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What Hedge Funds Really Do (A FR Exclusive)
FreeRepublic - Vanity ^ | 9/9/08 | tcostell

Posted on 09/09/2008 2:53:54 PM PDT by tcostell

Hedge funds are often vilified by those that don’t understand them as nothing more than secretive companies operating on the fringes of finance, and implementing some villainous agenda. The fact that they are required by law to provide only a limited amount of public disclosure makes them the perfect target for conspiracy theorists of all political stripes. They are often accused of being the “behind the scenes” engineers of any negative financial outcome, anywhere in the globe. They are a ready made scapegoat, and are often blamed for all sorts of financial chicanery, but virtually none of it is justified.

Because of all the hyperbole surrounding hedge funds, I was recently asked to put together a little write-up explaining how they work. I think most people would agree that my qualifications for this are adequate. At present I’m a portfolio manager for one of the best performing “large” hedge funds in the world. It’s the third hedge fund I’ve worked for in the last 11 years, and both of my prior employers were also hedge funds in the “above 10 Billion” bracket. All of the hedge funds I’ve worked for are listed in the top 10 of global performers almost every year, and are run by men who are well known in the industry, even if their tendency toward privacy keeps them from being household names.

So what is a hedge fund? Well at its core, it’s just an investment company with a structure that allows it a maximum degree of freedom in choosing the investments it makes. Mutual funds and other investment companies are highly restricted in the kind of risks they can take because they accept investment from people who don’t have much experience or knowledge in financial markets. A hedge fund’s clients are different. Hedge funds only allow investment from other investment professionals and from individuals who are so wealthy that it is assumed that they have a high degree of financial knowledge and can therefore take care of themselves. Pension funds, insurance companies, and many other companies have investments in hedge funds so there is some pass through to individual investors, but there is always an accountable professional involved providing a layer of protection for them.

Hedge funds are not restricted by law as to the kinds of risks they can take or the kind of investments they make other than those restrictions that apply to all investors. They still have to file 13D statements for instance if they buy more than 5% of any public company. The same tax laws apply to them as any other company, and the same rules apply with regard to short selling and international investment. They don’t’ rewrite the rules, the are just free from the kind of regulations that mutual funds have to live with because there are no “widows and orphans” with their investments at risk.

But just because hedge funds are allowed to engage in any legal investment doesn’t mean that just any type of investment is engaged in. In fact while there may be few government restrictions on “what you can trade” there are massive restrictions imposed by market forces. Risk controls at hedge funds are absolute. A trading strategy that makes money 99 days out of 100 will be shut down instantly if on that 100th day there is a loss which exceeds the “draw down limit”. A draw down is basically a loss measured from the peak performance of the strategy. Most multi-strategy hedge funds have a strategy draw down limit of somewhere between 10% and 20% of total assets. As an example, if a 100 million dollar trading strategy has made 1% per day, every single day for the last 40 days it would be up 40 million dollars. If on the 41st day it had a 22% “draw down from peak”, it would still be up roughly 9.2 million dollars but the portfolio manager would probably be fired.

The people who make investment decisions at a hedge fund are paid for mitigating risk. If you mitigate risk correctly then your strategy will make money at a steady and reliable rate. The fund you work for will want to see profits, every single day if possible, and for meeting that goal you will be well compensated. The people who make the trading decisions at a hedge funds are the “portfolio managers” or PM’s. In most cases the person who runs the fund will also be a PM, and often a very large one. All of the hedge funds I’ve worked for were run by a “man at the top” who made his way as a large portfolio manager. But there is a limit on market liquidity, so the most a single decision maker can usually manage is about 3 billion dollars or so. If their firm is larger than that then they have to delegate some of the decision making to other PM’s. A large hedge fund will typically have anywhere from 10 to 50 PM’s engaging in various (hopefully complementary) strategies. Those PM’s are the people who actually drive what positions the firm takes as a whole.

When a PM interviews for a job with a hedge fund, it’s usually with a claim to some specific expertise. No one starts their career at a hedge fund, and before they interview for their first PM role, many have spent a decade or more on the “sell side” working for the large investment banks. It’s there where they establish contacts, build credibility and expertise, and eventually rise to a level where they will be considered for a position with a fund. But when they interview with a fund they are being hired to provide a certain kind of exposure in a specific marketplace. Maybe they are an expert in convertible debt, or maybe in the Macro – Fixed income markets. Maybe they know a lot about Energy trading or derivatives. The fund will be hiring their strategy as much as them, and personality is actually much less of an issue than their correlation to other strategies, “Value at risk” over time, and the alpha and beta of their portfolio. At that level a job interview is more of a business negotiation than an interview for a salaried job.

