HEDGED. They shouldn't beat fast rising markets - they should slightly under perform rising ones and (hopefully significantly) outperform imploding ones. The focus is on RISK ADJUSTED returns.

Many hedge funds also invest in other markets (credit, macro, etc), so the performance of the "market" (S&P500) is just a completely meaningless metric by which to judge. If you want to outperform the S&P lever yourself up moderately in an ETF and hope we don't experience a massive bear.

Mar 2, 2018

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Mar 2, 2018

Actually the focus for hedge funds is absolute return and not risk adjusted return. Conceptually, HFs should make money when markets are good and when they're bad. They're supposed to successfully time markets, which they almost never do. The argument that HFs are a low beta asset class, comparable to gold but with a 20/2 fee structure us laughable. You hear this shit all the time when things go south.

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Mar 7, 2018

After reading some of your other comments, I'm going to throw it back at you and be blunt: everything in this response is just plain stupid and illustrates that you don't understand the hedge fund world.

"Conceptually, HFs should make money when markets are good and when they're bad. They're supposed to successfully time markets, which they almost never do. " - Who told you this? Only a small minority of the HF world would claim to gain edge from 'successfully timing markets'. There's a way you can make money in various market environments: BE DIVERSIFIED AND HEDGED. This means that you will almost certainly under perform when markets move up aggressively.

Several of the biggest hedge funds in the world (see: Millennium Management) are basically incapable of putting up a 20% year. How have they gathered so much assets? Because on a risk adjusted basis their performance is excellent - they have never had a losing year and rarely have multiple down months.

You also didn't address the rather big point: WHAT MARKET? If you want to beat equity indices then there is no real point in investing in credit, macro, etc. Yeah there are credit indices to comp to as well, but there is no 'index' for macro performance.

"The argument that HFs are a low beta asset class, comparable to gold but with a 20/2 fee structure us laughable." - Is this a joke? Gold is an insanely volatile asset that is sometimes (but not always) inversely correlated to equity markets. I don't know any hedge fund that would aim to have performance 'comparable to gold'

The bottom line is that most of the capital in hedge funds in in funds that are selling hedging, not out-performance of the market.

Mar 1, 2018

One simple argument that one could make is that some things have value, regardless of their relative performance vs the S&P, recent or long-term. For instance, in the past 8 years or so, bonds have underperformed the S&P. Does that necessarily imply bonds are BS?

More generally, like any broad category of investment strategies, HFs have their flaws and possibly some advantages.

Mar 2, 2018

Man this is a stupid response. It's true that both bonds and HFs haven't outperformed the general market in an absolute sense, but can you think of any differences in the risk profiles between the two asset classes? Does anything come to mind at all about the different sources and magnitude of risk between bonds and HFs? Anything?

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Mar 2, 2018

Why are you so quick to jump to "this is a stupid response" Martinghoul was implying that just because a HF doesn't outperform the S&P it doesn't mean that there is no "value". He backed up that claim by stating that bonds don't outperform the S&P but they are still a very feasible investment. (Hes trying to point to the fact that there are other things to concern such as risk adjusted returns as opposed to just "outperforming the S&P").

You're being an ignorant asshole by implying that martinghoul doesn't understand the notion of risk adjusted returns(or as you put it "sources and magnitude of risk between bonds and HF's) when in actuality that is the entire point of his "stupid response".

May god have mercy on whatever company you are a CD at lmfao.

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Mar 2, 2018

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Mar 5, 2018

Yes, indeed, my point was a very simple one, but you appear to have missed it...

More generally, it's likely that even the simple mean-variance framework that you appear to be so fond of isn't sufficient to explain the performance of a particular class of investment/strategy. Higher moments matter and sometimes they matter a lot. It's entirely possible that at least some of the broad class of strategies offered by HFs offer some particularly valuable characteristics. Alas, with your penchant for over-generalisation, you're probably not interested.

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Mar 10, 2018

Dude, you are an absolute cringe fest. Why do you spend so much time obsessing over the hedge fund industry?

https://www.wallstreetoasis.com/forums/percentage-...
Look at that post: What percentage of HFs "secrectly" (gasp) invest into crypto? Are you fucked? You have no clue how the industry is structured or works. you do not understand that there is a wide spectrum of firms/strategies that are classified as alternative investments and a lions share of these could be considered hedge funds.

There is a huge difference between firms like Oaktree, GSO, Ares and firms like AQR, Bridgewater or Elliott and shit holes like pershing square or any recent tiger cub shit fund...... I'm sure your only familiar with axe capital, so I'm not surprised that you have such a cartoonish understanding of the industry.

Further, I think you fail to understand that there is a pretty well-known (for those that aren't high school aged losers/cringe shows calling themselves "wolf of x") dichotomy between firms that have significant institutional business and firms that do not ( e.g. shithole firms that market to retarded HNWI; pretty much PWM shops with bottom barrel investment personnel)

Further, alpha is alpha. If you are factor neutral and are not exposed to any significant stand alone risks (theoretical scenario) then you could always overlay a systmatic exposure like an X amount of SPY e mini contracts ontop of your portoflio. that way you get both the S&P exposure that you are so focused on, and you earn alpha. Is a 2/20 fee structure defensible? infrequenty, yes, most of the time, no, but fees are always negotiable (things people on this forum don't seem to be able to comprehend)

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Mar 1, 2018

Most hedge funds are not long-only. I.e. they also short. Most of the time, hedge funds actually lose money on their short positions. But that's okay as long as the overall return when including long positions is positive.

