Hedge Fund Investments & When They Make Sense

This is the Invest Like a Billionaire podcast, where we uncover the alternative investments and strategies that billionaires use to grow wealth. The tools and tactics you'll learn from this podcast will make you a better investor and help you build legacy wealth. Join us as we dive into the world of alternative investments, uncover strategies of the ultra-wealthy, discuss economics, and and interview successful investors. Welcome back to the Invest Like a Billionaire podcast. I am your co-host Ben Fraser, joined by co-host Bob Fraser. And this episode we are going to be diving into the world of hedge funds, right? So we're in a series right now where we are covering the big three alternative investments. We've already covered real estate, And we did private equity last episode, and now we're doing the final one, which is hedge funds.

The mystery, the black box. What the heck is a hedge fund?

So this is probably one that's least understood by most kind of individual investors. What's pretty cool is your background. You actually ran a hedge fund for a period of time before Aspen. And so you have kind of a great perspective on just what the landscape is like. And obviously There are a lot of movies about hedge funds. There's a lot of headline billionaires from hedge funds. So people know that it can be a great strategy, but how's the performance and what is the really role of it in a portfolio? And so that's what we want to break down today. In these series of just broad stroke overviews, we really want to hit on what are the definitions, what are the strategies, what are the structures, and how do you invest in these and how should you think about these? On the alternative investment continuum, which we've talked about in a lot of episodes, this is level 4. So we kind of have, as you get more sophisticated, as you have a higher net worth, we see most investors kind of going up this continuum, which is starting with the stocks, bonds, and mutual funds, going to level 2 of real estate, then some private equity and hedge funds. And so, we've talked a lot about other past episodes of how the ultra-wealthy are investing. Hedge funds is a portion of that. So it's usually a smaller portion, at least in recent years. It's still something that the ultra-wealthy, the billionaires are looking at as a good place to get volatility protection as well as diversification and return.

And in general, the larger the investor and the more sophisticated, the more they like hedge funds. Yeah. So we want to pull back and look at the mystery, see what the major strategies they're using, what the advantages and and like that. So, you know, what is a hedge fund? Well, a hedge fund is basically pretty much you can do anything you want. And so that's the whole point about a hedge fund. And so they'll do long equities, which is buying stocks. They'll short, which is, you know, individual investors rarely do that. So actually make money when a stock goes down and do things like swaps, interest rate swaps, currency swaps, stock swaps. Credit default swaps, which are very complicated derivative instruments, commodities, everything goes. And so, so it's very sophisticated. Some of the smartest people in the financial world work for hedge funds and some of the smartest mathematicians. So we'll— let's, let's take a look at this a little bit as we dive in. So the average hedge fund in 2020 returned 11.6%, but the S&P 500 gained 16%. So actually the hedge fund, the smart guys, did worse. And so wait, wait a minute.

So is that over the past 10 years?

That's just— that was just 2020. So since 1994 to 2021, through both bull and bear markets, the passive S&P 500 index outperformed every major hedge fund by over 2.5%. So the hedge fund— the hedgies are, are basically getting creamed by the plain vanilla investors.

And there's kind of always been this argument of active versus passive investment in the public markets, right? Of, well, I'm just going to invest passively in an index. And so these hedge funds, they have to justify because they're charging fees, right? Generally higher than a passive mutual fund or an index fund. And so they have to justify those fees by getting better performance. But in the recent years, they haven't been able to do that.

So maybe, maybe you're ready to tune out now, but, but please listen because there's a reason that that's not— that's irrelevant. Exactly. So look at this chart here. So this shows during the decade of the 1970s, '80s, '90s, 2000s, and 2010s, really how hedge funds performed relative to the broader market. And you can see during the '70s, '80s, and '90s, hedge funds did very well or slightly better. And then in the decade of the 2000s, hedge funds massively outperformed the market, and then the next decade massively underperformed the market. But, but what I want to point out, well, the decade of the, of the, of the 2000s, you had both the dot-com crash and you had the 2008 crash.

Yes.

