Speaker 1: Bloomberg Audio Studios, podcasts, radio news.
Speaker 2: Gone to.
Speaker 1: Go Thinking about putting some money into hedge funds? You know,
Speaker 1: all the rockstar names who produce eye popping returns. Chasing
Speaker 1: that performance has led the hedge fund space to swell
Speaker 1: to over five trillion dollars in assets today, with forecasts
Speaker 1: topping thirteen trillion globally by twenty thirty two. But not
Speaker 1: all hedge funds are created equally. Investors should ask themselves
Speaker 1: is this the right investment vehicle for me? I'm Barry Ridolts,
Speaker 1: and on today's edition of At the Money, we're gonna
Speaker 1: discuss how you should think about investing your money in
Speaker 1: hedge funds. To help us unpack all of this and
Speaker 1: what it means for your portfolio, top bring in Ted
Speaker 1: Side's Ted began his career under the legendary David Swinson
Speaker 1: at the Yale University Investments Office. Today he's founder and
Speaker 1: CIO of Capital Allocators and hosts a podcast by the
Speaker 1: same name. His book, So You Want to Start a
Speaker 1: Hedge Fund? Lessons for Managers and Allocators is the seminal
Speaker 1: work in the space. So Ted, let's start out with
Speaker 1: the basics why hedge funds. What's the appeal.
Speaker 2: The original premise of hedge funds was to deliver an
Speaker 2: equity like return in marketable securities with less risk than
Speaker 2: the equity markets.
Speaker 1: So literally, hedged funds.
Speaker 2: A fund that had some hedging component that would reduce risk.
Speaker 1: And today I think a lot of so called hedge
Speaker 1: funds are not exactly edged. They seem to be falling
Speaker 1: into all sorts of different silos.
Speaker 2: Yeah, so hedge fund as a term became this very
Speaker 2: ubiquitous label, and if you look at how the industries
Speaker 2: evolve today, you have funds that fall under hedge funds
Speaker 2: that look like that original premise of equity like returns,
Speaker 2: and then you have a whole other set that look
Speaker 2: more like bond like returns. And different strategies can fit
Speaker 2: into those two different groupings.
Speaker 1: So I mentioned in the introduction, we always seem to
Speaker 1: hear about the top two percent of fund managers who
Speaker 1: are the rock stars. Anyone who puts up like really
Speaker 1: big numbers wildly up before in the market sort of
Speaker 1: gets fetted by the media and then they sort of
Speaker 1: fade back into what they were doing. It seems to
Speaker 1: create unrealistic expectations among a lot of investors. What sort
Speaker 1: of investment return expectations should people investing in hedge funds have.
Speaker 2: Yeah, those expectations should be more modest than what you
Speaker 2: might read in the press. Barry. What you just described
Speaker 2: describes markets. People do well, they revert to the mean.
Speaker 2: It happens in every strategy, and certainly the news sensationalizes
Speaker 2: great performance and lousy performance. So what you might read
Speaker 2: in the press is these incredible renaissance medallion fifty percent
Speaker 2: a year with these high.
Speaker 1: Fees sixty eight percent. If I recall Zuckerman's book, Greg
Speaker 1: Zuckerman's book on Jim Simon.
Speaker 2: Now, if you looked at hedge funds as a whole
Speaker 2: and try to get at let's say that equity like
Speaker 2: expected return you're talking about like a high single digits number,
Speaker 2: has nothing to do with sixty eight percent. Most of
Speaker 2: the action isn't on either tail. Most of the actions
Speaker 2: right in the middle.
Speaker 1: That seems to be very contrary to how we read
Speaker 1: and hear about hedge funds in the media. Is it
Speaker 1: that whoever's hot at the moment captures, you know, the
Speaker 1: public's fancy and then on to the next That's not
Speaker 1: how the professionals really think about the space, is it.
Speaker 2: No, that's right. I think that's generally how the media
Speaker 2: works it investing. The news stories are the things that
Speaker 2: are on the tails. But it's not how hedge funds
Speaker 2: are invested in by those who have their money at risk.
Speaker 2: They're really looking at it as risk mitigating strategies relative
Speaker 2: to your say, traditional stock and bond alternatives.
