When hedge funds are too boring

By Felix Salmon
January 11, 2011
Laurence Fletcher reports today on rich individuals with high risk appetites who are getting frustrated with modest hedge fund returns:

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Laurence Fletcher reports today on rich individuals with high risk appetites who are getting frustrated with modest hedge fund returns:

Many rich people were attracted to hedge funds by stories of George Soros’s $1 billion profit from his speculative attack on the Bank of England or John Paulson’s $3.7 billion earnings in 2007 betting on the subprime meltdown.

But institutions — who now account for over half of all hedge fund assets — often prefer lower-risk funds, targeting single-digit or low double-digit gains…

“There is certainly a pocket of family offices and high net worth individuals who are looking for more interesting returns, but from an asset-weighted standpoint, that is not where the industry is trending,” said Dan McNicholas, head of Asia financing sales at Merrill Lynch.

This makes conceptual sense to me. Once you’re rich enough that investment returns have no visible effect at all on your current or future standard of living, a large part of the attraction of hedge funds is the lottery-ticket aspect. If you strike it lucky, you could double or triple your money—or more. Meanwhile, institutions are naturally less interested in buying lottery tickets.

One obvious question here is to ask why, if investors want more risk, they don’t just get it themselves, by investing in hedge funds with borrowed money. If leverage within hedge funds is falling, then people who preferred life with 5X or 10X leverage can build it at home, by borrowing against their other assets and putting the proceeds in hedge funds.

There are two answers to that question. The first is if the leverage is external to the hedge funds rather than internal, then that raises the specter of investors losing substantially more than their original investment—something which isn’t possible if you invest in a highly leveraged fund. And the second is that while individual investors like the idea of leverage in theory, they don’t like engaging in such strategies personally. The way that hedge funds hide leverage in layers of opacity and obfuscation is quite attractive to investors who don’t want to blame themselves if their strategy ends up failing.

There are lots of high-risk venture capital funds out there, but they don’t tend to employ leverage, and they also tend to be very restricted when it comes to asset class. If you’re looking for bold bets in obscure markets, I can see how the professionalization and consolidation of the hedge fund world could be a disappointment to you. Maybe you’ll just have to make do with a $2 million investment in Facebook, at a $50 billion valuation.

Comments
5 comments so far

You nailed it Felix… when I invest personal funds I love to bet with money loaned by others with zero recourse to me. I rarely use leverage where I am personally on the hook.

Will Rite Aid go Bankrupt? What about Level 3? Clearwire? Time will tell on all of them but each of them are levered to the heavens. If they go chapter 11 than creditors bear 90% of the losses. If they thrive 90% of the gains acrue to stockholders… it’s risky business to be sure but if an investor stays prudently diversified I think it beats the pants of the market in the longterm. In 10 short years I’ve caught more falling knives than I care to remember, Worldcom, Delta, MovieGallery, half a dozen airlines… all total near total losses.

A single grand slam homeruns like American Airlines bought at a $1 and change and sold for $20 (it went as high as $40) paid for all my mistakes. A few other homeruns put me so far ahead of my actual investment that I doubt the market will ever catch me. I’m still a working stiff and if I’m lucky enough for my two kids to get into good schools I probably always will be.

I guess my point is that while it’s always better to be a big fish and have opportunities like Facebook pre-IPO, there are actually some advantages of being a little fish. Warren Buffett can’t really buy into a company with a sub 1 billion dollar market cap. He’d have to file his 13-d after putting just 43 million dollars to work and the price would skyrocket.

People with small portfolios can enter and exit positions in a few minutes. Good fund managers, the ones managing 10,000,000,000 need days even weeks to move into or out of all but the most liquid securities.

Contrary to public sedement, this market participant feels like the market is stacked infavor of the little guy rather than against him.

Posted by y2kurtus | Report as abusive

Maybe there’s too much money out there thirsting for residual income and the workers of the world cannot satisfy the returns that are desired by the ultra rich.

Maybe the idea below would stabilize global economies…

http://wallstreetchange.blogspot.com/201 0/11/2010-after-election-4-point-economi c.html

Re distribution of EXISTING wealth is MUCH MUCH different than distribution of future wealth. At some point, the ultra wealthy should be satisfied with preserving what they have versus lusting for more and more.

Posted by SWARMtheBANKS | Report as abusive

y2kurtus, you are playing a very different game than I am, but I wholly agree with your conclusion. The market has never been friendlier to the individual investor than it is today. Quality information abounds on every stock in the S&P500 and more besides. Transaction costs are a fifth of the “discount brokerage” commissions that I was paying thirty years ago when I started investing. You have the information you need to take smart risks on long shots. I have the information I need to ensure that I don’t lose the large gains amassed over the past decade.

Some commentators are inordinately focused on whether or not it is possible to “beat the market”. In contrast, I’d rather achieve my personal goals with a high degree of certainty.

Posted by TFF | Report as abusive

I think this is right…embedded leverage is far better than leveraging yourself. That’s why I rich person wouldn’t want to put the leverage on personally because if somehow the fund blows up he’d be liable for the debt (also he wouldn’t know if the fund is taking hidden or tail risks that could cause a sudden massive problem).

Posted by sditulli | Report as abusive

y2kurtus and TFF:

Small investors have one other long-term advantage in the markets – we don’t have shareholders looking over our shoulder at quarterly returns. We truly have a lifetime portfolio and the only thing that matters is what happens over a 40-60 year investment period.

I am not investing in individual stocks (except an illiquid ESOP that the company puts shares into) but I can vary my portfolio over time to manage what I perceive as both short-term and very long-term risks.

Since I am not leveraged, I can ride out pretty much any financial crisis without needing to do panicked sales of assets. In November 2008, I was able to buy some things that I felt were mispriced (oil, TIPs & emerging markets come to mind) because I didn’t have to worry aboutmeeting margin calls. I can hold onto things without doing quarter and year end “window dressing.”

The primary reason that many professional results look so good over the past few years is because they got access to massive wads of federal money that allowed them to stay in business. It is likely that many of the professionals would have had to fold in 2008-2009 because of their leverage. Even folks like Paulson relied on getting money from institutions that were getting federal money or their bets may never have actually been converted into cash as their counter-parties failed.

Posted by ErnieD | Report as abusive
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