Why Hedge Funds Are (and want to be) “Risky”

Why Hedge Funds Are (and want to be) "Risky" --- Primer & Gambler Analogy By Daniel Lawrence Abrams   Primer:   Hedge funds have been around since 1949 and have generally functioned as high-risk/high-reward mutual funds for advanced investors.   Not bound by the laws and conventions of generic mutual funds, hedge funds are empowered to assume extreme leverage and place bets on complex financial instruments (e.g. derivatives) in order to achieve extraordinary returns on investment.   Only the best investors even attempted to start hedge funds. Those that lost money quickly disappeared. Those that made profits in excess of the market were highly prized.   If the S&P 500 earns 8% and a given hedge fund (after all fees) returns 9% then why not invest in that hedge fund? Savvy investors may be more concerned with ROI for a given level of risk but since the concept of risk is so difficult to reliably quantify for predictive power it all boils down to the bottom line: If investment option "A" earns 8% while "B" earns 9%, ceteris paribus, people would rather get 9%. Hedge funds often yield substantially greater returns than the market which is why they exist in the first place.   Why do investment professionals start hedge funds? They have more freedom to make "riskier" bets that can yield those superior returns. Making this even more attractive is their particular compensation structure.   Most hedge fund managers use a traditional 2+20 compensation structure. Every year, 2% of the money invested is taken for the hedge fund managers as a management fee (maintenance fee). Additionally, 20% of the profits are also taken for the hedge fund managers as bonus compensation "performance fee".   For example: –$100mil invested, HF yields 30% ROI = $130mil before fees –HF managers take 2% of the initial amount = $2mil –HF managers take 20% of the $30mil profit = $6mil –Total returned to investors = $122mil (i.e. 22% ROI)   So there's an obvious incentive for the hedge fund managers to make their investors a lot of money (consequently resulting in an even better bonus for the hedge fund managers).   Now consider the following… Gambler Analogy:   A wealthy gambler sees you winning at a casino. He offers to give you the traditional 2+20 HF manager compensation formula to gamble his $100k for him. He gives you one night in a particular casino that only has these 4 kinds of games:   1) There is a big game of no-limit hold'em poker where you only play with the other players (not the house) against whom you estimate you may have a 10% edge for the night. The blinds are 25-50 and betting is capped at $50,000 per hand.   2) There is single-deck blackjack where you can actually count cards and gain a legal, fair, small edge (maybe 5%) over the casino but the maximum bet is $100 per hand.   3) There is also "Betting on Fair Coin Flips" against the house, which is obviously entirely luck-based, that pays winning predictions 99 cents on a one dollar bet. This means the casino has an edge over you of 1%. Note that the maximum bet for this game is $1,000 per player per flip.   4) Finally there is "The Big Wheel" which is like a simplified roulette wheel where there are 20 spaces (19 losers and 1 winner) and pays off a winner 17 to 1.  True odds would dictate you should get 19 to 1 so you're actually giving up a 10% edge to the casino. Note that there is no limit on the amount you can bet on this game only.   So in this casino gambler analogy, where you are the equivalent of a hedge fund manager, on what games should you bet the $100k you were given to gamble?   A) If you're a great poker player against weak opponents then you should play NLHE poker because that's where you can get the greatest edge/positive EV (over 10% ideally). Consequently your 2% will get you $2k plus 20% of the $10k profit (which is $2k) totals a net profit of $4k for you and $6k for the gambler. Getting the gambler 6% ROI in one day is pretty great (it'd make a merciless mafia loan shark jealous).   B) If you're not as good as the other poker players but still smart then you can pretty safely count cards playing blackjack and hope/expect a 5% ROI on the $100k. Consequently your 2% will get you $2k plus 20% of the $5k profit (which is $1k) totals a net profit of $3k for you and $2k for the gambler.   C) If you can't play poker or count cards in blackjack then you could bet on the coin flips but you're giving up a 1% edge and so should expect to actually lose money for the gambler. Consequently your personal profit theoretically should only be the $2,000.   D) "The Big Wheel" may seem counter-intuitive for many so let's explore it in detail… You know "The Big Wheel" has a negative expectation with the worst odds for the gambler's money. But let's still explore your personal "Expected Value" (as the HF manager) if you simply bet the whole $98k on one spin of "The Big Wheel". –19 times out of 20 you would lose it all and only make $2,000 personal profit. –1 time in 20 you hit then you'd win $1,666,000 on the $100,000 investment. Consequently, your 20% would equal $333k plus your $2k equals $335k. –So in 19 spins you'd get $2k each (total = $38k) and on the 20th theoretical spin you get $335k. That's $373k over 20 spins for an "Expected Value" of $18,650. WOW! But it's terrible for the investor who's EV on the game (before the 2/20) is 90% of his $100k resulting in a $10,000 theoretical loss. After the 2/20 compensation, his expected value is less than 70% of his $100k for an over $30,000 theoretical loss.   Recap: •NLHE POKER: 10% POSITIVE / Your expected personal profit = $4,000 •BLACKJACK: 5% POSITIVE  / Your expected personal profit = $3,000 •COIN FLIPS: 1% NEGATIVE / Your expected personal profit = $2,000 •THE BIG WHEEL: 10% NEGATIVE / Your expected personal profit = $18,650   THEREFORE: Even though "The Big Wheel" has the biggest mathematically "Negative Expectation" because of the 2+20 compensation formula it is immensely attractive to the hedge fund managers who don't have an edge.   CONCLUSION: It is therefore even more important to go with a hedge fund manager who has a real edge on the competition. Don't simply pick a financial "brand name" with only a recently good ROI (especially if the management has changed during its run). Such "chasing last year's winners" is a short & hind-sighted technique that historically underperforms. Instead, select an investor with at least a decade of extraordinary returns.  BTW - if you're an "accredited investor" then you can contact me for my personal recommendations.