If a PM is hired, the firm will usually allow no deviation whatsoever from the strategy that they’ve been hired to engage in. The PM’s portfolio risk in monitored continuously from a number of levels, and any major deviation will be a cause for intervention by management, or maybe even termination. Over the years I’ve seem a few people be fired for deviating from their state plan. And just because the government isn’t telling you what you can and can’t do doesn’t mean you are free to do whatever you like.

Also, even if you don’t deviate from your approved strategy at all, and you don’t exceed your draw down limits, you can still be fired for failing to produce enough profit. “Flat returns” will not be acceptable to most hedge funds either so there is substantial pressure to perform. A hedge fund’s size is usually limited by its ability to attract capital so they will want to make as much with their capital as they can. If you have capital committed but aren’t producing a steady return, the firm may decide that they can re-allocate that money to other managers and do better. Internal competition for assets can be fierce.

And even when you are successful there is constant pressure of competition. PM’s who are producing strong returns still compete with each other to get a greater allocation of the existing capital. Beyond that, hedge funds that are successful overall are in competition with other hedge funds for the limited amount of capital from investment clients. There are only a dozen of so funds at the very top for whom capital is basically unlimited, and even those funds need to continue to outperform all others or it will be a different story for them next year. Everything they do is considered, every judgment call is carefully weighed; every move they make is precisely planned. A hedge fund is not a place where they just “wing it” and see what happens. In all things, to the limit of their ability to understand, they will always want to be certain of the expected outcome.

Hedge funds don’t work in collusion, they work in opposition. Everything about a hedge fund is dedicated to gaining an advantage over everyone else however fleeting and slight it may be. There are a limited number of investment vehicles, a limited number of markets and a limited number of strategies that will yield constant returns, and hedge funds are in the financial equivalent of open war with one another to gain an upper hand in each of them. They tend toward the secretive when profitable because they know that whatever advantage they may have identified will be gone tomorrow if the competition finds out.

But even with all that competition, the hedge fund world is still a fairly small and mostly closed community. The entire population of investment decision makers in all the hedge funds in greater New York is probably no more than a few thousand people working at a few hundred firms. None of us are more than 2 degrees of separation from anyone else. There are another few thousand PM’s in London that might be one degree of difference further. I read a conspiracy theorists claim recently that said that there are 10,000 hedge funds listed in the Cayman Islands registry alone, but most of those are probably holding companies and sub-funds that are broken out for accounting and risk purposes. A large hedge fund may decide to put a legal entity around a specific strategy or two for marketing or legal reasons, and that would mean a new “hedge fund” in the Caymans even though there isn’t really a new fund.

Most of the “real” hedge funds are somewhere between 50 million and 15 billion in size. Below that size range it’s difficult to get the broker dealers to offer the services you need, and larger than that your return begins to drop relative to other funds. A firm of 50 million may have only a single PM or two, and run just a single strategy. The larger funds may have over 100 PM’s and many different strategies. But the same rules apply to all of them. They are required to manage risk, they are required to produce profit, and they are required to do it better than everyone else. The PM’s are all constrained by a natural set of checks and balances that have grown up around the market forces which apply to all of them.

When someone tells you “all the hedge funds do ________, don’t pay any attention. They’re just demonizing or shooting off their mouth. It probably means that they don’t actually know what they’re talking about. Hedge funds engage in all different kinds of business across the entire spectrum of financial products and are constantly struggling to find new ways to add value and produce return. They are a source of constant innovation in the hope that that innovation will temporarily put them slightly ahead of their peers. There is no cabal… no conspiracy… just the free market and some of the smartest people in the world trying to find honest and legal ways to profit from it. That’s what Hedge funds actually do.


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To: GOPJ
NOT one thin dime of my tax dollars should be spent bailing out millionaires

I couldn't agree with you more.

21 posted on 09/09/2008 3:37:47 PM PDT by tcostell (MOLON LABE - http://freenj.blogspot.com - RadioFree NJ)
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To: 9YearLurker
Unfortunately, that's really more of a specific strategy question and is a little outside my area of expertise.

I work in quant equity, but started my career in energy. the end of quarter end of year rebalancing issue is more focused on "unleveraged long only funds".

22 posted on 09/09/2008 3:43:35 PM PDT by tcostell (MOLON LABE - http://freenj.blogspot.com - RadioFree NJ)
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To: tcostell
Regardless of the competence of the hedge fund operators and the competitive environment, it still seems as if a major failure occured in the mortgage market.

Investment vehicles were created which were less transparent and less liquid than other instruments. Because of this, these instruments were less susceptible to the discipline of the market and only finally came to be adequately valued after it was too late to prevent a major collapse in the credit market.

I have a problem with the greatest and most creative minds being used to come up with new and better investment vehicles rather then new and better pharmaceuticals, energy sources, materials, material uses, chemicals, industrial processes, etc.

It seems to me that there are currently more than enough ways for those people with good ideas to get the funding they need to turn their ideas into reality. There is no real need for yet another way to repackage risk so that all the benefits go to a few, and the risks are sucked up by the unknowing, e.g. pensioners whose fund managers picked up one to many glossy hedge fund brochures.

