This article originally ran as issue 019 of our WTF is going on with the Economy? newsletter about hedge funds. Subscribe here and never miss an issue.
I’m sure you’ve heard of them—hedge funds: the elite’s mysterious investment vehicles. We’ve associated them as the perfect companion to decadent glamour and private-jet setting lifestyles. For years, that impression held up.
Yet today, like so many other parts of our lives around us, hedge funds are looking increasingly outdated. Over the past six months, investors pulled nearly a quarter-trillion dollars out of these flashy investment companies. Further, more hedge funds are closing than opening.
WTF is a hedge fund, anyways?
Let’s quickly break down the two words in “hedge fund.”
A fund is a collection of money pooled together for investment purposes.
A hedge in finance is a type of insurance to minimize losses.
You’ve probably heard the term “hedge your bets” referring to gambling where you make side bets against yours to help protect your losses. Hedging in finance is the same, where investors and corporate treasuries use complex financial instruments to protect themselves against a basket of risks.
The hedge fund’s underlying idea is simple: the fund’s investment managers will beat the market regardless of the conditions by insuring their bets through financial kung-fu. In exchange, investors pay a fee of 2% of their investment’s value and 20% of any profit.
On paper, everyone benefits. Investors get record-breaking returns, and fund managers become extraordinarily wealthy.
Hedge fund strategies
Hedge funds follow three different strategies to make money.
Arbitrage is the act of making a profit from price differences. For example, I see that my favorite peanut butter in Spain costs 5 EUR a jar on Amazon.es, and it sells for 10 EUR a pot north of the border on Amazon.fr. Instead of stocking my kitchen with peanut butter, I buy 10 jars of it for 50 EUR in Spain then resell them all for 100 EUR in France.
Arbitrage hedge funds do the same. Except, instead of looking for deals on peanut butter, they look for price mismatches on stocks, bonds, real estate, commodities, and more. Arbitrage opportunities exist regardless of the economic environment, making them an attractive target for fund managers.
Tactical hedge funds try to predict changes in either a specific sector or the economy as a whole and profit from them. For example, I think that peanut butter will go up in price in the next three months. I go out to buy 10 jars for 50 EUR from Amazon.es and then lock it up where I won’t be tempted to eat it (that’s a genuine problem in my house). Three months later, the price of peanut butter on Amazon is 8 EUR a jar. I quickly sell my stash and make a 30 EUR profit. In finance, we’d call this “going long” on peanut butter.
Conversely, I could also go “short” on peanut butter. Here, I think that its value will go down in the next month from 5 EUR to 3 EUR a jar (fat chance, but let’s go with it). I borrow 10 jars of peanut butter from a friend and quickly sell them on Amazon for 50 EUR total.
The best investors (and the ones who can sleep at night) invest within their risk tolerance. Do you know yours?
Next, I wait for the price to fall while my friend keeps pestering me for his peanut butter back. A month later, I’m right – peanut butter is now 3 EUR a jar. I order 10 pots for 30 EUR, give them to my friend, then keep the 20 EUR as profit.
Tactical hedge funds follow the same theory, except with currencies, commodities like oil, companies, and even entire economies. More specifically, it will take both a short and a long position to protect itself. Hedge fund manager and cartoon supervillain to conspiracy theorists George Soros is famous for getting rich by betting against the UK economy back in the 90s.
Event-driven hedge funds look to capitalize on some sort of corporate event. A corporate event could be a merger, acquisition, venture capital activity (like investing in a startup), or a predator taking advantage of a distressed company.
For example, let’s say that a company making peanut butter has a great product but borrowed way too much money and is about to go bankrupt. Here, a hedge fund would buy the peanut butter manufacturer, fire the employees, sell the factory, then license the brand to a better-run competitor.
In this case, the fund profits from both the sale of the assets and the more efficiently produced and marketed peanut butter. If you’ve ever seen the movie Wall Street, then you’ve seen this strategy in (fictional) action.
Regardless of the strategy, hedge funds see peanut butter not some long-term connection with everyone’s favorite sandwich spread but as a means to an end.
Why hedge funds are on their way out
So if hedge funds have it all figured out, then why have investors been leaving them lately?
For one, investing became much more democratic over the past decade. Low-cost investment products like ETFs and mutual funds exploded in popularity, bringing affordable access to diversified investments to the masses.
In addition to “passive” funds that accurately track big indexes, investors can also access “active” funds. These products take some of the positive parts of a hedge fund, such as making bets, insuring them, or borrowing money to increase returns without the high costs.
Wealthier investors who would traditionally gravitate towards hedge funds instead went to these lower-cost products. While the hedge funds recently dropped their fees, it still hasn’t stopped the mass exodus of capital and subsequent fund closures.
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Finally, hedge funds simply don’t perform as well as they’d like you to believe. Despite their allure, most hedge funds fail to consistently beat the market, even before their fees. The few that do perform well are remarkably selective about their client base. In other words, only the wealthiest individuals on the planet get into these funds.
Why don’t most hedge funds outperform the market? Because as mountains of research show, it’s nearly impossible to do so. Markets are vast, chaotic places where no one person can (legally) have the edge over everyone else.
Instead, when an investor learns something the others don’t and acts on it (say by selling a stock), everyone else will find out. The advantage disappears, and prices go back to “fair value.” Any fund manager can get lucky one time or one year. But to do so consistently? It’s practically impossible.
How to beat the hedge funds
What investors can do is invest directly in the market through low-cost funds. Here, they can get market returns while effectively managing risk (using an investment advisor makes this process even more manageable).
We won’t see hedge funds disappear tomorrow. It’s also safe to say that they’ll be around in some capacity for the foreseeable future.
It’s interesting to know though, that the economic events around us are upheaving all parts of the finance industry, including the so-called glamorous investment funds around.
PS Sorry (not sorry) that you’re going to buy peanut butter now.
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