WEBVTT - Ted Seides on Whether Hedge Funds Are Right For You

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<v Speaker 1>Bloomberg Audio Studios, podcasts, radio news.

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<v Speaker 2>Gone to.

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<v Speaker 1>Go Thinking about putting some money into hedge funds? You know,

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<v Speaker 1>all the rockstar names who produce eye popping returns. Chasing

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<v Speaker 1>that performance has led the hedge fund space to swell

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<v Speaker 1>to over five trillion dollars in assets today, with forecasts

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<v Speaker 1>topping thirteen trillion globally by twenty thirty two. But not

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<v Speaker 1>all hedge funds are created equally. Investors should ask themselves

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

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

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<v Speaker 1>discuss how you should think about investing your money in

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<v Speaker 1>hedge funds. To help us unpack all of this and

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<v Speaker 1>what it means for your portfolio, top bring in Ted

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<v Speaker 1>Side's Ted began his career under the legendary David Swinson

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<v Speaker 1>at the Yale University Investments Office. Today he's founder and

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<v Speaker 1>CIO of Capital Allocators and hosts a podcast by the

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<v Speaker 1>same name. His book, So You Want to Start a

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<v Speaker 1>Hedge Fund? Lessons for Managers and Allocators is the seminal

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

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<v Speaker 1>the basics why hedge funds. What's the appeal.

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<v Speaker 2>The original premise of hedge funds was to deliver an

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<v Speaker 2>equity like return in marketable securities with less risk than

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<v Speaker 2>the equity markets.

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<v Speaker 1>So literally, hedged funds.

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<v Speaker 2>A fund that had some hedging component that would reduce risk.

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<v Speaker 1>And today I think a lot of so called hedge

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<v Speaker 1>funds are not exactly edged. They seem to be falling

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<v Speaker 1>into all sorts of different silos.

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<v Speaker 2>Yeah, so hedge fund as a term became this very

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<v Speaker 2>ubiquitous label, and if you look at how the industries

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<v Speaker 2>evolve today, you have funds that fall under hedge funds

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<v Speaker 2>that look like that original premise of equity like returns,

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<v Speaker 2>and then you have a whole other set that look

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<v Speaker 2>more like bond like returns. And different strategies can fit

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<v Speaker 2>into those two different groupings.

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<v Speaker 1>So I mentioned in the introduction, we always seem to

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<v Speaker 1>hear about the top two percent of fund managers who

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<v Speaker 1>are the rock stars. Anyone who puts up like really

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<v Speaker 1>big numbers wildly up before in the market sort of

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<v Speaker 1>gets fetted by the media and then they sort of

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<v Speaker 1>fade back into what they were doing. It seems to

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<v Speaker 1>create unrealistic expectations among a lot of investors. What sort

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<v Speaker 1>of investment return expectations should people investing in hedge funds have.

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<v Speaker 2>Yeah, those expectations should be more modest than what you

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<v Speaker 2>might read in the press. Barry. What you just described

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<v Speaker 2>describes markets. People do well, they revert to the mean.

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<v Speaker 2>It happens in every strategy, and certainly the news sensationalizes

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<v Speaker 2>great performance and lousy performance. So what you might read

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<v Speaker 2>in the press is these incredible renaissance medallion fifty percent

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<v Speaker 2>a year with these high.

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

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<v Speaker 1>Zuckerman's book on Jim Simon.

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<v Speaker 2>Now, if you looked at hedge funds as a whole

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<v Speaker 2>and try to get at let's say that equity like

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

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<v Speaker 2>has nothing to do with sixty eight percent. Most of

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<v Speaker 2>the action isn't on either tail. Most of the actions

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<v Speaker 2>right in the middle.

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<v Speaker 1>That seems to be very contrary to how we read

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<v Speaker 1>and hear about hedge funds in the media. Is it

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<v Speaker 1>that whoever's hot at the moment captures, you know, the

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<v Speaker 1>public's fancy and then on to the next That's not

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<v Speaker 1>how the professionals really think about the space, is it.

