“Is Your Hedge Fund Really Worth It?” by Lee Levy
“Is your hedge fund really worth it?” is a common question from investors these days. Many take a dim view of the hedge fund industry, offering some valid criticism about fees and returns for the industry as a whole. As a hedge fund manager with more than 20 years’ experience, I can offer a deep, a first-person industry perspective on this question and others.
The evolution of the industry
The early managers of hedge funds in the 1960s and 70s would truly “hedge” their portfolios. They attempted to make money on the long and short sides of the markets. In some years, the great managers delivered outsized returns for their investments and handsome profits for themselves. Sadly, over time many investment professionals viewed hedge fund management as a quick and easy way to get rich very quickly, while avoiding the oppressive infrastructure of large mutual fund companies.
As the hedge fund industry grew, the underlying investment strategy at some funds was to swing for the fences with other people’s money. By definition, they weren’t hedge funds because they did not hedge, or reduce market risk. Instead, they used leverage to amplify a particular market’s return in an all-or-nothing bet on market swings. Other funds have earned cash-like returns with exorbitant fees. These funds paint a negative picture of the entire industry, skew the data and distort studies like the one quoted in the article. Some managers developed sophisticated ways to analyze the market and generate performance, while others used tried-and-true methods with good results.
In a rapidly changing industry with such a wide variety of strategies and headline-grabbing stories, I am never surprised by the variety of questions people ask me. Do I get a 30% return every year? How did I react to the headline du jour? What was the fund’s return on that one day five years ago? What happened with that other guy’s hedge fund? Over the last 15 years, I try to clarify what I do as a hedge fund manager. In short, I go into the office every day to find investment opportunities with solid return potential while hedging market risk. We have done a reasonable job thus far.
Hedge fund fees
The biggest complaint against hedge fund fees is the ‘incentive fee’. I cannot defend the fees for the entire industry. The big hedge fund names, such as Soros, Steinhardt, etc., didn’t begin charging those fees until after several years of strong performance. Most new managers view the incentive fees as a right, not a privilege. Some hedge funds are worth the high fees; others are not. Every profession represents a population with a wide range of skills. We take great care to find good mechanics, carpenters, doctors and lawyers. Finding a good hedge fund manager is no different.
In our view, investors often have unrealistic investment expectations. At times, the investment management industry (hedge funds and active mutual funds) responds to investors’ unrealistic expectations with false promises or extreme risk-taking.
Warren Buffett’s business partner Charlie Munger recently told a story about an accomplished investment manager who told his clients to expect a return of 20% per year. Munger replied wisely, “But you know that’s impossible” and the manager said ‘Of course it is impossible, but if I didn’t tell them that, they wouldn’t give me any money to invest!’
If it sounds too good to be true, it probably is. Avoid heroes. They are often zeros. By definition, a hedge reduces risk and leads to less volatility than the overall market. A hedge fund should be paid to generate return and manage risk, not to shoot the lights out one year and destroy your capital the next year. Healthy skepticism of big promises can help investors steer clear of the financial industry’s tendency to “oversell and under-deliver”.
Expecting your hedge fund to deliver solid long-term, risk-adjusted performance with a consistent process, as opposed to making lots of money, is the first step to finding a good hedge fund. Many hedge funds can and do have solid return potential while hedging market risk.
Penny wise, Pound Foolish
Mutual fund fees are not inexpensive when compared to hedge funds. In fact, mutual fund fees are often very high compared with their value added. Hundreds of comprehensive, long-term academic studies have demonstrated that active mutual funds, on average, fail to add value after fees. Many are high-cost, benchmark replication strategies. Similar to the competitive landscape of hedge funds, there are some solid mutual fund strategies that separate from the herd over long periods of time.
Low Cost Passive ETFs:
Passive ETFs that replicate portions of the stock market are a very handy addition to investors’ options. They’re low cost for a reason; they’re unmanaged. Study after study has demonstrated that the low-cost index approach outperforms the majority of higher cost, actively managed mutual funds. Without a doubt, low-cost indexing has been an investor-friendly development.
Nevertheless, the age-old problem of investing–when to buy and sell–is not solved by passive ETFs. Investors still have to make savvy decisions, calmly riding out the financial crisis and sticking with their basic strategy through the dotcom boom and bust. Passive ETFs are a cheap way to buy and sell the market. They are not a panacea.
Here are a few important considerations to ask before investing in a hedge fund:
- Know thyself is the first rule. What are your expectations and goals?
Investing our hard-earned money is a deeply personal decision that is as complex as every human being. Some clients are well served by investing a portion of their wealth in a well-managed hedge fund, while others might do well with good financial advice and a portfolio of ETFs. Having realistic expectations and goals and a balanced understand of your risk and return preferences can help navigate the world of hedge funds.
- What is the manager’s investment process?
Just like anything else, if a hedge fund sounds too good to be true, it probably is.
Neither “buy low, sell high” nor “we’re smarter than everyone else” are an investment process. Potential hedge fund investors should be on the lookout for managers with clearly-articulated, fundamentally-sound and risk-aware investment processes with strong commitments to transparency and client service.
We are also big believers in having skin in the game. What portion of your manager’s net worth is invested in the fund? An investor with a large investment in the fund can indicate the proper alignment of interests.
- Why invest in a hedge fund or an ‘alternative investment’?
Our investors look to us for downside protection, differentiated alpha, lower correlation and volatility management. Not every fund ‘swings for the fences’ and the ones that do, rarely have a repeatable process.
If you think about these critical factors, the result more often than not with a hedge fund managers who truly is “worth it.”
About Canid Asset Management LLC
Canid Asset Management LLC is a Silicon Valley-based boutique value hedge fund offering a broad range of wealth management solutions. Launched in 2009, Canid is a young fund that successfully manages a liquid long/short equity portfolio specializing in protecting investor capital during highly volatile markets