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

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Speaker 2: Thinking about putting some money into hedge funds? You know,

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Speaker 2: all the rockstar names who produce eye popping returns. Chasing

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Speaker 2: that performance has led the hedge fund space to swell

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Speaker 2: to over five trillion dollars in assets, with forecasts topping

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Speaker 2: thirteen trillion globally by twenty thirty two. But not all

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Speaker 2: hedge funds are created equally. Investors should ask themselves is

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Speaker 2: this the right investment vehicle for me? I'm Barry Ritolts,

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Speaker 2: and on today's edition of At the Money, we're gonna

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Speaker 2: discuss how you should think about investing your money in

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Speaker 2: hedge funds. To help us unpack all of this and

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Speaker 2: what it means for your portfolio, let's bring a Ted Side's.

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Speaker 2: Ted began his career under the legendary David Swinson at

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Speaker 2: the Yale University Investments Office. Today he's founder and CIO

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Speaker 2: of Capital Allocators and hosts a podcast by the same name.

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Speaker 2: His book, So You Want to Start a Hedge Fund?

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Speaker 2: Lessons for Managers and Allocators is the seminal work in

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Speaker 2: the space. So Ted, let's start out with the basics

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Speaker 2: why hedge funds. What's the appeal.

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Speaker 3: The original premise of hedge funds was to deliver an

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Speaker 3: equity like return in marketable securities with less risk than

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Speaker 3: the equity markets.

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Speaker 2: So literally, hedged funds.

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Speaker 3: A fund that had some hedging component that would reduce risk.

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Speaker 2: And today I think a lot of so called hedge

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Speaker 2: funds are not exactly edged. They seem to be falling

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Speaker 2: into all sorts of different silos.

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Speaker 3: Yeah, so hedge fund as a term became this very

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Speaker 3: ubiquitous label, And if you look at how the industries

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Speaker 3: evolve today, you have funds that fall under hedge funds

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Speaker 3: that look like that original premise of equity like returns,

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Speaker 3: and then you have a whole other set that look

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Speaker 3: more like bond like returns. And different strategies can fit

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Speaker 3: into those two different groupings.

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Speaker 2: So I mentioned in the introduction, we always seem to

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Speaker 2: hear about the top two percent of fund managers who

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Speaker 2: are the rock stars. Anyone who puts up like really

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Speaker 2: big numbers, wildly up erform in the market sort of

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Speaker 2: gets fetted by the media and then they sort of

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Speaker 2: fade back into what they were doing. It seems to

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Speaker 2: create unrealistic expectations among a lot of investors. What sort

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Speaker 2: of investment return expectations should people investing in hedge funds have.

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Speaker 3: Yeah, those expectations should be more modest than what you

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Speaker 3: might read in the press, Barry. What you just described

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Speaker 3: describes markets. People do well, they revert to the mean.

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Speaker 3: It happens in every strategy, and certainly the news sensationalizes

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Speaker 3: great perform, wormants and lousy performance. So what you might

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Speaker 3: read in the press is these incredible renaissancement dallion fifty

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Speaker 3: percent a year with these high fees.

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Speaker 2: Sixty eight percent. If I recall Zuckerman's book, Greg Zuckerman's

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Speaker 2: book on Jim Simon.

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Speaker 3: Now, if you looked at hedge funds as a whole

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Speaker 3: and try to get at let's say that equity like

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Speaker 3: expected return you're talking about, like a high single digits number,

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Speaker 3: has nothing to do with sixty eight percent. Most of

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Speaker 3: the action isn't on either tail. Most of the actions

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Speaker 3: right in the middle.

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Speaker 2: That seems to be very contrary to how we read

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Speaker 2: and hear about hedge funds in the media. Is it

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Speaker 2: that whoever's hot at the moment captures, you know, the

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Speaker 2: public's fancy and then on to the next that's not

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Speaker 2: how the professionals really think about the space, is it.

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Speaker 3: No, that's right. I think that's generally how the media

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Speaker 3: works it investing. The news stories are the things that

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Speaker 3: are on the tail. But it's not how hedge funds

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Speaker 3: are invested in by those who have their money at risk.

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Speaker 3: They're really looking at it as risk mitigating strategies relative

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Speaker 3: to your say, traditional stock and bond alternatives.