So when, when, when equities are likely to crash, the hedge funds did very much better. On the other hand, the two since 2010, well, we've had pretty much a one-way bull market That's been going one way straight up. Well, hedge funds, hedge funds have underperformed that. And that actually gives a lot of insight into how hedge funds work and when it makes sense to invest in hedge funds. So here's the saying is that hedge funds deliver, deliver equity-like returns with bond-like volatility. The idea is to get close to equity returns, but at far less risk. And far less volatility than the stock market. And in fact, that's been largely true throughout the 1980s, 1990s. So, and as we go into the strategies, you'll see why they're— why it's, it's like this. And so in today's market, it may make sense to start looking at hedge funds again. So hedge funds have been declining in popularity during the last 3 years, generally because of this, because Hey, when the stock market is going up so much, why not just put it in the S&P 500? And it's hard to compete with that, right? But if the stock market is in fact overvalued, you know, I've seen arguments both, both ways. And clearly it actually is on a fundamental basis overvalued. But that's not to say it's not going to continue to be overvalued. Right. Okay. So, but so, so, so, but if it is and in fact it is ready to, to be volatile, then you want to look at hedge funds because they outperform.

And this kind of goes back to the concept of risk-adjusted returns, right? We've talked about in other podcasts where you can have two similar opportunities of investment that produce around the same return, but one has significantly more volatility, you know, which is the proxy for risk relative to the other. Well, you're gonna want the one that's gonna have less volatility. And the stock market historically has had a lot of volatility. And especially later on in a market cycle, it can increase. And so what you're saying is, the hedge funds look to achieve an equity-like return. So a good double-digit return that you'd see in a bull market, but without a lot of—

Far less risk.

A lot of the risk.

And so there's a lot to be said for that. So are you willing to give up some of the return in order to avoid a lot of the downside?

The downside, yeah.

And so if that's what you wanna do, then hedge funds are definitely something you should be looking at. So the top performing hedge funds in 2020 were energy and basic materials funds, technology-focused funds, and healthcare funds. Now, and in good years, hedge funds can, can return, you know, 50% returns and better. I was just looking at the last over, over the, you know, top performing funds and over the last 3 years are— there's many that are over 35 to 40% returns and And there was one that, you know, even that it was returning around 40% per year for the last 3 years and only had 5% churn in their portfolio on a quarterly basis, meaning they're only changing their investments 5% quarter, which is insane.

It's very low for a hedge fund.

Yeah. So now, you know, that's probably blowing your cork a little bit and as it should. So who is doing this? Well, typically the stars. There's the star phenomenon in hedge funds. So whenever a hedge fund has a good year, a lot of times that star will go and start their own fund. And if you saw the movie The Big Short, there's hedge funds, hedge fund guys that made their hay by making the call. Little tiny guys that were stars made this incredible call, got super wealthy on that, well, now attracts a large amount of investors. So, there's a star phenomenon that this really is. There are certain people that really have the goods it takes to do this and other people that just don't.

So if you're looking at like a broad average of hedge fund returns, that may be misleading if you break it down by quartile or quintile or just looking at the top performers. It's the variance is very, very big in the types of returns you can get across.

And if you look at every hedge fund, they're generally, they'll tell you who their fund manager is.

Right.

So it's, it's, there's a celebrity. This is sure. This is the guy you want to invest with. And there's reason to do that. Yeah. So, so let's look at the structure. How does the hedge fund generally work? Well, they're all, they're all fairly similar, actually. You find very little variance on this. So we call it— it's called the 2 and 20. And the idea is they take 2% of the assets under management. So, so every year in order for, for, for managing it. So if there's $1,000,000 in assets, they'll take $20,000 a year off the top and then 20% of profits. So they only make that. If they're making money. So if there's no profits, they don't get that. So they're highly incentivized to make, to make profits. So that's, that's pretty much the way it works. It's generally, generally a general slash limited partner. So the manager is the general partner. The investor is a limited partner, means you don't have any say in the investments. It's, it's very, it's very passive from your perspective. These managers are actively managing, so they're actually trading their portfolios, buying the swaps, buying, buying the stocks and the shorts, etc. And the goal is to generate above average returns. And a lot of times these are, these are, you know, 6 to 7 figure minimum. So especially the bigger funds, you know, it's 7 figure minimum.

So, right.

So you got to pay to play. And most important thing in evaluating these is track record, track record, track record. Those are the top 3. Yeah.

I was talking with a broker who helps place money in hedge funds the other day and You know, everyone's heard the idiom in real estate that the most important thing is location, location, location, right? It's all about location in real estate. And he said the same thing in hedge funds. It's all about track record, track record, track record, right? It ultimately comes down to they live and die by their performance, right? And they're all looking to generate alpha, which is basically above market returns, above their benchmark. And so that's what every hedge fund's goal is. And, you know, the interesting thing too, let's make a quick kind of compare contrast here, is, you know, in the other two, uh, alternative categories we've talked about in private equity and private real estate, you know, this one stands out because it is in the public markets. Yes, right. And so that is a very big differentiator here. But the way that they're, they're, they're building these portfolios and these strategies and doing hedging can limit the volatility, which is really one of the main reasons you go to the private market. So you kind of get some of that in the public markets here. And so it does provide some of the benefits you would get in private, but obviously they're using publicly traded investment tools to do these portfolios.

