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Hedge Funds Are Terrible Investments. So Why Do Rich People Keep Using Them? - How Money Works - YouTube
Channel: How Money Works
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In 2008 Warren Buffett made a bet for
1 million dollars that a hand selected
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group of hedge funds could not outperform
the S&P 500 Index over a ten year period.
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In 2018, Buffett won the bet, and went home an
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extra million dollars richer (which I
am sure was a very big deal for him)
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This exposed a big flaw in the investment
industry which is that actively managed
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funds and in particular hedge funds
struggle to outperform the general market.
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When fees are considered there is
only a handful of funds that have
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returned money to their investors
in excess of what they would have
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received had those investors just taken
a more traditional investment approach.
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Hedge funds are also not open to the public, to
invest with one of these institutions you need
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to be what is called an accredited investor. What
qualifies as an accredited investor varies between
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different countries but here in the states it is
a person with an income of two hundred thousand
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dollars per year or more, or a couple with
a combined income of three hundred thousand
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dollars a year or more, this income must also be
sustained over the most recent two year period.
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A person or couple can also be accredited if they
have a net worth exceeding one million dollars
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excluding their primary residence. Finally,
you can be an accredited investor if they
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are a director, executive or general partner in
the unregistered business they are investing in.
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This is simply to make it possible for
people to invest in their own start-ups.
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You need to be an accredited investor to
invest in risky assets because the SEC
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wants to make sure than unsophisticated
investors are not preyed upon by dubious
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financiers pushing complicated financial
products with high fees and poor returns.
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Now even if you are an accredited
investor you will still find it
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difficult to invest with most hedge
funds. Most hedge funds will require
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a minimum investment of anywhere from one
hundred thousand to one million dollars.
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Ray Dalio’s Bridge Water has an investment
minimum of seven point five million dollars
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and charges up to 4 million
dollars a year in fees alone,
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on top of this you have to be invited to invest
in the fund, an honor which is typically given
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to people with an investable net worth of
seven point five billion dollars or more.
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But people this rich are generally not
stupid, so why would they invest in hedge
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funds when these funds have typically failed
to outperform a more basic investment strategy?
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One trends member took a report posted by trends
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Now let’s say you do start
a million-dollar company
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and start earning more money than you know what
to do with, investing is probably a good option.
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No businesses last forever and investing
wisely can set you and your children and
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your children’s children up for a life
where they only work if they want to.
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You have plenty of options available to you,
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if you want to play it safe then bonds
have historically been your go to,
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although with interest rates where they are
right now that isn’t a very attractive option.
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Crypto is risky and unproven,
it’s hard to build generational
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wealth on a foundation which has
only been around for a decade.
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Finally there is real estate and the stock
market, the two most generic investment options.
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They are popular for a reason, they
offer great returns and have been doing
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it for as long as capitalism has been a thing.
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Today it is easier than ever to
get into especially when you have
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millions if not billions of dollars in the bank.
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But then there are hedge funds. On
the surface they just look like a
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middleman between you investing your money
directly into the stock market yourself.
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A middleman that will take a very
significant cut of any future earnings.
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So where is the value here?
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Well, the first mistake is thinking
this is a problem. Warren buffets
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famous million dollar bet may
have made hedge funds look bad
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but it didn’t reveal anything that
sophisticated investors didn’t already know.
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Okay the market outperformed these funds,
so what? The market also outperformed bonds
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and real estate over the same period,
does that make bonds bad investments?
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No of course not, they are just different.
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The second mistake is assuming that all
hedge funds do is invest in the stock market.
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Some of them do, but not all of them.
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They also don’t invest in the way
that a regular individual would.
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When you and I buy a stock we are
usually planning to hold that stock
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because we think it is going to increase
in value. If we want to get technical,
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we might even short a stock if we think it
is overvalued and likely to fall in price.
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Some of us will even play with
stock derivatives like options,
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but we all know at that point it’s
little more than legalized gambling.
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Regardless of what we do as individual investors
we are just placing bets on a stock going up or
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down in price. Historically the bet that
most companies will become more valuable
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over time has been a good one, so that has
become the traditional financial wisdom,
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buy low-cost index funds and never sell them!
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There will be some years that are better than
others but so long as you hold a broad enough
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portfolio over a long enough time horizon
you are pretty much guaranteed to make money.
