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Speaker 1: Bloomberg Audio Studios, podcasts, radio news.

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Speaker 2: Gone to.

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Speaker 1: Go Thinking about putting some money into hedge funds? You know,

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Speaker 1: all the rockstar names who produce eye popping returns. Chasing

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Speaker 1: that performance has led the hedge fund space to swell

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Speaker 1: to over five trillion dollars in assets today, with forecasts

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Speaker 1: topping thirteen trillion globally by twenty thirty two. But not

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Speaker 1: all hedge funds are created equally. Investors should ask themselves

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Speaker 1: is this the right investment vehicle for me? I'm Barry Ridolts,

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Speaker 1: and on today's edition of At the Money, we're gonna

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Speaker 1: discuss how you should think about investing your money in

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Speaker 1: hedge funds. To help us unpack all of this and

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Speaker 1: what it means for your portfolio, top bring in Ted

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Speaker 1: Side's Ted began his career under the legendary David Swinson

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Speaker 1: at the Yale University Investments Office. Today he's founder and

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Speaker 1: CIO of Capital Allocators and hosts a podcast by the

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Speaker 1: same name. His book, So You Want to Start a

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Speaker 1: Hedge Fund? Lessons for Managers and Allocators is the seminal

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Speaker 1: work in the space. So Ted, let's start out with

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Speaker 1: the basics why hedge funds. What's the appeal.

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Speaker 2: The original premise of hedge funds was to deliver an

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Speaker 2: equity like return in marketable securities with less risk than

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Speaker 2: the equity markets.

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Speaker 1: So literally, hedged funds.

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Speaker 2: A fund that had some hedging component that would reduce risk.

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Speaker 1: And today I think a lot of so called hedge

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Speaker 1: funds are not exactly edged. They seem to be falling

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Speaker 1: into all sorts of different silos.

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Speaker 2: Yeah, so hedge fund as a term became this very

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Speaker 2: ubiquitous label, and if you look at how the industries

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Speaker 2: evolve today, you have funds that fall under hedge funds

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Speaker 2: that look like that original premise of equity like returns,

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Speaker 2: and then you have a whole other set that look

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Speaker 2: more like bond like returns. And different strategies can fit

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Speaker 2: into those two different groupings.

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Speaker 1: So I mentioned in the introduction, we always seem to

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Speaker 1: hear about the top two percent of fund managers who

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Speaker 1: are the rock stars. Anyone who puts up like really

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Speaker 1: big numbers wildly up before in the market sort of

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Speaker 1: gets fetted by the media and then they sort of

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Speaker 1: fade back into what they were doing. It seems to

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Speaker 1: create unrealistic expectations among a lot of investors. What sort

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Speaker 1: of investment return expectations should people investing in hedge funds have.

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Speaker 2: Yeah, those expectations should be more modest than what you

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Speaker 2: might read in the press. Barry. What you just described

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Speaker 2: describes markets. People do well, they revert to the mean.

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Speaker 2: It happens in every strategy, and certainly the news sensationalizes

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Speaker 2: great performance and lousy performance. So what you might read

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Speaker 2: in the press is these incredible renaissance medallion fifty percent

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Speaker 2: a year with these high.

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Speaker 1: Fees sixty eight percent. If I recall Zuckerman's book, Greg

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Speaker 1: Zuckerman's book on Jim Simon.

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Speaker 2: Now, if you looked at hedge funds as a whole

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Speaker 2: and try to get at let's say that equity like

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Speaker 2: expected return you're talking about like a high single digits number,

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Speaker 2: has nothing to do with sixty eight percent. Most of

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Speaker 2: the action isn't on either tail. Most of the actions

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Speaker 2: right in the middle.

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Speaker 1: That seems to be very contrary to how we read

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Speaker 1: and hear about hedge funds in the media. Is it

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Speaker 1: that whoever's hot at the moment captures, you know, the

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Speaker 1: public's fancy and then on to the next That's not

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Speaker 1: how the professionals really think about the space, is it.

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Speaker 2: No, that's right. I think that's generally how the media

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Speaker 2: works it investing. The news stories are the things that

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Speaker 2: are on the tails. But it's not how hedge funds

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Speaker 2: are invested in by those who have their money at risk.

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Speaker 2: They're really looking at it as risk mitigating strategies relative

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Speaker 2: to your say, traditional stock and bond alternatives.