I don't know who was helped by slicing and dicing millions of loans into trillions of parts and repacking them to the point of complete obfuscation.

I also have a problem with so much wealth being concentrated in so few places. Some of that wealth can be used (and was) to lobby politicians to look the other way. Now that these entities which are "too large to let fail" are starting to fail, the burden is being put on the shoulders of the taxpayer rather than the fund managers.

If we know ahead of time that the government will not allow businesses worth more than $X to fail, then no business should be allowed to be worth more than $X. What we have now is a weird system where we allow a supposedly free market system to drive toward the edge of a cliff, and when it goes over the edge it falls into a socialist safety net. If there were no net, then let whomever wants to drive over the cliff, but unfortunately there will always be a net comprised mainly of the backs of taxpayers.

23 posted on 09/09/2008 3:49:09 PM PDT by who_would_fardels_bear (The cosmos is about the smallest hole a man can stick his head in. - Chesterton)
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To: tcostell

Thanks for your informative, well written post. I’ll link to it the next time I come across someone from the “torch and pitchfork” crowd which should be any minute now.


24 posted on 09/09/2008 3:51:58 PM PDT by Moonman62 (The issue of whether cheap labor makes America great should have been settled by the Civil War.)
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To: tcostell

As long as the margin on oil is raised to the margin of everything else and the hedge funds take delivery of the oil they buy, I’m cool with it. Otherwise, not so much.


25 posted on 09/09/2008 3:52:58 PM PDT by mysterio
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To: tcostell

LOL, I just saw the torch and pitchfork graphic on your blog, after I posted the above reply.


26 posted on 09/09/2008 3:59:43 PM PDT by Moonman62 (The issue of whether cheap labor makes America great should have been settled by the Civil War.)
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To: who_would_fardels_bear
Well you have a problem with a bunch of stuff there... much of it I agree with. I don't think anyone should ever be bailed out of a bad decision and I've written a great deal about what went wrong in the credit space and how we can avoid problem like this is the future. It can all be found on my blog.

As for all that other stuff... I'll go create new drugs as soon as the government gets out of the way and lets me get compensated well for it. Until then I'm going where my higher than average intelligence will produce a higher than average income. That's wall street.

you'll notice that you aren't hearing about hedge funds blowing up because of the credit crisis, just investment banks. We manage risk, they didn't.

that isn't to say that there hasn't been other errors made, but on the whole the hedge fund industry is perfectly healthy right now, but the banking industry is taking a beating. You shouldn't mistake the two.

In my experience the only problem people ever really have with the concentration of wealth is that not enough of it is concentrated in their account.

27 posted on 09/09/2008 4:03:06 PM PDT by tcostell (MOLON LABE - http://freenj.blogspot.com - RadioFree NJ)
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To: Moonman62

Yeah ... it can be used for evil as well as good I guess. But remember, torches and pitchforks don’t kill people... angry mobs kill people...


28 posted on 09/09/2008 4:09:56 PM PDT by tcostell (MOLON LABE - http://freenj.blogspot.com - RadioFree NJ)
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To: tcostell

Thank you for posting this.


29 posted on 09/09/2008 4:18:23 PM PDT by snowsislander
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To: tcostell

I sent this to my nephew who is running a hedge fund in Texas ..Thanks


30 posted on 09/09/2008 4:34:42 PM PDT by woofie
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To: woofie
Every day I hear about more and more stuff being done in Dallas. I have a good friend going there to be CTO of a mid-sized fund, and I know another guy out there who is well established in the quantitative trading space.

Like I said, most of us are just two degrees or so away from one another so your nephew and I probably know some of the same people.

31 posted on 09/09/2008 4:38:11 PM PDT by tcostell (MOLON LABE - http://freenj.blogspot.com - RadioFree NJ)
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To: tcostell

The concept of secretiveness being the normal and necessary companion to extremely valuable investment decision processes is over the heads of reporters from the Leon Trotsky school of journalism, and unfortunately over the heads of many FReepers as well. I mean what possible reason could a hedge fund have for wanting to keep secret that it has accumulated holdings of 31% of the bank debt of a certain bankrupt company, and is looking to buy a little more? Clearly a sign of nefarious financial wrongdoing, in the minds of people to whom “blocking position” suggests something about a football game.


32 posted on 09/09/2008 5:03:10 PM PDT by GovernmentShrinker
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To: mysterio
As long as the margin on oil is raised to the margin of everything else

Non-Member Customer Initial Margin $12,488

hedge funds take delivery of the oil they buy, I’m cool with it.

LOL!

Otherwise, not so much.

LOL!

33 posted on 09/09/2008 5:55:28 PM PDT by Toddsterpatriot (Half the time it could seem funny, the other half's just too sad.)
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