Hedge Fund Red Flags

If you believe the adage "A penny saved is two pennies earned" or the pithier “Buck saved, buck earned”, forgoing the wrong hedge fund investment might be the most lucrative thing you ever do. Although these are excerpts written from the perspective of a fictional, unscrupulous (but oddly forthcoming) hedge fund manager, these practices and/or phenomena are very common in the industry. If and when I decide to start a fund open to outside capital, do challenge me on all these points - and if I don’t satisfactorily mitigate or address them, don't give me a dime.

• Consequences of 2 and 20 model: I will charge you “2 & 20”, i.e. 2% annually of the value of your assets under management, regardless of performance, and an additional 20% of any profits earned. Naturally this will incentivize me to spend a disproportionate amount of my time acquiring new clients, pitching (happy) existing clients to invest more capital, pacifying (discontent) existing clients, and making excuses for my perceived or real underperformance. I myself would never invest in a 2 and 20 model due to misaligned incentives and the sheer expense in both absolute and relative (to current low interest rates) terms. However, in a rising market I will hope you won't notice the high compounding effect of such fees on your overall returns.

• Lack of Creativity: I will spend very little time actually looking for undervalued investments. The bulk of my day will be spent managing the labyrinth of regulations, attending to administrative tasks, and client hand-holding. I will hardly bring an ounce of creativity to the table, regardless of my intellectual capacity or time available. A gutsy (and prudent) idea makes me look like a genius if it works, but like an idiot if it doesn’t. Since I fear you will judge me based on the uncertain investment outcome rather than the quality of the original idea, I will spare you from any such investment sophistication. In fact I am more likely to mimic a competitor’s bad idea than execute a uniquely good one. To understand why, imagine you find yourself leading in a sailboat race. The logical strategy is to hug your (inferior) competitor to catch the exact same draft to obtain equal speed – and therefore maintain a constant lead over this competitor. Deviating and risking a less favorable wind is an unnecessary risk when a win is a win, no matter the margin. A similar analogy follows in my industry as many of you will merely invest with the best performer within my niche, disregarding the magnitude of the outperformance.

• Financial FOMO: I will exploit your investing FOMO, impatience for returns, and short-term focus by giving you a steady stream of sexy investments that have no place in your portfolio but which will satisfy the dopamine-starved, financial-envy-ridden investor inside you. I will also hope you have never seen this clip (especially 1:45–2:00).

• Consequences of Untimely Redemptions: Your unpredictable redemptions motivated by fear and euphoria means I won’t earn the liquidity premium on illiquid assets nor will I effectively manage your tax liability, and so both yours and remaining investors’ returns will suffer. I will take minimal steps to insure this doesn’t happen. I will also play to your need to have excessive insurance in all aspects of your life. Over the long-run insurance sellers make money, and buyers lose when they purchase excess beyond their actual risk-mitigating needs. A long-term investor should not structure their portfolio to perform well in the midst of a financial crisis or else they have succumbed to this costly mistake.

• Consequences of Excess AUM: I will maximize assets under management (AUM) to earn the “2” in the “2 & 20” described above even though it hurts investment performance in a myriad of ways. Higher AUM after a certain level means increasing indirect transaction costs (due to more difficulty not moving markets when executing trades). This diseconomy of scale is especially important when investing in illiquid securities. As a result, early entrants into well-managed funds win, and latecomers will likely lose. However, I will continue to make money from all clients from the “2”.

• Asymmetrical Investing Philosophy: I won't ensure you are aligned with my investing philosophy and this will result in a host of problems. There is a reason incubated hedge funds - set up with a manager’s private capital - typically outperform the subsequent hedge fund that primarily consists of outside capital. For example, I may fail to make sure you are OK with a high allocation in cash so that I can use it as a valuable expiration-less call option on any asset to take advantage of future opportunities/depressed markets. Another example – I may fail to emphasize a long-term focus with a value approach applied to asset allocation decisions.

• Excessive Risk-taking: If I outperform in a given year, I can expect to bring in $X of new capital. If I underperform in a given year, I will lose $Y in capital through redemptions. Based on extensive historical data, X is a lot higher than Y. This phenomenon incentivizes me to take inappropriately high risks with your money and is known as convex capital flows.

• Remainder of Portfolio: Despite its importance, I won't concern myself with the rest of your investing portfolio or overall financial picture and will pretend as if your investment in my fund is prudent as long as you meet the minimum legal requirements.

• Bad Benchmarking: I will use an incorrect benchmark (i.e. passive index) or will become preoccupied with beating one despite the fact that beating a benchmark should not be the goal - capital preservation should. Benchmarks are often lousy and overly risky. Sometimes there is no benchmark for a given risk/reward profile or investment strategy and the focus should instead be on making wise decisions and making fat pitches with dry powder. In fact, allocating correctly among asset classes drives positive returns far more than picking the right securities within an asset class. But let’s say I believe my particular asset class will perform poorly over the next couple years (perhaps because it has run up and is likely overvalued), do you really think I’m going to call you up and say “Hey you should pull your money out and invest in a different asset class at another fund?” The fact is fundamental analysis in the pursuit of squeaking out an extra 1-1.5% is a fruitless effort because markets just aren't that inefficient. But I will make this my life’s work anyhow while convincing you it’s a path to prosperity.

• Illusory Optics: I will engage in rampant window-dressing and selectively use mark-to-market as allowed by law to skew reported performance. Return or yield is nearly impossible to accurately compute for many reasons, e.g. 1) MBS dividends, options’ premiums, etc. are partially a return of capital, rather than yield on capital, 2) Tax-loss harvesting, 3) High and variable cash allocation 4) No benchmark with a comparable risk/reward profile. ''Are you beating the S&P?" is the wrong question unless it happens to be the appropriate benchmark. For example, if I’m taking on more risk using a proprietary strategy with no available benchmark, the risk-adjusted returns should exceed the S&P.