The Hedge Fund Saving You from Yourself
Imagine making money when everyone else is losing their shirts.
This is exactly what hedge fund manager John Paulson did in 2009. Paulson made a string of smart bets against the US housing market just before it all collapsed.
At times, Paulson’s hedge fund was making more than a billion a day.
These are the stories we often hear about fund managers; geniuses making billions. But these are extreme examples. For years, it’s been one of the most unproductive industries.
Hedge funds, collectively, are leaving investors worse off than if they had they bought a low cost index fund.
Industry returns have been in a sharp decline for decades. In 2017, hedge funds posted an average return of 10.5%.
Yet after the traditional 2% management and 20% performance fees, the average hedge fund investor was left with only 6.3%.
It’s a terrible performance compared to many index alternatives.
Makes you wonder why anyone would let a hedge fund manager near their money!
But of course, not all hedge funds take your money and deliver poor results. Some are actually worth the hefty fees they charge.
A rare move to lock in profits
There aren’t a lot of hedge funds that deserve admiration. Most are just effective marketers.
They have the gift of the gab and can draw millions, sometimes billions to their fund. When it comes time to put that money to work however, they fall over.
What’s the excuse? It was the economic environment, or low interest rates, or the bull market, fund managers say.
They come up with a myriad of excuses to explain why they didn’t perform.
Not all are this bad. There are a select few that are worth the fees they charge.
Take Quantedge Global Fund as an example. They’re one of the world’s best performing quantitative hedge funds. That means they use computer models to buy and sell assets.
From 2006–17, the fund generated an average annual return of 26.5%, which was more than double of the return of S&P 500 over the same time.
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Last year, Quantedge was managing more than US$1.7 billion for investors. And in a rare step to secure profits, they asked if investors would like to lock-in their investments.
To sweeten the deal, they offered discounted fees for those that locked-in for three to five years.
I know what you’re thinking…who in their right mind would want to do that?
Sure, Quantedge has an impressive track record. But they’re still a hedge fund. It’s a highly unpredictable industry.
What if they don’t perform within that three to five year period? What if you need that money for something else in a year or two? What if bitcoin starts rocketing up again, but you’re stuck in a boring old hedge fund?
The truth is, investors would be doing themselves a favour by locking in their investments with Quantedge.
The reason why has little to do with Quantedge’s track record. Rather, locking in for such a period could save investors from themselves.
Let me explain…
You are your worst enemy
Whether it’s a low-cost index fund or an actively managed one, investors do worse, on average, than the fund they invest in.
How can this be?
It has nothing to do with fees, even though they are an important factor.
It all comes down to human psychology.
Let’s say you wanted to outsource your investing. You decide to go the active route and start looking for some of the highest returning funds around.
You reason that if a fund can generate high returns over a number of years, they must have some sort of skill.
Thus, you find the highest returning fund and plop your money in.
That night you have a wonderful dream about all the profits you’ll make in the coming years. But, to your surprise, the fund starts to underperform shortly after you invest.
Unhappy with how things played out, you pull out our money and hunt for a new high returning fund. It doesn’t take you long to find one. And again you plop your money in.
Guess what happens next?
The fund starts to underperform, and you find yourself with subpar returns…again. Is it you causing the funds to underperform?
I doubt it.
It’s because you’re buying highs (when returns are high) and selling lows (when returns decline).
Had you left your money alone, you might have doubled or even tripled your investment, provided the fund knows what they’re doing.
That’s why Quantedge’s lock-in policy might actually benefit investors. While returns can be lumpy from year to year, quality managers can earn high returns over time.
The traits you’ve got to kick
It’s pretty clear humans weren’t meant for the share market.
Instead of buying low and selling high, many buy into bull runs and sell out of bear markets.
That’s not to say you shouldn’t invest in rising stocks. A rising stock price is usually caused by rising earnings. If earnings continue to rise, then it might be an investment worth considering.
But buying highs, only to sell out when prices pull back, is a great way to lose money fast.
So what can you do to prevent such irrational behaviour?
For one, don’t jump into stocks just because the price is going up.
Yesterday when the ASX 200 ripped down 95 points, investors were reminded that there’s no such thing as a free lunch. You cannot simply throw money into the market and expect to do well.
So make sure there is some substance behind your buying decisions.
Another good idea is to forget about your positions from time to time.
Constantly worrying and stressing about price swings can led you to make dumb decisions, like selling out when your position drops 10% for no reason.
Warren Buffett once said ‘Investing is simple, but not easy.’
We all know what to buy — companies trading for less than they’re worth. The hard part is keeping your emotions in check.
Maybe that’s the problem. Investors believe it’s become too easy to make money in the market. Yesterday might have discouraged that kind of thinking. But we’re probably in for more declines yet.
So why not save yourself from yourself and learn from Quantedge. Lock-in for the long haul.
Editor, Money Morning