Okay. So let's look at the 7 main strategies that are used. And I'll just say these are 7 very big buckets that these strategies are— can be so diverse and so unique and so, so different. Here's 7 big strategies. And number 1, is the long-short equity strategy. So 75% of all hedge funds fall into this category, and it's basically they're picking stocks and with some shorts. So, you know, they'll pick— they'll pick— go long Apple, you know, long, long— you know, there's some real popular ones, long Google, long some of these, some of these techs. And, uh, so this is, this is the strategy, and including some short positions. So they may short a couple stocks that they think are overvalued. Now, right there, it tells you why is this equity-like returns with less volatility. As soon as you have a short, as soon as you're shorting a stock, you're making money if that stock goes down. But if all stocks are going up as they are right now, pretty much, you know, well then your returns are gonna be lower.

Yeah.

Right, because you've got some that aren't, you've got some that you're making—

Your short position is losing money.

Is losing money, yeah. So if you're making money when it's going down, if it's going up, you're losing money. And so that's why, but also if there is a correction, they will make money in those. So, so, so it's, it's, it's inversely correlated. So that is the number one strategy. And of course, not all stock pickers are the same. Some of these guys, some of these stars are, are doing this. And, and of course, if you really are a true, you know, savant and a true star, what you will do is you'll go start your own hedge fund, right? So, so some of these, that's what these do. If you want to find a star, they're not going to sit and work for, you know, a fixed wage somewhere. They want to make, they want to make millions or even billions of dollars. And so they'll go start their own fund based on their skill set. So, so there are a lot of stars out there, and, uh, and the, and the pickers really matter. So that's the number one strategy. The second strategy is a market neutral strategy. And what that is, is the idea is that, is that, let's say, you know, is to have zero broad market exposure. So the idea is if you believe in Apple and, and you think Google is way overvalued, or, or let's just pick Netflix, you know, Netflix is way overvalued relative to what it's actually producing, and Apple is actually a great investment. You take a— you, for the— for every dollar you invest in Apple, you short a dollar of Netflix. And, and so the idea is, if the stock market goes up, presumably both will go up and down. And so you're— it's actually neutral relative to the overall performance of the stock market. What you're playing is the The idea that Apple is going to overperform and Netflix is going to underperform. So that's a market-neutral strategy. Now, of course, everything's going up, that's not going to perform well. But if the market is very choppy or going down, these can do very, very well, these market-neutral. And presumably, again, superstar that's kind of making these calls and generally might be pretty good at what they do.

And going back to the data that we showed earlier, the 2000s, right, where hedge funds were actually positive in very positive while the broader indexes were negative. And that was a lot to do with some of these hedges or these other, these other positions that they took that actually performed well when they're going down. So it's—

yeah, right. So now we get into a whole bunch of, you know, arbitrage and quantitative strategies. And this is where the best mathematicians in the world are coming in. And arbitrage— and arbitrage is basically a way to play minute differences in different investments. So, you know, who was the guy who just wrote the Flash Boys? Was that Michael Lewis? And they're arbitraging the difference between literally the stock trading in Chicago versus the stock trading in New York. Same stock is trading pennies in difference. So they're buying one and selling the other than buying the other and selling the one and making pennies. And so that's the idea of arbitrage. But there's lots of different kinds of arbitrage. There's merger arbitrage. So you're arbitraging when companies ready to buy another company, the differences in those, in those stocks. There's convertible arbitrage, capital structure arbitrage. So for example, a lot of companies offer stock, of course, and they also offer bonds. Well, you may— you can get in situations where the bonds are underpriced relative to the stock. You go long, long the bonds and short the stock, or the other way around. So very, very common, called capital structure arbitrage. There's Fixed income arbitrage, so this is where you're long or short bonds relative to treasuries and you're playing differences in interest rates. And some of the greatest successes and failures have been in quantitative strategy, some of the greatest mathematicians in these kind of strategies. There is event-driven. This is roughly 10% of hedge funds operating in the event-driven space, which is things like mergers, restructuring, Shareholder buybacks, debt exchanges, security issuance, or other capital events. So they're playing an event, they're getting ahead of this event, and they're placing their bets and then post-event collecting on those events. So those are very popular as well, event-driven. And again, they don't have necessarily the same level of long or short exposure, pure long-only investment. The fifth here is global macro. This was what my hedge fund was. And this is where you look at economics and you invest based on what you think are economic realities. For example, the emergence of China or the fact that Chinese currency may be overvalued, you know, this kind of thing. You know, I had a strategy basically long the Swiss franc and short the euro. And it turned out to be very, very right one instant in time. So based on economic realities, You invest in those, basically you make money when you're right based on global economic trends. The sixth strategy is short only. So this is one, if you're an uber bear, you know what they call permabears, right? You know, you want to invest in this and these guys make money when the stocks go down. You know, shorting is not understood by all investors. Shorting is basically when you borrow a stock. So let's say, Ben owns Apple and I believe Apple is a bad investment. I believe it's going to go down. Well, I'll borrow his shares. So I'll borrow 100 shares of Apple. I will sell those. I'll get cash when I do that. Now, if Apple actually falls, well, then I buy those shares back some point later using my, using my cash, but now less cash than I sold them for. And I'll actually return his 100 shares back to him. Right. And so that's, that's the mechanics of how shorting works. Well, there's short-only strategies if you're a bear. Obviously in a market like this, you know, those are, those, that's gonna be really tough to make money in short only, right?

