Investing In Hedge Funds - The Definitive Guide
Updated: Feb 10, 2022
2021. A Tough Year For Hedge Funds
2021's financial markets saw an explosive start to the year. From January to May, retail investors, many housed in Reddit's now famed Wall Street Bets community, with too much time and money on their hands decided to dive head first into the stock market. The main vehicle these traders used was shares of GameStop, the much maligned and often beleaguered stock representing a company with a tired business model. Investors discovered a fundamental weakness: there were more shares shorted than actually existed. Retail investors pounced with call options and mass share buying, which began a snowball rolling rapidly downhill and headed straight for major investing institutions. GameStop shares accelerated thousands of percentage points in a matter of days, and institutions were forced to cover their shorts at massive losses.
Those institutions? Hedge funds, or "hedgies," as referred to on Wall Street Bets. One particular hedge fund, White Square Capital, was forced to close its doors after the drama due to the heavy losses inflicted. But this brought the whole industry into focus for the mainstream. What is a hedge fund? What do they do? How can you invest in one, and should you? Today, I want to break down exactly what a hedge fund is, answering all the questions you didn't know you had. Let's go!
What Is A Hedge Fund?
A hedge fund is a private company that uses a pooled amount of money from investors to invest in securities and other types of alternative investments with the goal of achieving positive returns. Hedge funds are only accessible to institutions and accredited retail investors.
The History of Hedge Funds
In reality, hedge funds they are the Great White Sharks of Wall Street. Hedge funds are private companies that usually have many, many investors feeding into them. The hedge fund then takes this investor money and applies their own investing philosophy, with the goal of making their clients money consistently over time. Sounds pretty good, right? Sure, assuming you're an accredited investor. Accredited investors are defined by the SEC as having either $1 million in assets (excluding your primary residence) or an individual making over $300,000 per year for at least the prior two years. That eliminates most of the population from participation, but those that remain now get to enter the sometimes shady world of the hedge fund.
Hedge funds got their start in the United States in the 1920's, with the earliest form being attributed to the "Graham-Newman Partnership" founded by one Benjamin Graham. This name will sound familiar to you if you're deep into your investing journey, but he's the famed author of "The Intelligent Investor," as well as one of the founders of the principles of value investing and the mentor to Warren Buffett. The partnership was an exclusive investing vehicle that was built to handle the money of wealthy individuals during the Roaring 20's (more on that in my deep-dive into stock market crashes) and provided the groundwork for what would later become "the hedge fund."
Fast forward to 1949 and we get the invention of the term "hedge fund" from sociologist Alfred W. Jones. The reason I gave this little factoid its own paragraph is because I wanted to touch on the term "hedge." Today, it's commonplace to refer to a hedge fund without giving it a second thought. However, have you ever taken a step back and asked why it's called that? It's because, back in the 1940's and 1950's, hedge funds were used by wealthy people to ride out intense periods of volatility in the stock markets. They would hand their money over to these investment funds, who would then invest this money with an eye on mitigating risk in an attempt to lower volatility while still seeing positive returns, called "hedging." Does it always work? Not really, but I can't argue as to where the name comes from.
In the 1970's, hedge funds continued to evolve, this time employing "long/short" strategies in order to gain that "hedge" effect I explained earlier. Well, this didn't work at all, because many hedge funds shuttered in the mid-70's due to the market crash wiping out investor assets. Not great. However, you can't keep greed down for long, and hedge funds exploded in popularity again in the early 1990's. Why? The 2/20 model.
Why Hedge Fund Managers are Billionaires
The 2/20 model is one of the most unbelievable business models in human history. A hedge fund generally runs on this model (with some notable exceptions which we'll touch on later), which means that the fund will charge a 2% annual fee to the investor on all assets they have invested with the fund, as well as a 20% fee on the total performance of the assets. It's confusing, so let's lay it out:
An investor has $100,000 with Atlanta Capital, a local hedge fund. Let's say the fund makes a 30% return on the money, so the investor now has, on paper, $130,000 at the end of the year. The fund will take 2% up front of that initial $100,000, so $2,000. Then they will also take 20% of the profits, so $6,000, giving them a total take of $8,000 from this client. The idea is that the client has made money, even after fees, so it doesn't matter to them. Now, $8,000 is not that much money, and certainly not enough to keep a whole investment fund with analysts and support staff open.
