What are hedge funds and how can individual investors apply strategies from top-tier hedge funds to their own portfolios.
What are hedge funds and how can individual investors apply strategies from top-tier hedge funds to their own portfolios.
In this episode, you’ll learn:
- The difference between an investment vehicle and an investment security.
- What is a hedge fund and how does it differ from a mutual fund.
- What are the fees and liquidity characteristics of hedge funds.
- Are hedge fund managers really that skilled.
- Investment lessons from hedge funds.
- How individual investors can hedge.
- The structural advantage hedge funds have over traditional money managers.
Show Notes
Howard Marks memo that includes his quote on asymmetries. Quote is on page 4.
Become a Better Investor With Our Investing Checklist
Become a Better Investor With Our Investing Checklist
Master successful investing with our Checklist and get expert weekly insights to help you build your wealth with confidence.
Summary Article
How To Invest Like A Hedge Fund
Several times a year I used to go to New York, Connecticut and Boston to meet with top-tier hedge funds.
A hedge fund is a private investment partnership run by an investment management firm. Hedge funds cater to institutions and high net worth individuals who invest their assets with the fund as limited partners.
Because I had clients invested with these funds, the managers were always gracious about answering the many questions I had about their portfolios and investment styles.
Here are a few lessons I learned from top-tier hedge fund managers that influence how I invest today.
1. Be Flexible and Patient.
Hedge funds have a great deal of flexibility in terms of their investment mandates. While some hedge funds run concentrated portfolios, the top-tier firms I prefer are not only well diversified, but they shift their portfolios to overweight the most attractive investment opportunities.
In many cases, those opportunities arise because investors become overly pessimistic and sell their investment holdings because they can no longer stomach the losses and uncertainty.
This creates areas of undervaluation that a hedge fund or other investors can profit from.
There are times, though, when no asset types appear to be undervalued. This can occur during the latter stages of a bull market when stocks and other asset classes have appreciated for several years running.
At those times, many top-tier hedge fund managers are willing to hold cash and patiently wait for opportunities to surface.
2. Protect Against the Unknowns
Hedge funds typically earn an annual incentive fee comprised of 20% of the investment partnerships’ annual profits.
When hedge funds lose money, not only do they not receive this incentive fee, but they have to make up all of the losses before they can start to again receive a percentage of the profits. This is called the high water mark.
One way hedge funds seek to avoid losing money is by hedging. Hedging simply means to give up a portion of the upside return to protect against portfolio losses.
Hedge funds often do this by entering into contracts where they pay small insurance-like premiums in exchange for receiving large payouts if specific events happen. These contracts can be privately negotiated or purchased on an exchange in the form of derivative securities, such as put options.
While many hedge funds won’t admit this, if you probe and ask what specific events they are hedging against, often they will say they don’t know. They are hedging against unpredictable, unknowable bad outcomes.
How Individuals Can Hedge
Individuals hedge when they purchase homeowners or auto insurance. They hedge by keeping an extra supply of food on hand or a backpack filled with essentials in case they have to exit their houses quickly during an emergency.
In investing, most individuals aren’t in the position to hedge their portfolios using derivative contracts or other types of portfolio insurance.
Instead, they can protect against the unknown by being broadly diversified among many different asset types.
They can also hedge by scaling their stock exposure to their ability to recover in the event of an extreme market sell-off.
Prudent investors recognize market losses can be far worse, happen more frequently, and cluster together more than what conventional financial theory predicts.
Margin of Safety
Individual investors can also hedge by keeping a margin of safety. A margin of safety is a cash buffer that includes emergency savings to pay for unexpected expenses.
Individuals can be like hedge funds by adjusting their cash buffer based on market conditions.
When markets are undervalued, investors are fearful and there are plenty of investment opportunities, then the margin of safety could be on the lower side. Those were the market conditions in the spring of 2009, which turned out to be a great buying opportunity.
Conversely, when markets are overvalued and investors are overly exuberant then a larger cash buffer might be warranted.
That allows individual investors to be flexible just like top-tier hedge funds without having to pay high investment management fees.