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<v Speaker 2>No, that's right. I think that's generally how the media

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<v Speaker 2>works it investing. The news stories are the things that

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<v Speaker 2>are on the tails. But it's not how hedge funds

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<v Speaker 2>are invested in by those who have their money at risk.

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<v Speaker 2>They're really looking at it as risk mitigating strategies relative

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<v Speaker 2>to your say, traditional stock and bond alternatives.

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<v Speaker 1>So we talk about alpha, which is outperformance over what

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<v Speaker 1>the market gives you, which is beta. Lately, it seems

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<v Speaker 1>that alpha comes from two places, emerging managers, new fund

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<v Speaker 1>managers who kind of identify market inefficiency, and the quants

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<v Speaker 1>who have seemed to be doing really well as of late.

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<v Speaker 1>What do you think about these two sub sectors within

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<v Speaker 1>the hedge fund space.

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<v Speaker 2>Well, in all the asset management, there's this aphorism size

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<v Speaker 2>is the enemy of performance, and it's certainly been true

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<v Speaker 2>in hedge funds that generally speaking, for a long time,

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<v Speaker 2>smaller funds have done better than larger funds. Not so

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<v Speaker 2>sure that's the case of emerging funds, which means new

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

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<v Speaker 2>and it gets into the quant is more and more

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<v Speaker 2>money has been sucked in by these so called platform

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<v Speaker 2>hedge funds. So Citadel Millennium point seventy two, places like that,

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<v Speaker 2>where have they have multiple portfolio managers and do a

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<v Speaker 2>phenomenal job at risk control, and they've seemingly in good

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<v Speaker 2>markets and bad generated that nice equity like expected return,

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<v Speaker 2>and there has to be alpha in that because there's

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<v Speaker 2>not a lot of beta.

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<v Speaker 1>That's really kind of interesting. You said something in your

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<v Speaker 1>book that resonated with me. The best allocators establish clear

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<v Speaker 1>processes for evaluating opportunities and setting priorities. Explain what you

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<v Speaker 1>mean by that.

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<v Speaker 2>Well, before you just decide I want to invest in

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<v Speaker 2>a hedge fund, it's really important to understand how are

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<v Speaker 2>you thinking about your portfolio and how do hedge funds

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<v Speaker 2>fit in. Now, keep in mind hedge funds can mean

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<v Speaker 2>lots of different things, and that the strategies pursued by

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<v Speaker 2>one hedge funds is going to look totally different from

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<v Speaker 2>another one. So you need to understand what is it

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<v Speaker 2>you're trying to accomplish. Are you trying to beat the

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<v Speaker 2>markets with your hedge fund allocation? Okay, you better go

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<v Speaker 2>to one that takes a lot of aggressive risk. Are

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<v Speaker 2>you trying to mitigate equity risk but get equity like returns. Okay,

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<v Speaker 2>you might want to look at a Jones model hedge

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<v Speaker 2>fund that has lungs and shorts but has market risk,

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<v Speaker 2>or are you trying to beat the bond markets? You

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<v Speaker 2>better go to one that doesn't take equity risk. So

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<v Speaker 2>you need to understand in advance what is it you're

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<v Speaker 2>trying to accomplish through that investment, and then go look

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<v Speaker 2>for the solution, not the other way around, just by saying, oh,

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<v Speaker 2>hedge funds are a good thing, let me go invest

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<v Speaker 2>in them.

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<v Speaker 1>So that sounds a lot like another phrase I read

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<v Speaker 1>in the book, and acute awareness of risk? Should investors

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<v Speaker 1>be thinking about performance first? Should they be thinking about

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<v Speaker 1>risk first? Or are these two sides of this coin?

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<v Speaker 2>There are two sides of the same coin, but without

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<v Speaker 2>a doubt, investors should be thinking about risk first. And

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<v Speaker 2>that's not specific to hedge funds. I would argue that's

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<v Speaker 2>true in all of investing. If you understand the risk

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<v Speaker 2>you're taking and you look for some type of asymmetry

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<v Speaker 2>or convexity, the rewards can take care of themselves. But

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<v Speaker 2>where you really get tripped up in hedge funds and

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<v Speaker 2>there's a long history of this, going back to long

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<v Speaker 2>term capital in nineteen ninety eight is when risk gets

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<v Speaker 2>out of control.