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Speaker 1: So we talk about alpha, which is outperformance over what

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Speaker 1: the market gives you, which is beta. Lately, it seems

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Speaker 1: that alpha comes from two places, emerging managers, new fund

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Speaker 1: managers who kind of identify market inefficiency, and the quants

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Speaker 1: who have seemed to be doing really well as of late.

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Speaker 1: What do you think about these two sub sectors within

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Speaker 1: the hedge fund space.

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Speaker 2: Well, in all the asset management, there's this aphorism size

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Speaker 2: is the enemy of performance, and it's certainly been true

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Speaker 2: in hedge funds that generally speaking, for a long time,

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Speaker 2: smaller funds have done better than larger funds. Not so

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Speaker 2: sure that's the case of emerging funds, which means new

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Speaker 2: but on size you get that. Now, what's an interesting dynamic,

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Speaker 2: and it gets into the quant is more and more

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Speaker 2: money has been sucked in by these so called platform

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Speaker 2: hedge funds. So Citadel Millennium point seventy two, places like that,

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Speaker 2: where have they have multiple portfolio managers and do a

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Speaker 2: phenomenal job at risk control, and they've seemingly in good

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Speaker 2: markets and bad generated that nice equity like expected return,

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Speaker 2: and there has to be alpha in that because there's

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Speaker 2: not a lot of beta.

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Speaker 1: That's really kind of interesting. You said something in your

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Speaker 1: book that resonated with me. The best allocators establish clear

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Speaker 1: processes for evaluating opportunities and setting priorities. Explain what you

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Speaker 1: mean by that.

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Speaker 2: Well, before you just decide I want to invest in

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Speaker 2: a hedge fund, it's really important to understand how are

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Speaker 2: you thinking about your portfolio and how do hedge funds

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Speaker 2: fit in. Now, keep in mind hedge funds can mean

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Speaker 2: lots of different things, and that the strategies pursued by

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Speaker 2: one hedge funds is going to look totally different from

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Speaker 2: another one. So you need to understand what is it

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Speaker 2: you're trying to accomplish. Are you trying to beat the

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Speaker 2: markets with your hedge fund allocation? Okay, you better go

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Speaker 2: to one that takes a lot of aggressive risk. Are

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Speaker 2: you trying to mitigate equity risk but get equity like returns. Okay,

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Speaker 2: you might want to look at a Jones model hedge

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Speaker 2: fund that has lungs and shorts but has market risk,

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Speaker 2: or are you trying to beat the bond markets? You

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Speaker 2: better go to one that doesn't take equity risk. So

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Speaker 2: you need to understand in advance what is it you're

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Speaker 2: trying to accomplish through that investment, and then go look

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Speaker 2: for the solution, not the other way around, just by saying, oh,

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Speaker 2: hedge funds are a good thing, let me go invest

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Speaker 2: in them.

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Speaker 1: So that sounds a lot like another phrase I read

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Speaker 1: in the book, and acute awareness of risk? Should investors

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Speaker 1: be thinking about performance first? Should they be thinking about

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Speaker 1: risk first? Or are these two sides of this coin?

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Speaker 2: There are two sides of the same coin, but without

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Speaker 2: a doubt, investors should be thinking about risk first. And

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Speaker 2: that's not specific to hedge funds. I would argue that's

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Speaker 2: true in all of investing. If you understand the risk

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Speaker 2: you're taking and you look for some type of asymmetry

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Speaker 2: or convexity, the rewards can take care of themselves. But

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Speaker 2: where you really get tripped up in hedge funds and

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Speaker 2: there's a long history of this, going back to long

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Speaker 2: term capital in nineteen ninety eight is when risk gets

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Speaker 2: out of control.

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Speaker 1: And long term capital management very famously blew up when

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Speaker 1: Russia defaulted on their bonds. They were leveraged one hundred

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Speaker 1: to one, so this wasn't like a bad year, this

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Speaker 1: was pretty much a wipeout. How can an investor evaluate

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Speaker 1: those risks in advance.

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Speaker 2: Well, there are three pillars that don't go together. Well, concentration, leverage,

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Speaker 2: and illiquidity. Take any one of those risks, but if

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Speaker 2: you take two or certainly three at the same time,

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Speaker 2: that's a recipe for disaster.

