How to think like a hedge fund manager
Prior to managing individual people’s money, I worked as a risk manager at the world’s largest publicly traded hedge fund. We ran a multi-manager pooled investment vehicle that invests into hedge funds as its core strategy. Asset allocation on steroids, with strategies ranging from long-short equity, to global macro, to arbitrage strategies on mergers, convertible bonds, and volatility. My role as a risk manager was to interview some of the most brilliant minds and powerful people in the investment world. Some hedge fund managers were quiet math nerds, while others were as boisterous as the characters on Billions. Regardless of who was in the seat across from me, my job was to understand what they did, and write a report that contained my opinion of whether this hedge fund was suitable for investment. In risk management, my job was two fold: to protect our clients from frauds, and to protect our client’s capital from unforeseen losses. While today I believe that successful investing doesn’t necessarily need to be as complicated as a hedge fund, the core lessons I learned in my former role do shape the way I think about investing today. I’d like to share those with you in this blog, and a few hedge fund stories along the way.
Lesson number 1: Know your counterparty. Understand where your money is being held.
This one sounds so obvious, and yet time and time again I see a lack of due diligence in this area. Hedge funds often engage with a multitude of financial counterparties to invest, obtain leverage, or lend for a return. It’s reasonable to work with a number of counterparties to get the best offerings available (think, shopping interest rates), but when proper due diligence isn’t performed, it can be painful. Understanding investment risk is one thing, but cash should be safe. What could go wrong? Lehman Brothers. In this classic example, we saw that many hedge funds who had cash held at Lehman during 2008 were still cleaning up the mess 10 years later, having lost a great deal of capital on what was supposed to be their safest investment, cash.
When cash is held in a bank account, up to $250k should be covered by FDIC insurance, which means that the US Government will provide protection over your cash in the case that the bank goes bankrupt. In an investment account, if your account is held with a SIPC member firm, you have similar protections through SIPC. These institutions are reliable, and further due diligence isn’t necessarily required if you have under $250k for cash or investments you manage. However, when your balance exceeds that amount, or when you hand over the reins to a third party, knowing where your cash is held is important.
Where could this matter for you?
If you have over $250k in an account, check the credit worthiness of the bank. If you don’t know how to do that, and you need to keep more than $250k in cash, it’s OK to spread your cash across multiple institutions to gain FDIC protection.
Working with a financial advisor. Your financial advisor should be granted limited power of attorney over your investments, which will allow them to invest on your behalf and charge a management fee. However, your financial advisor should be custodying your assets with a qualified custodian. This setup provides you, the investment account owner, with control of how cash is moved in and out of your account. Schwab, TD Ameritrade, Fidelity, and Pershing are all examples of qualified custodians.
Investing in cryptocurrency is complicated in general, but how cryptocurrency is safely held is an ongoing debate. We’ll point to one of our favorite financial planning gurus, Derek Tharp, Lead Researcher at Kitces.com, for his take on this. As you can see from this article, it’s not so straightforward! And frankly, is why I have yet to invest.
Investing in private companies. You should understand where your cash is being stored, what it can be used for, who has the authority to use it, and if it can be pledged for debt.
Lesson number 2: Don’t put all your eggs in one basket.
This one was relevant in 2000, it was relevant in 2010, and it’s relevant today. Concentration blows you up. Tiger Global Management is notorious in the hedge fund world. Obtaining training from Tiger is a badge of honor, it’s like going to an Ivy League college for stock picking portfolio management, so much so that anyone who comes out of there is referred to as a Tiger Cub. They are notorious, because they take big swings, and sometimes they hit it out of the park. But when it goes wrong, it goes really wrong. Here is the most recent instance, where the FT reports that Tiger blames inflation after a 50% drop in flagship hedge fund. But this isn't the first time! Back in 2000, the Washington Post reported that Tiger Funds was closing, blaming the irrational market.
We used to watch 13F filings* to evaluate our exposure to Tiger (the original & the cubs) concentrated holdings. (*Anyone investing over $100 million has to report to the SEC via a 13F filing what stocks they own, and this is publicly reported). Because so many of these portfolio managers came from the same training grounds, we would see a lot of added risk once they piled into certain positions. They did well as they were piling in, but as they started to unwind, there would be huge downward pressure, and we didn’t want that exposure or risk!
This is highly relevant for our client base, many of whom have concentrated stock positions. It’s great when it’s going well and you’re getting richer in two ways: stock is going up, and you’re probably getting a raise! However, the downside is painful. We’d prefer that none of our clients invest in their own company stock, but if they do, we always recommend setting a cap on how much exposure to have in that stock versus their investable assets / net worth, and sticking to it! More often than not, you don’t need to take huge concentrated risks to set yourself up for life.
Lesson number 3: You don’t have to be right 100% of the time, you just have to be right more than you’re wrong, and win more when you’re right than you lose when you’re wrong. The combination of those two forces can make you very rich.