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<v Speaker 1>And long term capital management very famously blew up when

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<v Speaker 1>Russia defaulted on their bonds. They were leveraged one hundred

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<v Speaker 1>to one, so this wasn't like a bad year, this

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<v Speaker 1>was pretty much a wipeout. How can an investor evaluate

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<v Speaker 1>those risks in advance.

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

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<v Speaker 2>and illiquidity. Take any one of those risks, but if

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<v Speaker 2>you take two or certainly three at the same time,

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<v Speaker 2>that's a recipe for disaster.

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<v Speaker 1>So your podcast is called Capital Allocators. Leads to the

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<v Speaker 1>obvious question, what percentage of capital should investors be thinking

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<v Speaker 1>about allocating to hedge funds? Whether they're a large institution

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<v Speaker 1>or just a high net worth family office. Where do

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<v Speaker 1>we go in terms of what's a reasonable amount of

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<v Speaker 1>risk to take relative to the capital appreciation you're seeking.

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<v Speaker 2>Well, if you start with a traditional risk construct, so

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

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<v Speaker 2>say seventy thirty, the question becomes outside of your stocks

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<v Speaker 2>and bonds, where can you get diversification, And you might

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<v Speaker 2>want to say, okay, I want equity like hedge funds.

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<v Speaker 2>And if you look at some of the most sophisticated institutions,

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<v Speaker 2>that might be as much as twenty percent of their portfolio.

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<v Speaker 2>The biggest difference for those institutions and the high net

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<v Speaker 2>worth individuals are taxes. Most hedge fund strategies are tax inefficient.

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<v Speaker 2>So that of that five trillion dollars, the vast majority

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<v Speaker 2>of it, maybe even as much as ninety percent, are

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<v Speaker 2>non taxable investors. There are only some hedge fund strategies,

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<v Speaker 2>and they tend to be things like activism that have

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<v Speaker 2>longer duration investment holding periods that make sense for taxable investors.

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<v Speaker 1>So and when you say non taxable investors, I'm thinking

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<v Speaker 1>of foundations, endowments large, not even tax deferred, just tax

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<v Speaker 1>exempt entities that can put that money to work without

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<v Speaker 1>worrying about Uncle Sam.

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<v Speaker 2>That is, that's right, YEA pension funds non US investors

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<v Speaker 2>as well.

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<v Speaker 1>All right, So if you're not you know, the l endowment,

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<v Speaker 1>but you're running a pool of money, how much do

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<v Speaker 1>you need to have to think about hedge funds as

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<v Speaker 1>an alternative for your portfolio.

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<v Speaker 2>You're probably in the double digit millions before millions and

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<v Speaker 2>nothing about it.

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<v Speaker 1>Yeah, ten million and up, and you could start thinking

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<v Speaker 1>about it and then what's a rational percentage? Is this

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<v Speaker 1>a ten percent shift or is this something more or less?

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<v Speaker 2>I know, for me individually, it's a lot less than

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<v Speaker 2>it was when I was managing capital for institutions. So

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<v Speaker 2>for me individually, it's about five percent because I need

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<v Speaker 2>to feel like the managers are so good that they

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<v Speaker 2>can make up for that tax disadvantage.

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<v Speaker 1>And so taxes are part of it. Ill equidally is

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<v Speaker 1>part of it, and risk is part of it. Are

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<v Speaker 1>those Is that the unholy trifecta that keep you at

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<v Speaker 1>five percent?

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<v Speaker 2>Yeah, depending on the strategy. A lot of hedgehund strategies

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<v Speaker 2>have quarterly liquidity, so it's not daily, but they are

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

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<v Speaker 2>just risk. How much risk are you willing to take

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<v Speaker 2>in the markets?