Let's take this example of the $100,000 client and expand it to actual numbers of real world hedge funds. Bridgewater Associates, the world's largest hedge fund, has $140 billion in assets under management, resulting in hundreds of millions, if not billions, of dollars in profit each year, depending on performance. That brings us to the apex predator of Wall Street. The alpha of all alphas: The Hedge Fund Manager.
If money is the empire, then hedge fund managers are the kings and queens of the realm. These managers are the ones you typically see only in name when another record-breaking New York penthouse hits the market, or a home in California sells for $200 million. They're typically the stuff of legend, and are usually the endgame for all of the silk-suited finance bros being pumped out of Wharton. Thanks to this 2/20 model employed by the industry, these managers are typically billionaires, and that doesn't even have to be career earnings. According to CNBC, 15 hedge fund managers made over $1 billion each last year alone. These people are so rich, so powerful and so mysterious that Showtime developed an entire drama series around their world, with one particularly ruthless hedge fund manager taking center stage.
Interestingly, in a 2016 press tour for a season of "Billions," actor Damian Lewis shared a unique insight into the mindset of a hedge fund manager when he was granted exclusive access with a few of them to study for the role:
When I spoke to the hedge fund guys, some of whom were billionaires several times over, I just got the sense from them that the money was incidental to the game. Playing the game was the most interesting thing, and winning the game is really what drove them. - Damian Lewis on "The Late Show With Stephen Colbert"
With that, let's take a look at a few of the managers who have won the game, and how they did it.
Net Worth: $20 billion
Rise To Prominence: Ray Dalio was, until recently, the CEO of the aforementioned Bridgewater Associates, the hedge fund which he founded. He graduated from Harvard Business School in 1975 and founded Bridgewater just two years later. Influenced by exposure to Richard Nixon's decision on the gold standard which caused disproportionate inflation and asset price spikes, Dalio founded Bridgewater to trade commodities. However, this flopped, and Dalio moved into focusing on currencies and interest rate trading. From there, he essentially became a content creator, pumping out research reports for a fee that were snapped up by every tycoon on Wall Street and Main Street. Using his own research, he opened an equity fund within Bridgewater, named "Pure Alpha" that has only lost money three years out of the 24 in which it was under Dalio's guidance. Dalio stepped down in 2017.
Net Worth: $1.9 billion
Rise To Prominence: Bill Ackman is the CEO of Pershing Square, a hedge fund which he founded. Another Harvard Graduate School student, Ackman launched his first company, Gotham Partners, in 1992. Designed to invest smaller amounts of money in public equities, Ackman gained national attention for attempting to purchase Rockefeller Center in 1995. Though he was unsuccessful, this garnered the attention of investors across the country, later directly attributing to Gotham's $500 million AUM by 2002. In 2004, Ackman left Gotham to form Pershing Square using $54 million of his own funds following a highly public feud with fellow billionaire Carl Icahn over a real estate company purchase.
Ackman and Icahn would clash again in 2012 after Pershing Square published a short-report on Herbalife, Icahn's biggest holding. The feud caught national attention after Ackman launched a media campaign designed to destroy the company's share price. Pershing Square ended up losing "between $400 and $500 million" in the short-feud, crushing investor returns. Down on his luck, Ackman resurrected the firm with a hail-mary position in Chipotle shortly after their health crisis, which bounced back in incredible fashion.
Finally, he's credited with one of the greatest public market trades of all time, occurring in 2020. After raising $27 million for a new investment fund, Ackman purchased credit protection swaps to hedge Pershing Square's public equity positions. These assets were designed to increase in value if the market tumbled, which is where the coronavirus comes in. The markets tanked a month after he purchased these swaps, increasing their value to over $2.6 billion in one month.
