Who are the investors in hedge funds and why do they do it?

I'll prob get downvoted to death but I'm actually curious. I'm currently an incoming IB analyst at an EB and want to move to HF down the line. However, I've always wondered why exactly investors are interested in putting their money into hedge funds? I remember Warren Buffett did a bet that the S&P500 would out perform hedge fund managers and Wall Street and ultimately won that bet. Moreover, hedge funds also seem risky with blowups such as that of LTCM or more recently with Archegos.

I get that maybe you want diversification and exposure to a short only fund or maybe a niche market focused fund as a hedge of sorts, but otherwise just don't understand the logic behind it. How consistently can hedge funds actually generate alpha? Also given the rise of WSB and the retail trader market wave, do you think the HF scene is set up to be disrupted soon? Would love some input. Thanks

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Comments (18)

Most Helpful
Apr 1, 2021 - 7:12am

Low net / genuine market neutral funds with tight risk limits are not trying to outperform the S&P. They're trying to outperform the risk-free rate - i.e. targeting a single digit % absolute return each year regardless of what the market is doing.

Institutional allocators giving this kind of fund money know exactly what the HF is trying to do and do not view the product as a replacement for long-only equity exposure - it's a replacement for fixed income / 'low risk' type assets with better returns / better sharpe ratio. 

Archegos was a family office not a HF open to institutional investment - no institutional allocator in their right mind would have given a fund running that amount of leverage with such poor risk management any capital.

Yes there are some HFs that run much higher nets and exhibit a lot more volatility / try to appeal to (high net worth) individual investors by trying to 'beat' the S&P. This is a very different model from the Milleniums / Citadels of the world.

Apr 1, 2021 - 8:39am

The goal of some hedge funds isn't to beat the market. Furthermore, higher returns doesn't mean a better hedge fund! The goal of a hedge fund is to hedge against market downturns to ultimately protect capital and generate returns that are uncorrelated to the market whatever the market condition. For example, fund ΑΒC might have a mandate that is 'we are going to generate sp500 like returns ie. roughly 10% however with half the volatility and be totally uncorrelated to the market'. That to an LP is attractive because whilst the market might beat the HF over a long duration of time, there are periods where the market could have significant drawdown whilst fund ΑΒC is still outperforming. Over a short time horizon it is possible that an investment in a HF would be much wiser than the market itself as whilst the market could extremely choppy, HF's can still generate returns as per their mandate. On the flip side, there are funds that do return much higher than the market (RenTech's medallion fund being one of them) and so if LP's wanted a more aggressive strategy then they could opt for that sort of fund. 

Archegos was a family office which is totally different to a hedge fund - that fund was essentially a one man band who over leveraged in naked exposures and ignored risk limits. This sort of greedy behaviour isn't indicative of the whole industry however there are certainly others who are probably too highly leveraged for their own good. With regards to WSB retail trader trend and GameStop, there were definitely HF's on the other side of the trade (ie driving the price higher - https://www.wsj.com/articles/this-hedge-fund-made-700-million-on-gamest…). I personally don't see retail to pose any threat to HF's, I mean the algorithmic HF's already front run their trades and make a killing of them anyway but even moving forward, in coming years I think the retail euphoria in the market now will die down after we get a sizeable enough correction in the market. Unfortunately high retail engagement and euphoria is a good contrarian indicator of the market topping off like the dot com bubble when everyday people were loading up on tech and even the years leading up to the Great Depression where newspapers where putting out adds to encouraging people to buy stocks. 

  • Quant in HF - Other
Apr 1, 2021 - 8:46am

 I mean the algorithmic HF's already front run their trades and make a killing of them anyway

Oh shit, are you so sure about this? 

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Apr 1, 2021 - 8:49am

I am currently writing my final thesis on HF activism, so I can point you to a few papers that give a great intro to HFs in general. The opinions from professionals here are absolutely great and important, but there is some empirical work that gives you a wider sense of why/which investors allocate to HFs and how the return characteristics are in the cross-section (despite all data issues).

Agarwal, Naik, Fung & Hsieh, and Ackermann have done some good work that you can look up on Google Scholar if you want to invest the time to get deeper into it. If you can't get the pdfs off of Google Scholar, shoot me a dm I have them downloaded. 

