Go-to Hedge Fund Strategy Isn’t Working

If you’re unfamiliar with hedge funds, think of them as very influential private investment firms. The reason why they’re so influential is because they trade in such large volumes. A great example of their influence can be demonstrated by the destructive George Soros.

16 September, 1992 in Britain is known as Black Wednesday.

It was the day that speculators broke the pound. They didn’t literally ‘break’ it. But they forced the British government to pull it from the European Exchange Rate Mechanism (ERM). Britain entered the ERM wanting to keep its currency above 2.7 marks (German currency) to the pound.

However, speculators, George Soros among them, began heavily shorting the pound. The British government gave in and withdrew from the ERM. It became clear that it was losing billions trying to keep its currency afloat. Soros pocketed $1 billion on the deal and cemented his reputation as the premier currency speculator in the world.

Increasing capital to increase returns

Let’s say you want to make a trade on the ASX, using a small-cap company. You put in $500 and, in the space of three months, the stock goes up 100%. This is not unusual for small-caps. In fact, Sam Volkering, the editor of Australian Small Cap Investigator, has picked many small-caps that have done exactly this…and then some.

Your profit on the trade is $500, therefore in total you can cash out for $1,000. It’s not a bad bit of chump change for the weekend. However, this is still quite a small scale in the grant scheme of things.

So instead of investing $500, what would happen if you invested $50,000? The returns stay the same; so you can cash out for $100,000, as you just made $50,000 on your original investment. So while it might be riskier to invest with more capital, it can also increase the total cash received.

And this is exactly what many hedge funds do. They increase the size of capital they trade in order to create more profits. Now, this might seem contradictory. The word hedge means to reduce your risk. But what many hedge funds actually do is increase their risk on a daily basis.

But that’s not to say these hedge fund managers are punting the market. They have many smart analysts and traders behind the scenes working on trades and strategies. But when they don’t pay off, then millions, if not billions, can be lost.

How long can hedge funds tread above water?

Hedge funds are now shrinking at the fastest pace since the financial meltdown. They face a challenge of reviewing their go-to revenue strategy of ‘smart beta’. In this model, money is pooled from private investors in what’s called ‘assets under management’. The hedge fund then charges a fee on this total pool of capital.

In most cases this levy charge is a quarter of the pool; however, any profits made will remain untouched. Think of it as a marketing ploy. Instead of taking a clip out of profits and charging a fee on assets under management, hedge funds can advertise ‘lower’ fees with the ‘smart beta’ model.

The reason why they have resorted to such drastic measures could be because of competition. But it’s also largely due to their inability to create positive returns this year.

Hedge funds are now in the firing line. Their performance has been horrible this year. A profit warning from GAM, the Swiss asset manager, shows just how bad things are.

GAM’s revenues come from fees. Last year, those fees dropped by 5%, to 0.65% of GAM’s average assets under management. Their performance fees (provided they make a profit) accounted for roughly 14% of total revenues.

GAM has resorted to streamlining their product offering. However, asset outflows have continued for GAM. And this has not just affected a couple of hedge funds. As reported by Chicago-based Hedge Fund Research:

Investors pulled a net $15 billion between January and March, reducing assets under management to $2.86 trillion from $2.9 trillion.

Hedge funds suffered the worst withdrawals last quarter. The last time outflows were higher was in the second quarter of 2009. The tail-end of the financial meltdown and falling commodities have caused losses at some of the best known firms.

It’s simple really. Hedge funds can’t protect investors from market turmoil. Because of that, more and more investors are fleeing money managers.

Why not then take control of your own money?

Sure, you might not have the capital that hedge funds have. But why put your money into the hands of managers who are losing money? Instead, you could potentially make great returns off small-cap stocks. There are always risks involved, but that’s the reality when you’re hunting for high returns.

If you’re unsure how to get started, then check out Sam’s report, ‘Top Three Aussie Small-cap Stocks’. In it, Sam reveals which small-caps you should be looking at.

Now not every single one of Sam’s stock recommendations for Australian Small-Cap Investigator is going to return large gains. No one can do that. But all up, the stocks currently on Sam’s ‘buy list’ have made average returns of above 50%. Take that, fund managers.

The results speak for themselves. To get your free copy of Sam’s report, click here.

Härje Ronngard,

Junior Analyst, Money Morning

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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