Speaker 1: So we talk about alpha, which is outperformance over what
Speaker 1: the market gives you, which is beta. Lately, it seems
Speaker 1: that alpha comes from two places, emerging managers, new fund
Speaker 1: managers who kind of identify market inefficiency, and the quants
Speaker 1: who have seemed to be doing really well as of late.
Speaker 1: What do you think about these two sub sectors within
Speaker 1: the hedge fund space.
Speaker 2: Well, in all the asset management, there's this aphorism size
Speaker 2: is the enemy of performance, and it's certainly been true
Speaker 2: in hedge funds that generally speaking, for a long time,
Speaker 2: smaller funds have done better than larger funds. Not so
Speaker 2: sure that's the case of emerging funds, which means new
Speaker 2: but on size you get that. Now, what's an interesting dynamic,
Speaker 2: and it gets into the quant is more and more
Speaker 2: money has been sucked in by these so called platform
Speaker 2: hedge funds. So Citadel Millennium point seventy two, places like that,
Speaker 2: where have they have multiple portfolio managers and do a
Speaker 2: phenomenal job at risk control, and they've seemingly in good
Speaker 2: markets and bad generated that nice equity like expected return,
Speaker 2: and there has to be alpha in that because there's
Speaker 2: not a lot of beta.
Speaker 1: That's really kind of interesting. You said something in your
Speaker 1: book that resonated with me. The best allocators establish clear
Speaker 1: processes for evaluating opportunities and setting priorities. Explain what you
Speaker 1: mean by that.
Speaker 2: Well, before you just decide I want to invest in
Speaker 2: a hedge fund, it's really important to understand how are
Speaker 2: you thinking about your portfolio and how do hedge funds
Speaker 2: fit in. Now, keep in mind hedge funds can mean
Speaker 2: lots of different things, and that the strategies pursued by
Speaker 2: one hedge funds is going to look totally different from
Speaker 2: another one. So you need to understand what is it
Speaker 2: you're trying to accomplish. Are you trying to beat the
Speaker 2: markets with your hedge fund allocation? Okay, you better go
Speaker 2: to one that takes a lot of aggressive risk. Are
Speaker 2: you trying to mitigate equity risk but get equity like returns. Okay,
Speaker 2: you might want to look at a Jones model hedge
Speaker 2: fund that has lungs and shorts but has market risk,
Speaker 2: or are you trying to beat the bond markets? You
Speaker 2: better go to one that doesn't take equity risk. So
Speaker 2: you need to understand in advance what is it you're
Speaker 2: trying to accomplish through that investment, and then go look
Speaker 2: for the solution, not the other way around, just by saying, oh,
Speaker 2: hedge funds are a good thing, let me go invest
Speaker 2: in them.
Speaker 1: So that sounds a lot like another phrase I read
Speaker 1: in the book, and acute awareness of risk? Should investors
Speaker 1: be thinking about performance first? Should they be thinking about
Speaker 1: risk first? Or are these two sides of this coin?
Speaker 2: There are two sides of the same coin, but without
Speaker 2: a doubt, investors should be thinking about risk first. And
Speaker 2: that's not specific to hedge funds. I would argue that's
Speaker 2: true in all of investing. If you understand the risk
Speaker 2: you're taking and you look for some type of asymmetry
Speaker 2: or convexity, the rewards can take care of themselves. But
Speaker 2: where you really get tripped up in hedge funds and
Speaker 2: there's a long history of this, going back to long
Speaker 2: term capital in nineteen ninety eight is when risk gets
Speaker 2: out of control.
Speaker 1: And long term capital management very famously blew up when
Speaker 1: Russia defaulted on their bonds. They were leveraged one hundred
Speaker 1: to one, so this wasn't like a bad year, this
Speaker 1: was pretty much a wipeout. How can an investor evaluate
Speaker 1: those risks in advance.
Speaker 2: Well, there are three pillars that don't go together. Well, concentration, leverage,
Speaker 2: and illiquidity. Take any one of those risks, but if
Speaker 2: you take two or certainly three at the same time,
Speaker 2: that's a recipe for disaster.