And I also think of activist investors a lot of times too, right? There's like the hedge fund billionaires, like a Bill Ackman or somebody who targets a company, basically determines that these guys are a fraud.

Muddy Waters.

Muddy Waters. And Herbalife was another one I remember he was trying to take down. So he would go and publish these, you know, really extensive research and basically try to convince everybody that this was a scam, right? And so if you take a big short position and try to get the market to agree to sell—

So it's a lot of research. They go try and find a dirty company or an overvalued company or something with all this hidden dirt under the surface. Right. And they'll go basically accumulate, borrow a bunch of shares over a long period of time of this. And they'll go borrow those and sell them. And then they go publish their dirt. Right. They go stir up the dirt. Muckrake, and, uh, and when that thing falls, then they, then they collect it all. So, right, you know, seems like kind of a, kind of an ugly business.

Yeah, you probably— when they, they are not successful. And it's, you know, the other challenge too, and we've seen this research where, I mean, the stock market generally goes up most of the time, right? I think it's 70% of the time it's going up. So you, you're really at a, a disadvantage from just a natural tide in this strategy. So it has to be really idiosyncratic of a specific company or a specific sector for a short period of time for this to be successful. So it takes a lot of guts to go do this well, but there are investors that are successful in that.

Yeah. So, and the seventh strategy is fund of funds. And fund of funds is generally where you have a manager who is investing in other hedge funds. And so this gets a bad rap because typically the numbers say they underperform because you're adding another layer of fees, right? You're adding generally another 1.5% of AUM fee and another 10% of, you know, so it's like fee on top of fee. But I actually think it's a good strategy because what they could do is they're finding who are the best up-and-coming stars, who are the— and also they can rotate strategies quickly based on macroeconomic realities, etc. So I think it deserves a look, especially for investors that want to get into hedge funds but don't necessarily— aren't as sophisticated as they would like to be and want to get in but let someone else manage the portfolios.

And because, to your point earlier, a lot of these minimums for these investors or these hedge funds are very high. So if it's a 6 or 7-figure minimum but you want to get exposure to multiple strategies, a fund of funds is a great way to go because you can put in a smaller dollar amount. A lot of times they have what's called access funds where they will actually lower the minimum. They negotiate with the operator, hey, we can bring a lot of capital if you, you know, we can lower our minimum to our investors, but we're going to invest a big dollar amount.

So it might be a good entry point. In fact, a lot of the fund of funds are actually smaller than the hedge funds themselves. This is what you wouldn't think about, you know. So far less money is in these and they're generally smaller funds with, as you said, smaller minimums. So I think especially if you wanted to get into it, this is, this is a decent way to take a look. The other way, there's actually a number of ETFs that actually invest in hedge funds. And so you can look those up on ETFDB or other resources and see if you want a poor man's approach to dipping your toe in hedge funds. But so as you can see from our strategies, they're going to be, You know, a lot of smart guys, if you believe the market is just going up, you really need a reason to invest in hedge funds. It's just not going to be, going to be as good. Most of the reason that institutional investors and large investors invest in hedge funds is diversification. That's the number one reason to get good returns, but reduce risk dramatically and diversify from the market. So you want to have, you want to have uncorrelated or negatively correlated assets. And if you do, well, that reduces your overall risk, but it also reduces your overall return potentially.

