What Investors Need To Know About Investing In Hedge Funds
About Professor Kevin R. Mirabile, C.P.A, D.P.S.:
Following last week, we are happy to share the second part of our interview with Dr. Kevin R. Mirabile, C.P.A., D.P.S. Dr. Mirabile received his B.S. in Accounting from S.U.N.Y Albany in 1983, M.S. in Banking and Finance from Boston University in 2008, and a doctorate in Finance and Economics from Pact University in 2013. After serving as a senior executive at Morgan Stanley and Barclay Capital, Dr. Mirable is a Clinical Associate Professor of Finance at Fordham University, where he teaches courses on the principles of finance, investment analysis, derivative and alternative investing.
- Our client base tends to think outside the box, and they are interested in diversifying beyond standard mutual funds. Hedge funds hold an allure, but presumably they are more complex than the way they are positioned. What do you think are the most important elements that investors should consider that they wouldn’t find out by reading online summaries?
Hedge funds are often associated with increased risk in the types of strategies that they implement for investors. Ironically, in most cases, hedge funds deliver decreased risk, reduced volatility, and higher shop ratios for compensation per unit of risk. You really need to look below the surface. Hedge funds as a category is really a bit of a misnomer. A hedge fund is essentially just a legal structure – a limited partnership – as opposed to an asset class. Digging deeper, the category can be broken down further into macro hedge funds, equity hedge funds, fixed income hedge funds, and event-driven hedge funds. Each of these delivers a different risk and reward profile. It used to be that people thought about hedge funds as one big, amorphous choice, just like investing in stocks or bonds. Today, however, investors are savvier and they’ll look at the different types of hedge funds (equity-oriented, fixed-income-oriented, macro-oriented, or event-oriented) when making asset allocation decisions.
- How do you feel about hedge fund managers who they themselves are not invested in the fund? Is that a red flag or could it be that they are already so tied to the fund, they just don’t want the additional exposure?
You know, traditionally, I go all the way back to the beginning of the hedge fund industry. It was not uncommon for a hedge fund manager to tell you that they had substantially all, 90% or more, of their liquid net worth in that fund. It was referred to as an alignment of interest. They would take risks and use leverage, but you always knew that if you lost money, they lost money. In the early days of hedge fund investing, that was considered sacrosanct. In fact, as part of your due diligence, you would not allocate capital to a hedge fund manager who did not meet those criteria.
However, as the business became institutionalized and we saw billions become trillions, it was really impossible for hedge fund managers to maintain pace. When you were launching a fund with $10 million and you were $2 million and not represented $2 million out of the $3 million that you had is your net worth, everything made sense. But as soon as you took $100 million from a pension plan, all of the sudden you became 1% of the fund, not 10, 20, or 30% of the fund. Yes, it’s still important to look at the general partners’ or managers’ interest in the fund, and in particular, changes in that interest. While he’s raising money from investors, is he also liquidating his own positions? However, the answer to this question is now a data point as opposed to a deal-breaker. Sometimes the guy is buying a house or going through a divorce and maybe there are legitimate liquidity reasons for reducing his exposure in a fund. It’s still an important part of the conversation, but not in the same way. This wouldn’t hold true for a mutual fund where the manager’s exposure doesn’t really exist.
- What role do you feel that hedge funds should play in a well-balanced portfolio?
There definitely should be some hedge fund allocation, but the two that come to mind are the macro funds or the lowest correlation, the traditional stocks and bonds. They’re very important diversifiers. Allocation to macro funds for sure should be part of a diversified portfolio. As for low correlation assets, there has been a lot of talk about the 60% equity and 40% bond portfolio no longer providing the conservative, balanced growth that it once did where the bond portfolio acted as a partial hedge for the stock portfolio. Bonds go up in value when interest rates fall. They go down in value when interest rates rise. Well, if interest rates can’t fall much further, that means bonds won’t be going up in value very much. In short, they won’t be acting as a hedge for your equity portfolio. Consequently, there has been a lot of research about the role of managed futures and systematic macro funds as replacements for bond allocations in growth and conservatively managed accounts. They give you some downside protection, while also supplying the low level of correlation to equities that bonds no longer provide.