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Speaker 1: So your podcast is called Capital Allocators. Leads to the

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Speaker 1: obvious question, what percentage of capital should investors be thinking

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Speaker 1: about allocating to hedge funds? Whether they're a large institution

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Speaker 1: or just a high net worth family office. Where do

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Speaker 1: we go in terms of what's a reasonable amount of

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Speaker 1: risk to take relative to the capital appreciation you're seeking.

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Speaker 2: Well, if you start with a traditional risk construct, so

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Speaker 2: let's say that's a seventy thirty stock bond or sixty forty,

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Speaker 2: say seventy thirty, the question becomes outside of your stocks

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Speaker 2: and bonds, where can you get diversification, And you might

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Speaker 2: want to say, okay, I want equity like hedge funds.

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Speaker 2: And if you look at some of the most sophisticated institutions,

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Speaker 2: that might be as much as twenty percent of their portfolio.

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Speaker 2: The biggest difference for those institutions and the high net

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Speaker 2: worth individuals are taxes. Most hedge fund strategies are tax inefficient.

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Speaker 2: So that of that five trillion dollars, the vast majority

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Speaker 2: of it, maybe even as much as ninety percent, are

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Speaker 2: non taxable investors. There are only some hedge fund strategies,

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Speaker 2: and they tend to be things like activism that have

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Speaker 2: longer duration investment holding periods that make sense for taxable investors.

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Speaker 1: So and when you say non taxable investors, I'm thinking

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Speaker 1: of foundations, endowments large, not even tax deferred, just tax

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Speaker 1: exempt entities that can put that money to work without

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Speaker 1: worrying about Uncle Sam.

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Speaker 2: That is, that's right, YEA pension funds non US investors

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Speaker 2: as well.

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Speaker 1: All right, So if you're not you know, the l endowment,

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Speaker 1: but you're running a pool of money, how much do

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Speaker 1: you need to have to think about hedge funds as

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Speaker 1: an alternative for your portfolio.

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Speaker 2: You're probably in the double digit millions before millions and

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Speaker 2: nothing about it.

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Speaker 1: Yeah, ten million and up, and you could start thinking

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Speaker 1: about it and then what's a rational percentage? Is this

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Speaker 1: a ten percent shift or is this something more or less?

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Speaker 2: I know, for me individually, it's a lot less than

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Speaker 2: it was when I was managing capital for institutions. So

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Speaker 2: for me individually, it's about five percent because I need

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Speaker 2: to feel like the managers are so good that they

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Speaker 2: can make up for that tax disadvantage.

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Speaker 1: And so taxes are part of it. Ill equidally is

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Speaker 1: part of it, and risk is part of it. Are

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Speaker 1: those Is that the unholy trifecta that keep you at

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Speaker 1: five percent?

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Speaker 2: Yeah, depending on the strategy. A lot of hedgehund strategies

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Speaker 2: have quarterly liquidity, so it's not daily, but they are

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Speaker 2: relatively liquid. But for sure taxes matter, and then it's

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Speaker 2: just risk. How much risk are you willing to take

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Speaker 2: in the markets?

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Speaker 1: And you know, since you mentioned liquidally, we hear about

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Speaker 1: gates going up every now and then. Where a hedge

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Speaker 1: funnel say, hey, we're we're you know a little this

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Speaker 1: quarter and we're not letting any money out. How do

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Speaker 1: you deal with that, as an investor, you have to be.

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Speaker 2: Very careful about what the structure of your investment is.

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Speaker 2: So to take an example, in the world of credit,

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Speaker 2: distressed debt used to be bucketed in hedge fund strategies

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Speaker 2: with quarterly liquidity, but it's not a great match for

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Speaker 2: the underlying liquidity of those debt instruments. More and more

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Speaker 2: those moved into medium terms, a two to five year

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Speaker 2: investment vehicles, and now you see much more of that

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Speaker 2: in the private credit world that have an asset liability match.

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Speaker 2: It's much more appropriate for the underlying assets. So it's

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Speaker 2: less what the liquidity is and trying to make sure

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Speaker 2: that whatever that hedge fund manager is investing in is

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Speaker 2: appropriate for the liquidity that they're offering.