Break down real quick what a perfect correlation is or a 1-to-1 correlation is.

So 1-to-1 correlation means if the general stock market goes up a dollar, your portfolio went up a dollar. Right. A -1 correlation means if the stock market went up a dollar, you lost a dollar. Right. Okay. So that's a -1 correlation. Positive and negative correlations. A zero correlation means you didn't lose or gain, right? So you're in cash, you know, it's under, you know, uh, correlation of zero is, yeah, when you stuffed your cash in the mattress and the stock, you have a correlation of zero.

Yeah.

And so what happened, we say correlations go to one, it's pretty much all investors went the same direction and they, you know, everything went up or everything went down at exactly the same time. And it's horrible for somebody who's trying to get diversification. So if your market outlook is bullish, you, you need a specific reason to invest in, in, in hedge funds. So generally they, they will be— they will underperform, but, but they have various different levels of correlation. So if you can look at this, this chart from Investopedia, I love this, and it shows here is basically of the, of the big strategies that we outlined, how they correlate to the general market. And the, the long-short is going to be most correlated to the market, of course. Of course, because they're pretty much in the stock market, right? A few shorts. So you can see all the way down to dedicated short has a negative correlation to the market. So this is a good little chart to get you started on thinking about how do I want to, want to diversify my, my portfolio. Most academic studies out there actually show that hedge funds are on average far less volatile than the stock market. And, and you can, you know, look up some of those realities yourself. So, how do you find these best hedge funds and how do you do the due diligence? Well, most of them are very black boxy. Most of them are very secretive about what they do. You know, start to have some conversations. You know, there's a website called Hedge Follow. You can see some of the top performing funds in the last year, the last 3 years. But here's some of the questions you want to ask. Who are the founders? Founders and principals, what are their backgrounds and credentials? One of my favorite things is to look at some of these, some of the decks that they— their thesis decks. These are some of the smartest guys on the planet. So, I think DoubleLine is one of my favorites and they do— they're hedge fund managers and they publish a deck quarterly of kind of their investment thesis. Kyle Bass is another one. With, uh, I can't remember the name of his, his fund, but these guys are super smart. And if nothing else, they will make you think and challenge your presumptions. I like to, I like to read a lot of this stuff, and then, then kind of the, the balance comes out, or the truth comes out when you hear all these different opinions and you, you know, read the data yourself. So yeah, so, but they're super smart. So that's a way to kind of get to know the Know their thesis, know their, their investment staff and what they, what they think is going to, going to happen. You want to look how long they've been in business, what their track record is. You want to look at their ownership structure. You want to look at their fee structure. You want to understand their basic investment strategy. And usually that'll, that'll come out in the PPM and the pitch decks. And then you want to look at just how often are valuations performed. Again, these are public markets generally with publicly traded securities, so they're typically valued every quarter. In fact, they have to report, you know, the bigger ones have to report to the SEC every quarter. And then what are the lockup periods? What are the liquidity provisions? So kind of again, in summary, hedge funds are probably the domain of the most sophisticated and the most wealthy investors, right? For good reason, because they get really, really good returns. Returns at, at far less risk, right, than, than the, than the just being long only. Very star-based, very, very much based on a personality, a, a celebrity, a superstar, and usually it's well deserved. And a lot of different strategies. So if, if you like investment, investing, you like research, there's— it's— you learn so much by just reading about what these guys are doing, talking to them, etc. So, so really, as you know, and I think in today today's timing, I think it makes a lot of sense, right, to look, to look at these hedge funds because, you know, with the market in these, at these levels, I believe that there's a lot of risk, a lot of downside risk. Personally, I believe because of the incredible amount of liquidity, we're probably going to continue to rise. The stock market is probably going to continue to rise, but it's going to be increased volatility because the valuations are so, so, so high. High right now. So, but hedge funds are probably a really good choice at this time. Yeah.

We published some of that economic research where we basically kind of give our sentiment of where we think the stock market is going, but expect choppy waters ahead just at this part of the economic cycle and just given where the valuations are. So it is something to consider.

And we're—

we have a few guests already identified that we're gonna be bringing on that are kind of experts in this kind of arena and And I'm really excited to talk with them and break it down a little bit more and understand how does an individual investor get more access to these types of investments and what are the kind of process of evaluating when that's a good time and all that. But hope this was really helpful and it's kind of breaking down what this kind of mysterious world of hedge funds really is. And thanks so much for joining and stay tuned for some more great episodes coming up.

See you next time.