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Speaker 2: So we talk about alpha, which is outperformance over what

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Speaker 2: the market gives you, which is beta. Lately, it seems

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Speaker 2: that alpha comes from two places, emerging managers, new fund

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Speaker 2: managers who kind of identify market inefficiency, and the quants

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Speaker 2: who have seemed to be doing really well as of late.

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Speaker 2: What do you think about these two sub sectors within

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Speaker 2: the hedge fund space.

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Speaker 3: Well, all of the asset management, there's this aphorism size

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Speaker 3: is the enemy of performance, and it's certainly been true

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Speaker 3: in hedge funds that generally speaking, for a long time,

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Speaker 3: smaller funds have done better than larger funds. Not so

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Speaker 3: sure that's the case of emerging funds, which means new

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Speaker 3: but on size you get that. Now, what's an interesting

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Speaker 3: dynamic and it gets into the quant is more and

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Speaker 3: more money has been sucked in by these so called

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Speaker 3: platform hedge funds. So Citadel Millennium point seventy two, places

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Speaker 3: like that, where have they have multiple portfolio managers and

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Speaker 3: do a phenomenal job at risk control, and they've seemingly

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Speaker 3: in good markets and bad generated that nice equity like

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Speaker 3: expective return, and there has to be alpha in that

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Speaker 3: because there's not a lot of beta.

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Speaker 2: That's really kind of interesting. You said something in your

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Speaker 2: book that resonated with me. The best allocators establish clear

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Speaker 2: processes for evaluating opportunities and setting priorities. Explain what you

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Speaker 2: mean by that.

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Speaker 3: Well, before you just decide I want to invest in

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Speaker 3: a hedge fund, it's really important to understand how are

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Speaker 3: you thinking about your portfolio and how do hedge funds

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Speaker 3: fit in. Now, keep in mind hedge funds can mean

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Speaker 3: lots of different things, and that the strategies pursued by

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Speaker 3: one hedge funds is going to look totally different from

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Speaker 3: another one. So you need to understand what is it

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Speaker 3: you're trying to accomplish. Are you trying to beat the

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Speaker 3: markets with your hedge fund allocation? Okay, you better go

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Speaker 3: to one that takes a lot of aggressive risk. Are

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Speaker 3: you trying to mitigate equity risk but get equity like returns? Okay,

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Speaker 3: you might want to look at a Jones model hedge

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Speaker 3: fund that has lungs and shorts but has market risk.

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Speaker 3: Or are you trying to beat the bond markets? You

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Speaker 3: better go to one that doesn't take equity risk. So

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Speaker 3: you need to understand in advance what is it you're

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Speaker 3: trying to accomplish through that investment, and then go look

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Speaker 3: for the solution, not the other way around, just by saying, oh,

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Speaker 3: hedge funds are a good thing, let me go invest

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Speaker 3: in them.

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Speaker 2: So that sounds a lot like another phrase I read

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Speaker 2: in the book, and acute awareness of risk. Should investors

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Speaker 2: be thinking about performance first? Should they be thinking about

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Speaker 2: risk first? Or are these two sides of the same court.

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Speaker 3: There are two sides of the same coin, but without

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Speaker 3: a doubt, investors should be thinking about risk first. And

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Speaker 3: that's not specific to hedge funds. I would argue that's

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Speaker 3: true in all of investing. If you understand the risk

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Speaker 3: you're taking and you look for some type of asymmetry

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Speaker 3: or convexity, the rewards can take care of themselves. But

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Speaker 3: where you really get tripped up in hedge funds, and

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Speaker 3: there's a long history of this, going back to long

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Speaker 3: term capital in nineteen ninety eight is when risk gets

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Speaker 3: out of control.

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Speaker 1: And.

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Speaker 2: Long term capital management very famously blew up when Russia

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Speaker 2: defaulted on their bonds. They were leveraged one hundred to one,

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Speaker 2: so this wasn't like a bad year, this was pretty

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Speaker 2: much a wipeout. How can an investor evaluate those risks

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Speaker 2: in advance.

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Speaker 3: Well, there are three pillars that don't go together, well, concentration, leverage,

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Speaker 3: and illiquidity. You can take any one of those risks,

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Speaker 3: but if you take two or certainly three at the

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Speaker 3: same time, that's a recipe for disaster.