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This is very solid advice for
ninety-nine-point nine percent of people.
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When combined with some real estate
holdings and a little dip into crypto
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and alternative investments it can be
a very powerful wealth building tool.
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But the zero-point one percent
need something more, they need
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wealth that is constantly accumulating
no matter what the market is doing.
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Good hedge funds should not be exposed to
what investors call market risk. This is
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the risk inherent in an investment caused
by widespread downturns in the market.
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Almost every public stock apart from a
select few are subject to market risk,
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if the market crashes the stocks that
make up the market crash with it,
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even if the underlying
companies are doing just fine.
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There are two ways to get rid of this risk,
the easiest way is just to wait it out,
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that’s why people always say
to invest for the long term.
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The other way is to hedge against market risk.
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Doing this is very complicated
but lets take a simple example.
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A hedge fund predicts steam will corner
the video game market on PC and consoles.
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With this knowledge they will buy shares in steam
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and short and equal value of shares in a
collection of other companies like Game Stop.
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This means if the market crashes then the losses
from their position in steam will be counteracted
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by their short positions in the other companies.
They will have hedged their bet, hence the name.
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If steam then announces that they will be
partnering with Sony, Microsoft and Nintendo to be
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the exclusive release platform for all video games
then the stock price will rally relative to these
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other companies and they will make a profit off
that news while not being exposed to market risk.
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This can still go horribly wrong. If meme lords
on the internet decide that they like Game Stop,
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then the hedge fund will lose money on that short.
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But that doesn’t matter because that’s just
regular speculative risk, which doesn’t matter
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so long as it’s not market risk. So why is it so
important to get rid of market risk? Because rich
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people are already exposed to that risk with their
own businesses and all of their other investments.
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It’s very hard to diversify
away from market risk because
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most traditional investments are still
correlated with the stock market.
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A stock market crash would likely dampen
real estate prices and visa versa.
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Rich people are looking for uncorrelated return
streams. If their hedge fund is having a bad year
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then hopefully the market is doing better, if the
market is down then their hedge fund might be up.
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Investing in a group of uncorrelated
investments is surprisingly more
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powerful than simply investing in whatever
has the highest average returns over time.
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The math behind this principle is complicated,
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but it all has to do with a theory
called dollar cost averaging.
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Dollar cost averaging assumes that
an investor contributes a set amount
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of money at regular intervals into their
portfolio regardless of market conditions.
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When the market is up, they will invest
the same as when the market is down.
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This means the investor naturally buys more
assets when the market is down then when the
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market is up which automatically takes care of
the “buy low” part of investings golden rule.
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Having uncorrelated assets means that
something will always be doing well
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while something else is doing poorly which means
dollar cost averaging can be fully utilized.
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Normal people usually invest for
a singular goal like retirement,
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so the broadness of their
investments doesn’t matter
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as much as the broadness of their time
horizon. Rich people like to be able to
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access their money quickly to take advantage
of opportunities as they present themselves.
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If a billionaire is presented an
investment opportunity in the next Facebook
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they don’t want to pass it up because
they are afraid of liquidating their
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portfolio while the market is down thirty percent.
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There is another reason that
hedge funds are still around today
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and that’s because rich people like
to think that they can pick a winner.
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Investing in a hedge fund is not
like investing into the stock market,
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it is more like investing into a private business.
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Most businesses fail, just like most
hedge funds under-perform the market,
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but if you were lucky enough to invest
into the medallion fund back when it was
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getting started then you would almost
certainly be a multi-millionaire today.
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For many wealthy people that’s
enough of an incentive to write
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a few checks to promising new hedge fund
managers with a decent investing thesis.
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Today hedge funds are not nearly as popular
as they were in the eighties and nineties,
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the fashion amongst billionaires is now private
equity. But there is still a reason these
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businesses exists, they offer a very specific type
of solution to a very specific type of individual.
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If you would like to learn more about
the ins and outs of hedge funds then you
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should check out Patrick Boyle here on
YouTube, he is a hedge fund manager and
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financial author who makes criminally
underrated videos here on YouTube,
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his videos helped me a lot when making this
one so make sure to go and check him out.
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Thanks again also to today’s sponsor trends for
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making it possible for everybody to
keep on learning How Money Works.
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