Speaker 1: So your podcast is called Capital Allocators. Leads to the
Speaker 1: obvious question, what percentage of capital should investors be thinking
Speaker 1: about allocating to hedge funds? Whether they're a large institution
Speaker 1: or just a high net worth family office. Where do
Speaker 1: we go in terms of what's a reasonable amount of
Speaker 1: risk to take relative to the capital appreciation you're seeking.
Speaker 2: Well, if you start with a traditional risk construct, so
Speaker 2: let's say that's a seventy thirty stock bond or sixty forty,
Speaker 2: say seventy thirty, the question becomes outside of your stocks
Speaker 2: and bonds, where can you get diversification, And you might
Speaker 2: want to say, okay, I want equity like hedge funds.
Speaker 2: And if you look at some of the most sophisticated institutions,
Speaker 2: that might be as much as twenty percent of their portfolio.
Speaker 2: The biggest difference for those institutions and the high net
Speaker 2: worth individuals are taxes. Most hedge fund strategies are tax inefficient.
Speaker 2: So that of that five trillion dollars, the vast majority
Speaker 2: of it, maybe even as much as ninety percent, are
Speaker 2: non taxable investors. There are only some hedge fund strategies,
Speaker 2: and they tend to be things like activism that have
Speaker 2: longer duration investment holding periods that make sense for taxable investors.
Speaker 1: So and when you say non taxable investors, I'm thinking
Speaker 1: of foundations, endowments large, not even tax deferred, just tax
Speaker 1: exempt entities that can put that money to work without
Speaker 1: worrying about Uncle Sam.
Speaker 2: That is, that's right, YEA pension funds non US investors
Speaker 2: as well.
Speaker 1: All right, So if you're not you know, the l endowment,
Speaker 1: but you're running a pool of money, how much do
Speaker 1: you need to have to think about hedge funds as
Speaker 1: an alternative for your portfolio.
Speaker 2: You're probably in the double digit millions before millions and
Speaker 2: nothing about it.
Speaker 1: Yeah, ten million and up, and you could start thinking
Speaker 1: about it and then what's a rational percentage? Is this
Speaker 1: a ten percent shift or is this something more or less?
Speaker 2: I know, for me individually, it's a lot less than
Speaker 2: it was when I was managing capital for institutions. So
Speaker 2: for me individually, it's about five percent because I need
Speaker 2: to feel like the managers are so good that they
Speaker 2: can make up for that tax disadvantage.
Speaker 1: And so taxes are part of it. Ill equidally is
Speaker 1: part of it, and risk is part of it. Are
Speaker 1: those Is that the unholy trifecta that keep you at
Speaker 1: five percent?
Speaker 2: Yeah, depending on the strategy. A lot of hedgehund strategies
Speaker 2: have quarterly liquidity, so it's not daily, but they are
Speaker 2: relatively liquid. But for sure taxes matter, and then it's
Speaker 2: just risk. How much risk are you willing to take
Speaker 2: in the markets?
Speaker 1: And you know, since you mentioned liquidally, we hear about
Speaker 1: gates going up every now and then. Where a hedge
Speaker 1: funnel say, hey, we're we're you know a little this
Speaker 1: quarter and we're not letting any money out. How do
Speaker 1: you deal with that, as an investor, you have to be.
Speaker 2: Very careful about what the structure of your investment is.
Speaker 2: So to take an example, in the world of credit,
Speaker 2: distressed debt used to be bucketed in hedge fund strategies
Speaker 2: with quarterly liquidity, but it's not a great match for
Speaker 2: the underlying liquidity of those debt instruments. More and more
Speaker 2: those moved into medium terms, a two to five year
Speaker 2: investment vehicles, and now you see much more of that
Speaker 2: in the private credit world that have an asset liability match.
Speaker 2: It's much more appropriate for the underlying assets. So it's
Speaker 2: less what the liquidity is and trying to make sure
Speaker 2: that whatever that hedge fund manager is investing in is
Speaker 2: appropriate for the liquidity that they're offering.