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Speaker 2: So your podcast is called Capital Allocators. Leads to the

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Speaker 2: obvious question, what percentage of capital should investors be thinking

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Speaker 2: about allocating to hedge funds, whether they're a large institution

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Speaker 2: or just a high net worth family office. Where do

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Speaker 2: we go in terms of what's a reasonable amount of

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Speaker 2: risk to take relative to the capital appreciation you're seeking.

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Speaker 3: Well, if you start with a traditional risk construct, so

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Speaker 3: let's say that's a seventy thirty stock bond or sixty forty,

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Speaker 3: say seventy thirty, the question becomes outside of your stocks

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Speaker 3: and bonds, where can you get diversification? And you might

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Speaker 3: want to say, okay, I want equity like hedge funds.

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Speaker 3: And if you look at some of the most sophisticated institutions,

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Speaker 3: that might be as much as twenty percent of their portfolio.

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Speaker 3: The biggest difference for those institutions and the high net

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Speaker 3: worth individuals are taxes. Most hedge fund strategies are tax inefficient.

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Speaker 3: So that of that five trillion dollars, the vast majority

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Speaker 3: of it, maybe even as much as ninety percent, are

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Speaker 3: non taxable investors. There are only some hedge fund strategies,

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Speaker 3: and they tend to be things like activism that have

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Speaker 3: longer duration investment holding periods that make sense for taxable investors.

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Speaker 2: So and when you say non taxable investors, I'm thinking

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Speaker 2: of foundations, endowments large, not even tax deferred, just tax

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Speaker 2: exempt entities that can put that money to work without

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Speaker 2: worrying about Uncle Sam.

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Speaker 3: That is, that's right, that pension funds non US investors

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Speaker 3: as well.

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Speaker 2: All right, So if you're not you know, the yl endowment,

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Speaker 2: but you're running a pool of money, how much do

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Speaker 2: you need to have to think about hedge funds? As

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Speaker 2: an alternative for your portfolio.

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Speaker 3: You're probably in the double digit millions before think about it, Yeah.

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Speaker 2: Ten million and up, and you could start thinking about

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Speaker 2: it and then what's a rational percentage? Is this a

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Speaker 2: ten percent shift or is this something more or less?

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Speaker 3: I know, for me individually, it's a lot less than

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Speaker 3: it was when I was managing capital for institutions. So

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Speaker 3: for me individually, it's about five percent because I need

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Speaker 3: to feel like the managers are so good that they

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Speaker 3: can make up for that tax disadvantage.

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Speaker 2: And so taxes are part of it. Ill equidally is

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Speaker 2: part of it, and risk is part of it. Are

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Speaker 2: those Is that the unholy trifecta that you at five percent?

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Speaker 3: Yeah, depending on the strategy. A lot of hedgehund strategies

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Speaker 3: have quarterly liquidity, so it's not daily, but they are

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Speaker 3: relatively liquid. But for sure taxes matter, and then it's

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Speaker 3: just risk. How much risk are you willing to take

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Speaker 3: in the markets.

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Speaker 2: And you know, since you mentioned liquidally, we hear about

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Speaker 2: gates going up every now and then, where a hedge

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Speaker 2: funnel say hey, we're we're you know, a little tight

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Speaker 2: this quarter and we're not letting any money out. How

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Speaker 2: do you deal with that? As an investor, you have

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Speaker 2: to be.

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Speaker 3: Very careful about what the structure of your investment is.

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Speaker 3: So to take an example, in the world of credit,

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Speaker 3: distressed debt used to be bucketed in hedge fund strategies

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Speaker 3: with quarterly liquidity, but it's not a great match for

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Speaker 3: the underlying liquidity of those debt instruments. More and more

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Speaker 3: those moved into medium terms, a two to five year

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Speaker 3: investment vehicles, and now you see much more of that

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Speaker 3: in the private credit world that have an asset liability match.

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Speaker 3: It's much more appropriate for the underlying assets. So it's

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Speaker 3: less what the liquidity is and trying to make sure

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Speaker 3: that whatever that hedge fund manager is investing in is

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Speaker 3: appropriate for the liquidity that they're offering.