Net Worth: $25.2 billion
Rise To Prominence: Jim Simons is likely a name you've never heard of, even if you are deep into the finance world. Simons is formerly a mathematician, holding a PhD in geometry and topology of manifolds. His dissertation dove into "holonomy groups" of the Riemannian manifolds, which later led to his discover of the Chern-Simons classes of characteristics. All that is to say: he's an actual genius who specializes in pattern recognition. You can see where this is going, and so could the government, who recruited him to the NSA in 1964 as a code breaker. Following his second career in the government, his third act was even better. He became the founder of Renaissance Technologies, a hedge fund that used the mathematical principles that had guided his pattern recognition work in the education and government fields in order to generate superior returns.
At Renaissance, Simons is considered the greatest investor of all time. His fund has averaged an annual return of 39.1%, net of fees, from 1988-2018. I mention "net of fees" because Simons sees the 2/20 model and laughs in its face. Simons employs the 5/44 model, which explains his remarkable net worth. He also only allows employees of Renaissance to buy into the main Medallion fund, so it's a very exclusive club.
Something to note about these people: they are frequently in the spotlight, especially from the government. Ackman has testified in front of Congress several times, and has drawn widespread criticism of his use of an appearance on CNBC to juice his credit swap trade. Simons ended up having to pay over $6 billion in back taxes due to a failed attempt to leverage an IRS loophole using complex options transactions. And Dalio was indirectly involved in a reported company sex scandal at Bridgewater. The amount of money generated by these titans of industry often draws scrutiny, both in the court of public opinion and the court of you're going to fucking prison.
The Downsides of Hedge Funds
Now that we've outlined what hedge funds do, let's talk about what they don't do: hedge. Hedge funds, as shown earlier this year, are reticent to actually hedge their positions unless they see some sort of opportunity like Ackman in 2020. Hedge funds are now seen as "rich people get richer" vehicles, where the wealthy go to accelerate their gains. Hedge funds no longer seem to care about the downside risk, chasing positive percentage points or leveraging funds for personal vendettas, again like Ackman with Herbalife. And this is a problem, because these investors are paying massive fees in order to gain entry into the club, and now they're seeing returns that aren't keeping up with the market, or worse, actually losing money. Hedge Fund Research, a financial research firm that tracks return statistics, found that the average hedge fund returned 11.6% in 2020. While the clients made money, they lagged behind the S&P 500 index that returned 16% in the same time frame. Bridgewater got clobbered, losing nearly $47 billion, and seeing Dalio's personal fortune tumble by $12 billion in 2020 alone. Yet, despite all of this, hedge funds still saw record inflows and profits. Why?
Because investors seek calm in a volatile world, and I'm not just talking about your average, everyday millionaire. When I mentioned that Bridgewater has $140 billion in assets under management, did you ever wonder where all of that money came from? Sure, there are tons of wealthy individuals who invest with them, but who else is throwing cash at these funds? How about state and local governments, as well as unions?
That's right! Hedge funds are now so ingrained in our society that the elderly teacher down the road has a vested interest in the performance of one, or several, of them. State and local government employee pension plans total about $4.5 trillion nationally. Of this, an estimated 7% is invested with hedge funds for safe keeping and growth, according to the Center for Retirement Research at Boston College. The list is even worse when you look at non-governmental pension programs, like Eastman Kodak (41%), Eli Lilly (28%) or even the Directors Guild of America (28%).
So let's jump back to January 2021, right where we started this article. Retail investors, sick of losing a "rigged" game, decided to turn the tables on hedge funds and pump GameStop, Bed Bath and Beyond and AMC Entertainment shares, among others. The plan worked, and hedge funds got creamed (shout out to Melvin Capital and Point 72). "Eat the rich" was the common refrain from the man in his parents' basement that threw his live savings into GME call options. But did the billionaire hedge fund manager get hurt? Sure, maybe a little, but they can mop up their tears on yacht number three. The ones who really got hurt? The teachers, the retired police and firefighters in your communities that have their pension plan tied up into those losses. I'm not defending hedge funds, but the top dogs of these funds have maneuvered their way into our everyday lives, making even a moral victory hollow as we see poor Mrs. Johnson lose a year of her retirement savings because Ethan down the street decided he needed to make a few grand on AMC. Hedge funds are here to stay, regardless of their size, strength or even effectiveness. They are the smartest guys in the room, anyway.
What do you think of hedge funds? Are you one of the few invested in a fund? Let me know in the comments below, and don't forget to sign up for my email list to get notified of posts in the future!