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<v Speaker 1>And you know, since you mentioned liquidally, we hear about

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<v Speaker 1>gates going up every now and then. Where a hedge

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<v Speaker 1>funnel say, hey, we're we're you know a little this

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<v Speaker 1>quarter and we're not letting any money out. How do

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<v Speaker 1>you deal with that, as an investor, you have to be.

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<v Speaker 2>Very careful about what the structure of your investment is.

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<v Speaker 2>So to take an example, in the world of credit,

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<v Speaker 2>distressed debt used to be bucketed in hedge fund strategies

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<v Speaker 2>with quarterly liquidity, but it's not a great match for

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<v Speaker 2>the underlying liquidity of those debt instruments. More and more

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<v Speaker 2>those moved into medium terms, a two to five year

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<v Speaker 2>investment vehicles, and now you see much more of that

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<v Speaker 2>in the private credit world that have an asset liability match.

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<v Speaker 2>It's much more appropriate for the underlying assets. So it's

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<v Speaker 2>less what the liquidity is and trying to make sure

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<v Speaker 2>that whatever that hedge fund manager is investing in is

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<v Speaker 2>appropriate for the liquidity that they're offering.

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<v Speaker 1>So let's talk a little bit about performance. Before the

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<v Speaker 1>Financial Crisis, it seemed that every hedge fund was just

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<v Speaker 1>killing it and printing money. Following the Great Financial Crisis,

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<v Speaker 1>hedge funds have struggled. Some people have said, you only

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<v Speaker 1>want to be in the top decile or two. What

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<v Speaker 1>are your thoughts on who's generating alpha and how far

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<v Speaker 1>down the line you could go before you know you're

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<v Speaker 1>in the bottom half of the performance track.

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<v Speaker 2>Yeah, I mean over these last fifteen years, the world

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<v Speaker 2>has gotten a lot more competitive. So for sure, whatever

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<v Speaker 2>pool of alpha is available before the financial crisis, if

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<v Speaker 2>it's the same pool, it's there are a lot more

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<v Speaker 2>dollars pursuing it, and it's been much harder to extract

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<v Speaker 2>those returns. So I do think it's become the case

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<v Speaker 2>that some of the more proven managers that have demonstrated

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<v Speaker 2>they can generate excess returns are the ones who have

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<v Speaker 2>commanded more dollars. And so you've seen an increased concentration

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<v Speaker 2>of the assets going to certain managers in the hedge

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<v Speaker 2>fund space.

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<v Speaker 1>Let's talk about fees. Two and twenty has been the

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<v Speaker 1>famous number for hedge funds for a long time. Although

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<v Speaker 1>we have heard over the past ten years about one

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<v Speaker 1>in ten, one in fifteen, where are we in the

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<v Speaker 1>world of fees.

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<v Speaker 2>You don't see a lot of two and twenty. And

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<v Speaker 2>part of that is that fees are just determined by

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<v Speaker 2>supply and demand. Think of it as a clearing price

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<v Speaker 2>for supply and demand. So when returns generally have come down,

0:13:15.400 --> 0:13:18.959
<v Speaker 2>those strategies don't really command as high a fee structure

0:13:18.960 --> 0:13:22.480
<v Speaker 2>because the gross return is lower. The pies a little smaller.

0:13:22.640 --> 0:13:24.920
<v Speaker 2>You need to take a smaller slice of that pie.

0:13:25.640 --> 0:13:28.040
<v Speaker 2>The exceptions to that, of course, are the managers who

0:13:28.040 --> 0:13:31.240
<v Speaker 2>have continued to deliver, and in some instances you actually

0:13:31.240 --> 0:13:32.439
<v Speaker 2>see fees going.

0:13:32.320 --> 0:13:34.000
<v Speaker 1>Up three and thirty.

0:13:34.280 --> 0:13:36.440
<v Speaker 2>You've seen a deep Shaw raise their fees a year

0:13:36.520 --> 0:13:39.320
<v Speaker 2>or two go. But for the most part, that kind

0:13:39.320 --> 0:13:42.720
<v Speaker 2>of one and a half and fifteen is probably around

0:13:42.840 --> 0:13:43.840
<v Speaker 2>where the industry is.

