Ten Things You Should Know About Hedge Funds

Chris Dillow asks why 'market neutral' hedge funds have performed so badly of late. (Market neutral means they are supposed to be indifferent to the ups and downs of the stock market because the are 'neutral' the market by being both long and short stocks.)

Having worked in the industry for many years, perhaps i can enlighten,

i) Hedge Funds are never 'market neutral'. They are generally long stocks with upwards momentum (e.g. commodity stocks, banks) and short those out of favour (conglomerates, healthcare).

ii) They invariably all have the same trades on. When the market turns, they all try and get out at the same time. Officially this is known as 'illiquid markets' or 'dislocation'. Unofficially this is called 'panic'.

iii) In a rising market, they tend to be an awful lot 'longer' than they are 'shorter' (i.e. they own far more stocks than they are 'short'). They should probably be called 'market neutral-ish'.

iv) In the golden days (pre-2003), HFs used to be able to genuinely 'arbitrage' the markets (put on riskless trades) because there were so few hedge funds. Now that every dog and his wife is a HF manager, these arbitrage opportunities are long gone. Now they are just stock pickers with a track record no better than a monkey throwing darts at the WSJ.

v) HFs are not asset managers. They are fee-generating machines with an attached asset management business.

vi) There are Two Golden Rules.
a) Golden Rule No.1 is "Never accept money paying less than '2 and 20'". i.e. never accept fees that don't pay 2% annually plus 20% of all performance. Some good HFs only take 20% excess performance (the return over the risk free rate). But this hard to do so they tend not to.

b) Golden Rule No. 2 is 'Always play with OPM' (other people's money). OPM is much easier to lose and much less painful than your own.

vii) The ultimate fee-machines are 'Fund of Funds'. These really are modern alchemy - they turn client assets into fees. Brilliant and simple. Their after-fee returns are similar to a Treasury bond (5%) but not quite so good.

viii) HF managers all work in three streets in London - Berkely Square, Curzon St and St. James'. They all drink at the same bars, attend the same parties, and are paying alimony to the same divorced wives.

ix) HF managers are all 'long a call option'. This means that they incentivised by their firms to bet the house. If they are right, they are paid on average 10% of whatever they make. This can and often does amount to millions of dollars. If they are wrong, they are fired and re-appear fully refreshed after a month's vacation at another HF.

x) In order to keep the client money rolling in, HFs have to show to the world that they really do make outsized returns. Hence these ever ingenious folk have come up with a unique concept - 'survivor bias'. This means that the HF Indices showing overall returns exclude those HFs that have gone bust (about 1 in 5 each year) so blostering the average returns. Neat, huh?

All HF managers are aware of these ten points and all know the game will soon be up. Hence all are gambling furiously with your money right now before the ref blows the whistle for full-time.