The Mysterious World of Hedge Funds

I’ve been doing some reading about the hedge fund industry lately.  You don’t hear them talked about much in the financial media because up until recently the SEC had laws prohibiting them from marketing themselves or advertising in anyway.  These are funds generally reserved for the wealthy (or the “sophisticated investor”) who already has at least $1,000,000 to invest.

The purpose of a hedge fund is just what it sounds like – it’s goal is to ‘hedge’ against all possibilities of loss, while providing a market-beating return to investors.  These funds are comprised of groups of analysts and investment professionals who work around the clock analyzing every possible angle of every possible investment opportunity that they come across.  If there’s a good chance of a successful trade without a lot of risk, they’re going to go for it.  This is not a ‘let’s buy a basket of blue chip stocks for our clients and sit on our hands’ kind of industry.  These guys are doing arbitration, longs and shorts, looking at mergers, spinoffs, macro-economic trends, and other special situations.

So I’ve been wondering – if I had the money, would it be worth it to invest in a hedge fund?  I’ve reached two different preliminary conclusions: Yes, and No.  Let me explain.

First, I’ll explain the No position.  Let’s now bring up the fact that hedge funds typically have a 2/20 fee structure.  This means they take 2% of assets off the top, and then 20% of profits before you get your cut as the investor.  So, if we know that the general market performs at about 10% per year over long periods of time, a hedge fund would at a bare minimum have to return over 12% in order to make it worth your while as an investor.

Now, hedge funds do do this – some make rates of return far in excess of 12%, 14%, and beyond.  But, how can I know for sure that that’s going to happen?  On the one hand, there are very sophisticated financial professionals who are working day and night to protect and grow my money, but on the other, they’re taking such a huge cut of the assets that I might just want to invest the money myself in a solid portfolio that is well-diversified and structured conservatively.

On the Yes side, I can see why say, a small business owner who has made it big and sold their business for a cool $5,000,000, would want to entrust a large portion of their wealth to a hedge fund.  Maybe they aren’t that interested in managing their money and want someone to grow it reliably with a high level of skill – something they’re not sure that the typical wealth management firm would do as well.

There are incentives at work – if someone is willing to entrust their millions with you, you’d better produce some results.  Capital attracts capital.  For the DIY investor though, once you’ve made it to a few million, you’re likely to stick to your guns and keep investing the way you always have in the first place.  For those who suddenly come into a lot of money, either through inheritance, business liquidation, or some other event, a hedge fund might make sense under the right circumstances.

The Asset Class You Love to Hate But Hate to Love

Let’s talk a little bit about bonds.  In this day and age, bonds are not really all that sexy.  In fact, they’re boring.  Even more so than dividend paying stocks.  I mean, you get no capital appreciation due to growth of an enterprise, the payments are fixed, and they end once you reach maturity.  The way I feel about bonds is the way I feel about grapes freshly picked from the vine – nothing exciting right now but give it a few years to ferment and we can have ourselves a party.

Although I’m still learning about bond basics, you don’t have to look hard to realize that bond yields are at all time lows.  The 30 year note is trading for 2.56%, and the 10 year note is trading for 1.90%.  Check out the historical data:

yeah - not so great a time to be buying bonds

yeah – not so great a time to be buying bonds

If you’re looking for robust streams of income, bonds may not be the choice for you.  The problem is in the US, we are undergoing a massive demographic shift with baby boomers retiring in droves everyday.   A lot of these folks don’t have much to retire on at all (which is another post), but for those that do have money invested somewhere, standard asset allocation practices shove a good chuck of that money into investment-grade bonds (by investment grade, I’m talking about bonds that are rated as credit worthy by the big agencies – Standard and Poor’s, Moody’s, etc.).

This flow of money compounds the problem.  The Federal Reserve wants to keep interest rates low in order to keep stimulating the economy until they feel that it can stand on its own in a higher rate environment.  Add to the fact that more money is being put in retiree’s bond allocations and that’s going to drive prices up and yields down.

Another thing to consider here is that there are wayyy wayyy more bonds to invest in than plain vanilla US treasuries.  There are corporate bonds, municipal bonds, etc.  While these typically sport higher yields or tax advantages, a lot of fund managers out there are thirsty to juice of returns.  Instead of sticking with tried and true traditional bonds, many bond funds are starting to dabble in riskier securities that have a higher coupon rate.  Because the word “high yield” scares a lot of people off, a lot of these funds are called “non-traditional” bond funds.