You might ask why you would take a short position that you know will more likely than not lose you money. Well, the answer is that long/short portfolios usually have significantly lower volatility than a long-only portfolio. Market neutral strategies (a type of long/short) often have 3% volatility whereas long only strategies (sp500) will have 15%+ volatility.

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Mar 1, 2018

When you think of hedge funds, think of an extremely risky and costly investment, but also a chance for extremely profitable investment.

An easy example to understand would be in comparison to a phone app or a podcast, what originally started as something targeted at a very specific subset has now expanded but also been degraded. There are some great apps/podcasts out there, but most are mainly a waste of time or copycats that don't push the envelope.

It might not make 100% sense to your father (and not wanting to judge someone), but it's easier to understand when you have a very high net worth and are able to lose money. For example, if you have $800mn, you are set for life, and your kids kids are also set. Even if you use $200mn for yourself, the remaining $600mn can be used for investments. All $600mn can be safely invested, but at the same time why not risk $20mn or $30mn with an experienced fund manager to try and generate above market returns.

What I'm saying is its all percentages. $30 is a lot more to someone whose net worth is $100, but a lot less to someone whose net worth is $100mn.

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Mar 1, 2018

this line of reasoning is applicable to some hedge funds but certainly not all or even most. the primary purpose of most hedge funds (on the equity side at least) is to generate returns higher than bond yields in any market environment. of course, not all hedge funds achieve this but that is why people invest in them. with few exceptions it is not really to play slots for the chance of making huge returns. if that was the reason they invested in hedge funds they would go to vegas instead.

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Mar 1, 2018

Hedge Funds are NOT supposed to be extremely risky, but they DO use some extremely risky strategies. There are some long/short funds (pretty much same as a HF) where the surrender fees are much lower, the strategies employed are not exotic, and the returns have been pretty consistent for nearly 10 years. That said, HFs have been historically expensive (2 and 20), and the majority have underperformed, as have active management.

My firm has a narrow number of HFs we recommend, and only in very specific circumstances, but they do have a place in the investing landscape.

Mar 1, 2018

All about volatility and market correlation. If you have a 4%+ draw on your capital every year as an institution, significant down years hurt your long-term capital levels a lot more than a significant up year would help. Hedge funds aren't meant to be down less in down years and up more in up years. They are meant to be low volatility instruments with low correlation to the overall market and "equity-like" returns. With that said, our benchmark for our hedge fund portfolio is not an equity index, it's an equity/bond mix. We don't expect our hedge funds to beat the S&P 500 for example (although most in our portfolio get really close).

Mar 2, 2018

Yes, the modern hedge fund industry, as I've highlighted many years ago on this forum, is an entirely inefficient investment vehicle that persists primarily because of tradition and regulations associated with the SEC act (regulation D and what not).

In the past, hedge fund managers were more successful because public markets where less liquid, efficient and diversified. As global markets continue to evolve (more and more markets opening for previously illiquid assets, greater efficiency with HFT, introduction of various hedging securities, etc.) the ability to generate persistent alpha diminishes, if not vanishes altogether.

Hedge funds under preform on an absolute and on a risk-adjusted basis. Their portfolio's consist of investments in international markets with high country risk premiums, in small caps and in illiquid assets. This alone should generate higher absolute returns (though not risk-adjusted returns) but doesn't. HFs themselves are an illiquid investment that carries a required premium. Your money is tied up for a certain period of time which introduces another dimension of risk. The poor performance, in every dimension, and the insane fee structure simply won't persist. This is why we're seeing and will continue to see a secular decline in the industry.

This is not to say that all hedge funds will go away. There will always be the "smartest guy in the room" but the pretenders won't be able to make as much money as they have (if any at all). This is part of a broader trend in finance towards greater market efficiency that will impact not only HFs but also IB, S&T (already has), PE, VCs, etc. It isn't surprising to anyone that understands financial theory conceptually. It's only really a surprise to those who have completely rejected theoretical finance altogether.

The HF industry is literally based on the denial of science. So yeah, it won't last and at this point, that's blatantly obvious.

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Mar 2, 2018

You're sounding a little shrill here. Agreed that the ubiquity of most popular algorithmic strategies and the relative ease with which one can acquire the minimum necessary infrastructure to start up a hedge fund are factors which will contribute to the continuing shake out of smaller players from the industry in coming years (along with other factors you mention, like the introduction of new derivatives and diversification).

But to suggest that HFs are going the way of the dodo? Dream on, man. In many ways the fall of HF's from grace is the result of them being a victim of their own success. It's hard to capture market inefficiencies when you and your cohort have already so effectively exploited and undone these same inefficiencies.