Apr 1, 2021 - 10:56am

Bit odd, anyone who wants to work at a HF down the line would think this way/ask this. Warren example was over 20 years not 1 year outlook that was his point. Warren is basically saying "ignore the vol short-term" long-term the market as a whole creates value. Everyone in finance is going to say this and truly we should otherwise we all got no jobs.

Now, why hedge funds exist. Cause within that twenty year span this is a wide range of moves/changes which are hard to keep track of or hard to invest your time to specialize in a lot of them. That is how Alpha is created. Today we have more funds than 10 years ago which means we will have more losers and more winners, again definition of Alpha.

Not sure why we keep picking on Archegos. Sure the guy is a massive shady mofo and should possibly be in jail (but blame the law and government). But if you search twitter his actual strategy was not that wild, I bet over the 3 year span hes not net down a shit ton and the banks allowed him the insane leverage remember they "margin called him" otherwise I am sure Hwang would have doubled down again. His actual strategy was not that bad truly just execution here. Ohh lastly as mentioned was mainly his own money...guy had enough yachts wanted to chase Elon and Bezos.

  • Intern in IB-M&A
Apr 6, 2021 - 5:00pm

What was his strategy? Could you share some pieces of news or similars explaining it? I'd really appreciate it. Thanks

Apr 6, 2021 - 10:03pm

I take back some of my comments. BIll was more nuts than previously thought with all the details out now. But basically he always like'd "larger" high growth tech and media names it seems. He used TRS to gain leverage (which are common and not super illegal or bad). He grew the fund quickly using them after his other shady trading. Here is where things go bad...he lacked collateral in them, he purposely over levered to push the market in his favor, he did not tell some prime brokers he just signed a deal with their competitor. So truly he did not offer full disclosure to anyone.

Clearly the "delta one" and "risk folks" who DJ D-Sol said are great today were smart enough to build contractual language that moment the positions went offside was game over.

Oh lastly, sounds like he used NQ and ES hedges in his basket...which really hurt him when "Viacom" genuis execs were like let's sell our stock for some reason we are better than the index. 

https://twitter.com/TrungTPhan/status/1378758610499502080

https://twitter.com/bauhiniacapital/status/1375765326298718212

https://twitter.com/bauhiniacapital/status/1377506222320967682

https://twitter.com/bennpeifert/status/1377314492363644928

The last one there guy gives an idea of a PB should be doing and should be aiming to honest information. Truly TRS or any swap is not bad. But in the wrong hands you can lose 8b in a week.

Finally, lots of funds do similar swap strategies and are levered. ZH is already chasing down Citadel etc...Lots of places people worship on here that said I think they are all honest to their PBs (Chase Coleman everyones hero of 2021 I am sure is).

Apr 7, 2021 - 7:12am

The reason is that Warren Buffet, you and I are targeting a total return i.e., what is the best way to get the maximum amount of money at the end of 20 years if I just put it into a single fund and leave it. The clear answer to that has been to put it into an S&P500 index fund because despite the large volatility, you will earn a higher return in the long run over any other type of fund. However, pension funds, insurance companies and possibly sovereign wealth funds depending on their mandate, do not target a total return without worrying about volatility, as they are focused on their liabilities that they have to pay out, and so the sequencing of the returns actually does matter. By way of example, say a hedge fund manager returns 5% every year, while the S&P returns 10% every year but drops by 50% once every 20 years:

1. You invest $100 with both the hedge fund manager and the S&P500 index fund. At the end of 20 years, the hedge fund investment is worth $265, while the S&P investment is worth $306. Whether the S&P500 drops 50% in the first year, the last year, or somewhere in the middle, it doesn't matter. You can check this yourself using Excel and actually encourage you to do so.

2. Now say you are a pension fund that has $100bn in assets and needs to pay $5bn in pensions every year into perpetuity. With the hedge fund, you are covered - every year you get $5bn, every year you pay out $5bn. On average, the S&P will give you a higher return each year, however, if the S&P drops 50% in the first year, you are now left with $50bn of assets, and still have to pay $5bn out, and therefore left with $45bn. A 10% return on this will not even cover the $5bn you have to pay out every year, and so you will slowly erode your asset base over the next 20 years.

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