Now, I’m not going to make a blanket statement and say that these funds are a bad buy, because I don’t really know.  I’m sure there are some that are better than others.  The problem is, I don’t think that most people should venture off beyond the world of bonds that are considered investment grade.  What’s that famous quote?  More money has been lost reaching for yield than has been taken at the barrel of a gun.  Be careful where you put your money and always look at risk-adjusted rates of return.

I’m certainly not going to write bonds off forever, but right now, they just don’t seem like much of a bargain at all (on a basket basis – I’m sure there are deals out there but my level of knowledge is not sophisticated enough yet to spot them).  Look at the treasury yields back in the late 70’s and early 80’s.  The yields were over 10% – on government debt!  Part of me wishes I was around in those times.  There was inflation and stagflation going on, but if you knew the historical data that inflation over the long term in this country runs at about 4% per year, you could have made a relatively safe projection that the high interest rates of the day would not last and bought a bunch of high yielding Treasury debt.

Alas, I digress.  It is not wise to dwell too long on missed opportunities, especially if they are opportunities I couldn’t actually take advantage of because I wasn’t born yet!  My point is to say that these days, a lot of financial people don’t talk about fixed income because the yields are so darn low right now.  However, it would be wise to look at history and remember that financial markets come in cycles – no asset class stays at any given level forever.  Hopefully one day, I’ll be able to rationally add bonds to my family’s portfolio.  Realistically though, I doubt that will happen for a few decades.  After all, I tend to prefer dividends as a source of passive income because they are tied to business profits, which rise exponentially over time for a successful enterprise.

Above A Certain Threshold, Always Shop Around

In day to day life experience, you’ll come across lots of opportunities to spend money.  In fact, people will want you to spend a lot of it.  Once you develop basic savings habits, it’s relatively easy to ignore most of the marketing efforts.  However, when it comes to spending money on something that’s truly important – like medical care for example – many people simply fork over money on the spot without thinking about if they are getting the best deal.  The trauma and urgency of certain events tends to mask opportunities for making rational purchase decisions.

This is something I thought of due to a major expense coming up for our family.  It’s one of those things that is not a fire that needs to be put out, but falls into the “not urgent, but important” category of life tasks that are on one’s plate.  So often, it seems like these are the things that fall by the wayside because of our busy lives.  I have to give credit to Mrs. Mase here, because she’s the one that brought this particular looming expense to my attention.

It’s the kind of thing that requires a specialist of sorts, so you can’t just walk into Wal-Mart or Target and buy something that’s going to solve the problem.  So, we started shopping around, looking at various options.  We talked to multiple professionals and set up appointments at different places.  It’s been sort of a chore, to be sure, but I’m glad we’re doing it.

One of the people we spoke to quoted us what seemed like a fair price.  It was the first person we spoke to though, so how could I rationally know that it was fair?  As soon as I saw the cost on the piece of paper, my mind immediately made assumptions based on previous experiences of purchasing services from this industry, and a range of acceptable prices probably popped into my subconscious mind.  Who knows though?  Sometimes you can make decisions based largely off of intuition, but this was not one of those times.

Going to another person for the same group of services, we were quoted about 30% less!  I thought that this place would be somewhat more affordable, but I was quite pleasantly surprised.  My wife found a creative solution to the problem and suggested we talk with a group of people that I would have never even thought about consulting.  Talk about economies of scale in a family – two minds are definitely better than one 🙂

We’re going to keep shopping around some more, but I think we’ve probably found the place that can suit our needs.  Major expenditures call for major research and due diligence.  I once heard a quip that stuck with me: whenever you are about to spend money, spend as much time thinking about the purchase as it would take you to earn the amount of money to make the purchase.  

This strikes me as a good rule of thumb because it strikes at the heart of a good balance between production and consumption.  If you’re a high earner in your field and know that you can replenish your cash reserves quickly without much more work, many small purchases will be inconsequential to you.  However if you’re just starting out and working two full time jobs just to keep the lights on, you need to weigh decisions to buy many things much more carefully.  But really, regardless of your level of income, if you’re trying to make significant progress toward aggressive financial goals (aka like the Mrs. and I), then you’re going to have to weigh most spending decisions with a certain gravity that you wouldn’t otherwise if you didn’t have attaining financial independence as a priority.

Every dollar has present utility and future utility.  It’s your job to figure out the best use of any dollar at any given moment in your life.