Your argument misses the point that HFs fulfill a unique role within the financial ecosystem - namely, their purpose is to seek out and capitalize on inefficiency in the public markets. Without them, there is no other profitable, institutionally accepted, ubiquitous means for tasking capital with ferreting out market inefficiency.

You're right that the dissemination of information - both in the form of info that supplies model inputs as well as the academic papers containing the models themselves - will limit the ability of novice players to stake out a space for themselves in the industry. But for those survivors who can afford to invest in proprietary data and infrastructure, there will always be a place, because there's no other commonly accepted vehicle for deploying "skeptical" capital into public markets.

Mar 2, 2018
Fugue:

You're sounding a little shrill here. Agreed that the ubiquity of most popular algorithmic strategies and the relative ease with which one can acquire the minimum necessary infrastructure to start up a hedge fund are factors which will contribute to the continuing shake out of smaller players from the industry in coming years (along with other factors you mention, like the introduction of new derivatives and diversification).

If it were just the smaller players than I wouldn't have much of an argument. It's really the whole industry, big and small (Pershing, Brevan, etc.). I'm convinced that there's a very small fraction that knows what's up and the rest of the funds that make money do so by acting on inside information through personal connections.

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Mar 6, 2018

I think the key term is 'modern'. In the past hedge funds were valued for their lack of correlation with whatever index/asset class the investor was trying to 'hedge' against. The shift of focus from reducing total portfolio variance to absolute return is a very modern development.

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Mar 6, 2018

Can you elaborate? When did this shift happen and do you have an idea why?

Mar 6, 2018

I may get my first shit thrown from this post, but hedge funds as a whole are obviously hurting (exception: Axe Capital), due to their outrageous fees and inability to outperform the market (your dad is correct in that sense) on a consistent basis. The only people they benefit are the portfolio managers who work for them and earn fixed commissions regardless of their relative returns.

By doing your own research you'll be able to realize just how silly modern portfolio theory and technical analysis is. At this point, I'm convinced that endowments and the like only invest with hedge funds for the brand name.

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Mar 6, 2018

The purpose of long/short equity hedge funds is to generate equity-like returns while maintaining the volatility of short-term bonds. The correct benchmark for any market neutral (type of L/S for those unaware) is bonds. NOT the SP500. Obviously, not all or most hedge funds succeed at doing this and those hedge funds end up failing. But the repetition of the extremely ignorant argument that hedge funds are dumb because they don't beat the SP500 is extremely annoying. Look at the sharpe ratios.

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Mar 6, 2018

Sharpe ratio not relevant for asymmetric return distributions.

Mar 7, 2018
Esuric:

Sharpe ratio not relevant for asymmetric return distributions.

Tell that to pretty much every LP that exists lol. Sortino ratio is fine too to take account for some of the asymmetry.

Mar 7, 2018

This.

A conventional portfolio is 75% equity and 25% fixed income. Fixed income is generating such a low return, and is at such historical highs, that it does not make sense for many investors with long time horizons.

Hedge funds are an interesting replacement for part of the 25% fixed income allocation. IF, 1) they are somewhat uncorrelated to the 75% equity bucket, and 2) can generate higher returns than fixed income.

Some excerpts from Buffett and Berkshires recent annual report highlight the benefit of an uncorrelated, higher returning HF.

"Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. "Risk" is the possibility that this objective won't be attained
It is a terrible mistake for investors with long-term horizons - among them, pension funds, college endowments and savings-minded individuals - to measure their investment "risk" by their portfolio's ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk"

Mar 7, 2018
S.P.O.R.T.:

Hedge funds are an interesting replacement for part of the 25% fixed income allocation. IF, 1) they are somewhat uncorrelated to the 75% equity bucket, and 2) can generate higher returns than fixed income.

This is the purpose of market neutral hedge funds, yes.

Mar 7, 2018

"You're going hiking along a wooded path along a river. You have a rubber ducky that you really love, but you don't want to hold it during your hike. A hedge fund takes said ducky, puts it in the river, and catches it at the end of the trail. Upon returning it, it demands you to pay them money, even though nature (the momentum of the river) did all the work."

^ yes, it's a bit cynical, but it's the truth. HF managers are no different from you and I.

mind you, I work in AM.

Mar 9, 2018

Hedge funds are supposed to earn 6 to 8% per year, with low volatility, through all market conditions. The public compares them to the S&P... The comparison means nothing to most people in the industry. Obviously all funds are different so you should definitely take this with a grain of salt (A long-only equities fund should still be compared to the S&P...)

With that said, there is a fair argument that the industry should contract some. Managers do whatever it takes to boost AUM to get higher fees. They get paid absurd amounts. People start funds with a pedigree and connections yet lack of a strong track record... I believe the industry is here to stay, but only the best and brightest managers will stay.

Mar 10, 2018

Gonna skip over this wall of text.

OP, Hedge Funds will be there to fight another day. In a market like this, a lot of Robinhood kiddies think they're hot shit but blew up their trust-fund/bar mitzvah money on the correction. It's all about longevity, and preservation.

Mar 11, 2018
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