Speaker 1: So let's talk a little bit about performance. Before the
Speaker 1: Financial Crisis, it seemed that every hedge fund was just
Speaker 1: killing it and printing money. Following the Great Financial Crisis,
Speaker 1: hedge funds have struggled. Some people have said, you only
Speaker 1: want to be in the top decile or two. What
Speaker 1: are your thoughts on who's generating alpha and how far
Speaker 1: down the line you could go before you know you're
Speaker 1: in the bottom half of the performance track.
Speaker 2: Yeah, I mean over these last fifteen years, the world
Speaker 2: has gotten a lot more competitive. So for sure, whatever
Speaker 2: pool of alpha is available before the financial crisis, if
Speaker 2: it's the same pool, it's there are a lot more
Speaker 2: dollars pursuing it, and it's been much harder to extract
Speaker 2: those returns. So I do think it's become the case
Speaker 2: that some of the more proven managers that have demonstrated
Speaker 2: they can generate excess returns are the ones who have
Speaker 2: commanded more dollars. And so you've seen an increased concentration
Speaker 2: of the assets going to certain managers in the hedge
Speaker 2: fund space.
Speaker 1: Let's talk about fees. Two and twenty has been the
Speaker 1: famous number for hedge funds for a long time. Although
Speaker 1: we have heard over the past ten years about one
Speaker 1: in ten, one in fifteen, where are we in the
Speaker 1: world of fees.
Speaker 2: You don't see a lot of two and twenty. And
Speaker 2: part of that is that fees are just determined by
Speaker 2: supply and demand. Think of it as a clearing price
Speaker 2: for supply and demand. So when returns generally have come down,
Speaker 2: those strategies don't really command as high a fee structure
Speaker 2: because the gross return is lower. The pies a little smaller.
Speaker 2: You need to take a smaller slice of that pie.
Speaker 2: The exceptions to that, of course, are the managers who
Speaker 2: have continued to deliver, and in some instances you actually
Speaker 2: see fees going.
Speaker 1: Up three and thirty.
Speaker 2: You've seen a deep Shaw raise their fees a year
Speaker 2: or two go. But for the most part, that kind
Speaker 2: of one and a half and fifteen is probably around
Speaker 2: where the industry is.
Speaker 1: And there was a movement a couple of years ago
Speaker 1: towards pivot fees or beta plus, which was, hey, we're
Speaker 1: going to charge you a very modest fee and you're
Speaker 1: going to pay us only on our outperformance over the market.
Speaker 1: What happened with that movement? Did that gain any traction
Speaker 1: or where are we with that?
Speaker 2: Most of the institutions would be happy to pay high
Speaker 2: fees for true alpha, so there are always efforts to
Speaker 2: try to figure out how do you separate the alpha
Speaker 2: from the beta? How can we pay not much for
Speaker 2: the beta and happy to pay a lot for the alpha.
Speaker 2: At the same time, of the five trillion in assets,
Speaker 2: two or three trillion have existed before people started talking
Speaker 2: about that, so you already had a handshake on what
Speaker 2: the deal is those handshakes often are difficult to change,
Speaker 2: but for sure in new structures, when new capital gets allocated,
Speaker 2: you do see that attempt to really isolate paying for performance.
Speaker 1: So to sum up, if you have a long term
Speaker 1: perspective and you're not awed by some of the big
Speaker 1: names and rock stars who occasionally put up spectacular numbers,
Speaker 1: and you're sitting on enough capital that you can allocate
Speaker 1: five percent or ten percent to a fund that might
Speaker 1: be a little risk and have a little higher tax effects,
Speaker 1: but simultaneously could diversify your returns and could generate better
Speaker 1: than expected returns. You might want to think about this space.
Speaker 1: You really want to think closely about your strategy and
Speaker 1: your liquidity requirements, and be aware of the fact that
Speaker 1: the best funds may not be open to you, and
Speaker 1: you may not have enough capital to put money in that.
Speaker 1: But if you're sitting on enough cash, and if you
Speaker 1: have identified a fund that's a good fit with your
Speaker 1: strategy and your risk tolerance, there are some advantages to
Speaker 1: hedge fund investing that you don't get from traditional sixty
Speaker 1: forty portfolios. I'm Barry Ridults. You're listening to Bloombergs at
Speaker 1: the Money Enough I want to take a body chet MHM,