4. Can you define a Macro-fund?
A Macro-fund is a fund that takes thematic bets on the direction of financial assets or commodities based on macroeconomic research. If someone thinks global growth is accelerating top-down, they go out and buy commodity futures. That could include wheat and corn, or copper, palladium, zinc, and other materials that go into the industrial manufacturing process. The macro-fund will get into these investments using futures products. They won’t be buying, storing, and warehousing rolls of copper wire; rather, they’ll buy copper futures on the CME. Based on the trends research, they will either short the asset or go long on the asset and short the dollar. These funds don’t buy IBM and they don’t buy a two-year note. They’re trading commodities and stocks and bond futures contracts based on top-down, big picture research and turning them into profits. Typically the Macro-funds will be focusing on 10-20 different themes around the world at once. For instance, the fund could be betting on the Euro to rise while betting on the South African Rand to fall, and at the same time betting on growth in GDP in Japan. In general, the numbers in the macro-funds tend to not bear a lot of direct correlation to change in the S&P 500.
- As far as the hedge fund world goes, it used to be that the average hedge fund would accept any investment at the standard entry point of $100,000. Obviously, that has grown. Especially in the Macro world, the entry point for the better macro funds is probably a minimum investment of a very substantial amount. Are there smaller macro funds that would take smaller investments?
Great question. There are bigger macro funds that will take smaller investments. The question is “how?” Today, if you want to invest in one of the world’s best, global macro funds, it’s probably a $1 million or $5 million investment, like Ray Dalio at Bridgewater. However, many of those managers now created additional structures called liquid alternative investments that are Forty Act Funds. These act as feeders into their main fund and core strategy. For example, Cliff Asness is a well-respected scholar and hedge fund manager who runs a company called AQR. AQR manages billions of dollars for institutions and high-net-worth individuals. If you go to Fidelity, you can invest in the AQR Futures Fund, and you can invest in the AQR Macro Fund. They’ve created structures that allow them to collect retail assets because they already have the factoring in place to do the trades. Now, it’s just a matter of generating another type of account that they’re trading for. This has happened in the last five or ten years pretty dramatically.
Today, probably 25% of the hedge fund industry is coming from places like Fidelity and Charles Schwab. They have helped macro funds, longshore equity funds, and other hedge funds who trade liquid instruments set up Forty Act Funds to collect assets from retail. For them, the computer does the allocation of trades in much the same way a trust company does the allocation of trades to client accounts. In essence, they’re just putting on more of the same trades and allocating 5% to their mutual fund portfolio instead of to their limited partnership portfolio. These have been very popular, and they are readily available by retail. They’re also available for retirement accounts. Currently, most financial advisors will build in a hedge fund allocation and a managed futures allocation (which is a specialty section of the hedge fund community).
- What are the advantages and disadvantages of a smaller hedge fund versus a larger hedge fund?
The cost of being a hedge fund has gone up dramatically since 2007. This includes rising compliance costs, requirement score monitoring, employee training, and the requirements for ensuring diversity and ESG criteria. The rules and regulations hedge funds need to follow are much more similar now to traditional asset managers. Back in the day, hedge funds were considered an unregulated asset class. Then they transitioned into what was known in the industry as a lightly regulated asset class. Today, they are a fully regulated asset class. In almost all cases, the manager of a hedge fund has to be SEC-registered as a financial advisor. There’s still a safe harbor that the fund itself is not a registered vehicle. The limited partnership is subject to the limitations of either 99 or 499 investors so that they don’t have to register the fund with the SEC. However, overall the cost of running a hedge fund is much higher.
It was a common expression in the 80’s and 90’s that two men and a dog could launch a fund, collect a two-and-twenty, and retire by age 30. That’s not the case anymore. The two men and a dog might still be there, but there’s also going to be a chief compliance officer, a diversity officer, and a long-term lease on their space rather than a year-to-year lease. Thus the requirement to gather money from institutions is so much more serious now than it used to be. A hedge fund with $10 million is going to have a hard time surviving because they may have to spend $2 million per year just to keep the lights on. That would eat up the entirety of their income in a two-and-twenty; they’d only be getting a $200,000 management fee, and they’d have to have 30-40% performance to pay the bills. To break even now, a hedge fund needs to conservatively launch between $400 million to $500 million.
That doesn’t mean that smaller hedge funds don’t exist. There are still a lot of hedge funds that are launching with $25 and $30 million, and they’re just hoping that they’re going to have a tremendous collective performance fee and use that to grow their business. However, if they miss a year or two in terms of double-digit performance, then they close. Consequently, small hedge funds tend to go out of business more frequently than mutual funds or larger hedge funds. You rarely hear about a private equity or real estate investment fund closing after 18 months or three years due to a lack of profitability. In fact, more hedge funds fail and close each year than launch now. That was never the case before 2007; then it was like a 10:1 ratio. There’d be ten new launches every year for every one failure. Today, there are about six failures for every four launches.
For more about Professor Mirabile, visit his Fordham webpage.
To read his books about hedge funds and exotic investments, click here.