There’s a hedge fund strategy called statistical arbitrage that exemplifies this concept. The primary execution of the strategy is to go long stocks with leverage, and short stocks with leverage in the same amount, while eliminating all possible market risk. This meant that on $1 million of investments, they could go long on $5 million of stocks (betting that the price of these stocks would go up and $5 million short of stocks (betting that the price of these stocks would go down). However, it would be very nuanced, where there would be equally long and short country exposure, sector exposure, industry exposure, factor exposure, and the list goes on and on and on. These funds are often run by a combination of computer scientists and PhDs who are responsible for analyzing and extrapolating big data into trends. To juxtapose the variety of how analysis was done:
Fund 1 used software to translate and analyze small local newspapers across Asia to evaluate how companies were spoken about, to determine if they should bet on or against a company.
Fund 2 used beacons to track customers shopping at Target, and then essentially used this beacon to monitor individuals’ online behavior and determine whether they were more of a Craigslist or Restoration Hardware shopper. Based on this categorization, the model would then decide if they should be for or against a given stock. Hearing this for the first time blew…my…mind.
These funds took big bets from an overall exposure perspective, but actually on an individual risk perspective, each bet was very small (we’re talking less than 0.3% of a portfolio). Their main goal was to win more times than they lost, and win more when they won, than lose when they lost. By doing so, they locked in extremely high returns. The best of this sort is Renaissance Technologies, who from 1988 to 2020 is reported to have earned 66% returns per year on average.
Simplifying this to what you can do: be a long term investor in the stock market. Jeremy Schwartz and Jeremy Siegel of WisdomTree share research in the book Stocks from the Long Run about how the S&P 500 performed over various time horizons. Some stats:
If your holding period is over 10 years, since 1802, stocks have outperformed T-Bills 75% of the time. Even on a 1 year basis, stocks outperformed T-Bills 63.2% of the time.
Similarly, reviewing all 10 year periods since 1802, the best stock performance was +16.8% per year, and the worst was -4.0%. The upside/downside profile is more extreme, but still favors the upside on a 1 year basis. The best year for stocks was +66.6% and the worst year was -38.6%.
Lesson number 4: Don’t confuse marketed time horizon for actual time horizon. Only buy illiquid investments with money you don’t need at a specific time. Being a forced seller is painful.
Back in 2012, a large European bank was aiming to bring hedge funds to the masses. However, to compete in the individual investing space, the bank wanted to provide investors with terms similar to mutual funds. This meant that you could buy and sell these funds on a daily basis, and receive daily pricing. This was a huge hurdle for the hedge fund world to overcome, and really opened the doors to a new audience for hedge fund investments. In performing due diligence, our team noticed something. The returns of the hedge funds these funds were meant to track didn’t look at all like the returns of the hedge funds themselves. Why? Because of liquidity.
In the most extreme example, a fund was created to track a large high yield credit hedge fund, but offered daily liquidity. This hedge fund would buy companies out of bankruptcy, and make their money by restructuring the businesses they bought. Their bread and butter was their ability to rebuild a business that no one else could wrap their heads around, through creating complex securities and selling pieces of the business off over time. The fund that was meant to track this hedge fund was having individuals come in and out of the fund on a daily basis. Anytime someone would leave, the hedge fund would be forced to sell these companies shortly after buying them, ahead of any of the good work being done. Since they were the only ones that saw value in the company, knowing what they could do to repair it, no other buyers were available. The price of the security went down, and then more investors wanted out. This sent the “liquid” fund into a tailspin, which resulted in a 50% difference in what investors in the daily liquidity fund received, versus those that locked up their money to see the investment through to the end. Just because daily liquidity was offered, doesn’t mean it was the best for the investment strategy.
Where I see this most today is related to private equity or real estate investments. Oftentimes investors are pitched on a two-year turnaround on a project, but the reality is that sometimes for an investment to see its potential, longer is needed. You don’t want to be a forced seller, and not get to see the investment through to its purpose. It’s OK to take illiquidity risk, but take it with funds where you really don’t have a timeline.
Lesson number 5: Expect the unexpected.
One of my core responsibilities in managing a portfolio of hedge funds was to determine worst case scenarios. This is obviously not an easy feat, because anything could happen. How we approached this was to think about it from an individual risk perspective; what would happen if stocks lost 10%, if credit spreads widened 100 basis points, if interest rates rose 1%, if the US Dollar dropped by 5% versus other currencies, or if volatility spiked by 20%. On a monthly basis, we would review all 100 hedge funds we invested in to determine how each of them stacked up so these risk factors. Then, we’d think about historic events and how these risk factors compounded, and then we’d round up! Even if it felt unlikely, or even impossible, we posed the question of what would happen to our investments if this were the case. This gave us great comfort over how to size our investments, and if our overall investment return was commensurate with the risk we were willing to take.
Just because you don’t have a crystal ball, knowing and understanding how your investments behave in a variety of markets is important analysis. This can help inform you if you’re taking too much risk in your investments, or if you have too many eggs in one basket. Ultimately your goal as you build your net worth should be diversification, finding investments that will zig while your other investments zag.
Summing it up
Although today, my investing is a lot less complex than it once was, my time spent in the hedge fund world built the foundation for Mana’s investment philosophy. There are so many ways to make money, but when undue risks are taken, it can easily be lost. Our goal for our readers and Mana clients is to help provide safeguards to maximize their wealth. We hope the stories we shared provide you with some insight on how to think about investments like a risk manager or a hedge fund manager would. Remember: know where your cash is parked, investment sizing matters, be patient, and don’t forget to consider what happens if you’re wrong. Humility is a wonderful quality in this business.
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.