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Speaker 2: So let's talk a little bit about performance. Before the

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Speaker 2: Financial crisis, it seemed that every hedge fund was just

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Speaker 2: killing it and printing money. Following the Great Financial Crisis,

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Speaker 2: hedge funds have struggled. Some people have said, you only

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Speaker 2: want to be in the top decile or two. What

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Speaker 2: are your thoughts on who's generating alpha and how far

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Speaker 2: down the line you could go before you know you're

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Speaker 2: in the bottom half of the performance track.

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Speaker 3: Yeah, I mean over these last fifteen years, the world

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Speaker 3: has gotten a lot more competitive. So for sure, whatever

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Speaker 3: pool of alpha is available before the financial crisis, if

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Speaker 3: it's the same pool, it's there are a lot more

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Speaker 3: dollars pursuing it, and it's been much harder to extract

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Speaker 3: those returns. So I do think it's become the case

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Speaker 3: that some of the more proven managers that have demonstrated

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Speaker 3: they can generate excess returns are the ones who have

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Speaker 3: commanded more dollars. And so you've seen an increased concentration

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Speaker 3: of the assets going to certain managers in the hedge

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Speaker 3: fund space.

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Speaker 2: Let's talk about fees. Two and twenty has been the

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Speaker 2: famous number for hedge funds for a long time. Although

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Speaker 2: we have heard over the past ten years about one

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Speaker 2: in ten one in fifteen. Are we in the world

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Speaker 2: of fees?

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Speaker 3: You don't see a lot of two and twenty. And

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Speaker 3: part of that is that fees are just determined by

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Speaker 3: supply and demand. Think of it as a clearing price

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Speaker 3: for supply and demand. So when returns generally have come down,

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Speaker 3: those strategies don't really command as high a fee structure

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Speaker 3: because the gross return is lower the pies a little smaller.

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Speaker 3: You need to take a smaller slice of that pie.

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Speaker 3: The exceptions to that, of course, are the managers who

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Speaker 3: have continued to deliver, and in some instances you actually

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Speaker 3: see fees going.

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Speaker 2: Up three and thirty.

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Speaker 3: You've seen a deep Shaw raise their fees a year

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Speaker 3: or two go. But for the most part, that kind

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Speaker 3: of one and a half and fifteen is probably around

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Speaker 3: where the industry is.

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Speaker 2: And there was a movement a couple of years ago

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Speaker 2: towards pivot fees or beta plus, which was, hey, we're

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Speaker 2: going to charge you a very modest fee and you're

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Speaker 2: going to pay us only on our outperformance over the market.

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Speaker 2: What happened with that movement? Did that gain any traction

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Speaker 2: or where are we with that?

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Speaker 3: Most of the institutions would be happy to pay high

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Speaker 3: fees for true alpha, so there are always efforts to

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Speaker 3: try to figure out how do you separate the alpha

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Speaker 3: from the beta? How can we pay not much for

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Speaker 3: the beta and happy to pay a lot for the alpha.

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Speaker 3: At the same time, of the five trillion in assets,

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Speaker 3: two or three trillion have existed before people started talking

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Speaker 3: about that, so you already had a handshake on what

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Speaker 3: the deal is those handshakes often are difficult to change,

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Speaker 3: but for sure in new structures, when new capital gets allocated,

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Speaker 3: you do see that attempt to really isolate paying for performance.

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Speaker 2: So to sum up, if you have a long term

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Speaker 2: perspective and you're not awed by some of the big

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Speaker 2: names and rock stars who occasionally put up spectacular numbers,

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Speaker 2: and you're sitting on enough capital that you can allocate

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Speaker 2: five percent or ten percent to a fund that might

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Speaker 2: be a little riskier, have a little higher tax effects,

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Speaker 2: but simultaneously could diversify your returns and could generate better

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Speaker 2: than expected returns. You might want to think about this space.

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Speaker 2: You really want to think closely about your strategy and

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Speaker 2: your liquidity requirements, and be aware of the fact that

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Speaker 2: the best funds may not be open to you, and

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Speaker 2: you may not have enough capital to put money in that.

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Speaker 2: But if you're sitting on enough cash, and if you

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Speaker 2: have identified a fund that's a good fit with your

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Speaker 2: strategy and your risk tolerance, there are some advantages to

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Speaker 2: hedge fund investing that you don't get from traditional sixty

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Speaker 2: forty portfolios. I'm Barry Ridolts. You're listening to Bloombergs at

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Speaker 2: the Money

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Speaker 1: Enough agbody, a chao