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.

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