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Speaker 1: So let's talk a little bit about performance. Before the

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Speaker 1: Financial Crisis, it seemed that every hedge fund was just

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Speaker 1: killing it and printing money. Following the Great Financial Crisis,

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Speaker 1: hedge funds have struggled. Some people have said, you only

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Speaker 1: want to be in the top decile or two. What

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Speaker 1: are your thoughts on who's generating alpha and how far

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Speaker 1: down the line you could go before you know you're

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Speaker 1: in the bottom half of the performance track.

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Speaker 2: Yeah, I mean over these last fifteen years, the world

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Speaker 2: has gotten a lot more competitive. So for sure, whatever

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Speaker 2: pool of alpha is available before the financial crisis, if

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Speaker 2: it's the same pool, it's there are a lot more

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Speaker 2: dollars pursuing it, and it's been much harder to extract

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Speaker 2: those returns. So I do think it's become the case

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Speaker 2: that some of the more proven managers that have demonstrated

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Speaker 2: they can generate excess returns are the ones who have

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Speaker 2: commanded more dollars. And so you've seen an increased concentration

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Speaker 2: of the assets going to certain managers in the hedge

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Speaker 2: fund space.

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Speaker 1: Let's talk about fees. Two and twenty has been the

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Speaker 1: famous number for hedge funds for a long time. Although

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Speaker 1: we have heard over the past ten years about one

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Speaker 1: in ten, one in fifteen, where are we in the

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Speaker 1: world of fees.

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Speaker 2: You don't see a lot of two and twenty. And

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Speaker 2: part of that is that fees are just determined by

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Speaker 2: supply and demand. Think of it as a clearing price

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Speaker 2: for supply and demand. So when returns generally have come down,

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Speaker 2: those strategies don't really command as high a fee structure

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Speaker 2: because the gross return is lower. The pies a little smaller.

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Speaker 2: You need to take a smaller slice of that pie.

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Speaker 2: The exceptions to that, of course, are the managers who

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Speaker 2: have continued to deliver, and in some instances you actually

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Speaker 2: see fees going.

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Speaker 1: Up three and thirty.

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Speaker 2: You've seen a deep Shaw raise their fees a year

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Speaker 2: or two go. But for the most part, that kind

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Speaker 2: of one and a half and fifteen is probably around

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Speaker 2: where the industry is.

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Speaker 1: And there was a movement a couple of years ago

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Speaker 1: towards pivot fees or beta plus, which was, hey, we're

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Speaker 1: going to charge you a very modest fee and you're

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Speaker 1: going to pay us only on our outperformance over the market.

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Speaker 1: What happened with that movement? Did that gain any traction

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Speaker 1: or where are we with that?

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Speaker 2: Most of the institutions would be happy to pay high

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Speaker 2: fees for true alpha, so there are always efforts to

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Speaker 2: try to figure out how do you separate the alpha

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Speaker 2: from the beta? How can we pay not much for

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Speaker 2: the beta and happy to pay a lot for the alpha.

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Speaker 2: At the same time, of the five trillion in assets,

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Speaker 2: two or three trillion have existed before people started talking

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Speaker 2: about that, so you already had a handshake on what

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Speaker 2: the deal is those handshakes often are difficult to change,

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Speaker 2: but for sure in new structures, when new capital gets allocated,

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Speaker 2: you do see that attempt to really isolate paying for performance.

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Speaker 1: So to sum up, if you have a long term

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Speaker 1: perspective and you're not awed by some of the big

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Speaker 1: names and rock stars who occasionally put up spectacular numbers,

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Speaker 1: and you're sitting on enough capital that you can allocate

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Speaker 1: five percent or ten percent to a fund that might

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Speaker 1: be a little risk and have a little higher tax effects,

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Speaker 1: but simultaneously could diversify your returns and could generate better

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Speaker 1: than expected returns. You might want to think about this space.

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Speaker 1: You really want to think closely about your strategy and

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Speaker 1: your liquidity requirements, and be aware of the fact that

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Speaker 1: the best funds may not be open to you, and

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Speaker 1: you may not have enough capital to put money in that.

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Speaker 1: But if you're sitting on enough cash, and if you

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Speaker 1: have identified a fund that's a good fit with your

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Speaker 1: strategy and your risk tolerance, there are some advantages to

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Speaker 1: hedge fund investing that you don't get from traditional sixty

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Speaker 1: forty portfolios. I'm Barry Ridults. You're listening to Bloombergs at

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Speaker 1: the Money Enough I want to take a body chet MHM,