0:13:44.280 --> 0:13:47.040
<v Speaker 1>And there was a movement a couple of years ago

0:13:47.160 --> 0:13:51.560
<v Speaker 1>towards pivot fees or beta plus, which was, hey, we're

0:13:51.559 --> 0:13:53.839
<v Speaker 1>going to charge you a very modest fee and you're

0:13:53.880 --> 0:13:57.600
<v Speaker 1>going to pay us only on our outperformance over the market.

0:13:57.960 --> 0:14:01.240
<v Speaker 1>What happened with that movement? Did that gain any traction

0:14:01.720 --> 0:14:02.640
<v Speaker 1>or where are we with that?

0:14:04.400 --> 0:14:07.520
<v Speaker 2>Most of the institutions would be happy to pay high

0:14:07.559 --> 0:14:11.600
<v Speaker 2>fees for true alpha, so there are always efforts to

0:14:11.640 --> 0:14:13.839
<v Speaker 2>try to figure out how do you separate the alpha

0:14:13.920 --> 0:14:16.800
<v Speaker 2>from the beta? How can we pay not much for

0:14:16.840 --> 0:14:20.200
<v Speaker 2>the beta and happy to pay a lot for the alpha.

0:14:20.280 --> 0:14:23.080
<v Speaker 2>At the same time, of the five trillion in assets,

0:14:23.240 --> 0:14:26.480
<v Speaker 2>two or three trillion have existed before people started talking

0:14:26.480 --> 0:14:28.560
<v Speaker 2>about that, so you already had a handshake on what

0:14:28.600 --> 0:14:31.720
<v Speaker 2>the deal is those handshakes often are difficult to change,

0:14:32.040 --> 0:14:35.320
<v Speaker 2>but for sure in new structures, when new capital gets allocated,

0:14:35.360 --> 0:14:40.680
<v Speaker 2>you do see that attempt to really isolate paying for performance.

0:14:41.800 --> 0:14:44.360
<v Speaker 1>So to sum up, if you have a long term

0:14:44.360 --> 0:14:47.680
<v Speaker 1>perspective and you're not awed by some of the big

0:14:47.800 --> 0:14:51.880
<v Speaker 1>names and rock stars who occasionally put up spectacular numbers,

0:14:52.320 --> 0:14:55.720
<v Speaker 1>and you're sitting on enough capital that you can allocate

0:14:55.880 --> 0:14:59.160
<v Speaker 1>five percent or ten percent to a fund that might

0:14:59.200 --> 0:15:03.440
<v Speaker 1>be a little risk and have a little higher tax effects,

0:15:03.560 --> 0:15:10.360
<v Speaker 1>but simultaneously could diversify your returns and could generate better

0:15:10.400 --> 0:15:14.160
<v Speaker 1>than expected returns. You might want to think about this space.

0:15:14.720 --> 0:15:18.440
<v Speaker 1>You really want to think closely about your strategy and

0:15:18.520 --> 0:15:22.880
<v Speaker 1>your liquidity requirements, and be aware of the fact that

0:15:23.560 --> 0:15:26.520
<v Speaker 1>the best funds may not be open to you, and

0:15:26.560 --> 0:15:29.440
<v Speaker 1>you may not have enough capital to put money in that.

0:15:29.960 --> 0:15:32.560
<v Speaker 1>But if you're sitting on enough cash, and if you

0:15:32.720 --> 0:15:36.280
<v Speaker 1>have identified a fund that's a good fit with your

0:15:36.320 --> 0:15:39.960
<v Speaker 1>strategy and your risk tolerance, there are some advantages to

0:15:40.000 --> 0:15:43.560
<v Speaker 1>hedge fund investing that you don't get from traditional sixty

0:15:43.640 --> 0:15:48.880
<v Speaker 1>forty portfolios. I'm Barry Ridults. You're listening to Bloombergs at

0:15:48.920 --> 0:16:07.880
<v Speaker 1>the Money Enough I want to take a body chet MHM,