Are hedge funds bad? Thinking about how hedge funds are different from other institutions
Are hedge funds bad?
- Hedge funds are talked a lot about in the press
- and usually with a slightly suspicious or negative tone
- so what I want to do in this video is think about
- or give us a way of thinking about
- whether a hedge fund, or really any financial type of organization
- or institution is good or bad,
- and I won't try to take one side or the other
- just give you some type of things to think about.
- So the first thing that sometimes is complained about
- when people talk about hedge funds,
- is that the compensation structure,
- because the hedge fund gets 20% of the profits
- but if the fund were to kind of blow up and go to zero
- the hedge fund manager isn't on the line for 20% of the losses
- people would argue that that encourages hedge fund managers
- to take disproportionate levels of risk
- and that is true to some degree
- but one thing that is true about hedge funds is that usually
- it's expected that the manager or the general partner
- has some of their own skin in the game
- so as an example, I drew a Pete Capital Fund 1
- the manager committed 10% of the funds
- and what's more important, as apposed to just the
- percentage of the total fund is
- what percentage of Pete's total net worth is in the fund?
- Some fund managers will put a significant amount
- of their own personal net worth in the fund
- so even though they get 20% of the upside,
- if the fund were to really do horribly,
- if it were to blow up,
- that manager usually will really be on the line
- and that's usually the job of the limited partners here
- we've mentioned before that versus a mutual fund
- the limited partners of a hedge fund need to be sophisticated,
- they need to be accredited investors, they need to have a certain net worth
- they need to show that they understand these type of instruments
- and so it's really the job of the limited partners
- and it's really in their interest
- to make sure that they're investing in a fund
- where one, Pete looks like a credible guy,
- Pete has some skin in the game, and hopefully
- a substantial amount of skin in the game relative
- to Pete's net worth.
- Pete has a reputation, and then they have to decide
- their own comfort level with how transparent
- Pete is, a lot of hedge funds won't tell their investors a lot of
- what they're doing with this $100,000,000
- sometimes they'll give a little bit more information
- or a little bit less,
- that could be a negative obviously, because who knows?
- Maybe they're going to Las Vegas and they're gambling away this money
- but that's where the reputation of the manager matters a lot
- but also the secrecy actually could be good for the limited partners
- because sometimes if everyone knows exactly what's happening inside of the fund
- and that information goes out,
- there could be other people that could somehow
- trade against the fund, or make the same investments of the fund
- or if this was a large fund, go ahead of that fund
- and try to buy whatever this fund was trying to buy ahead of time
- so there's kind of pros and cons to the secrecy,
- but that risk is definitely there,
- and, you know, one thing that I guess is probably interesting to point out
- is that this idea of getting a percentage of the upside
- but having very limited downside is not unique to hedge funds
- in fact, this is probably true of most corporate executives,
- in fact, most corporate executives probably don't have as much skin in the game
- we've all heard about golden parachutes and all of the rest
- if CEOs do really well, they usually get huge, huge, huge bonuses,
- if they do horribly and they get fired, they still get golden parachutes
- and that actually probably doesn't happen to hedge fund managers,
- so this idea of a percentage of the upside
- without the same percentage of the downside
- isn't unique to hedge funds managers,
- it happens to corporate executives, it happens to
- heads of banks, it happens to bankers generally
- where they get these huge bonuses in a year
- but in the next year, if the bank goes out of business
- no one asks them to kind of give back their bonuses.
- So I'm not going to defend it, I'm just going to say that it's not unique to hedge funds.
- Now the other kind of notion that sometimes people
- talk relative to a hedge fund is this idea of secrecy
- because it is not regulated, the hedge fund manager
- kind of has its choice of what they do over here
- and this secrecy, you know, I'll put a little asterix over here,
- because in order for these people to be willing to commit their fund
- the hedge fund manager has to tell them something about
- what he's up to, so it's up to the hedge fund manager.
- But some people work that the secrecy
- the secrecy that the hedge fund has,
- combined with the fact that they're allowed to invest
- in more, I guess you could say, exotic things
- they don't have to, and I want to be very clear
- a lot of hedge funds, even though they have this whole structure
- with the 2% management fee, and the 20% carried interest,
- a lot of hedge funds, their actual investments
- might look very similar to a lot of mutual funds
- in fact, some of them might be more conservative
- than many mutual funds, so it's not necessarily the case
- that hedge funds are doing crazy things over here.
- But some of them are, and so that combination
- of the secrecy, that they might be speculating on this or that
- or buying all sorts of crazy derivatives contracts
- that makes people feel that hey, there might be something shady
- going on over here.
- And, the way I think about it is, if the hedge fund is relatively small
- and $100,000,000 would actually be small in the scale of a hedge fund
- or I guess another way to think about it:
- if the assets that are controlled are relatively small
- because with sophisticated derivatives, with $100,000,000
- you can actually control much more than
- $100,000,000 in notional assets, but if the notional assets
- that the hedge fund controls are relatively small
- then the secrecy, and kind of the, whatever the hedge fund might do
- it really just puts the investors of the hedge fund at risk
- and so it's really these people's job,
- it doesn't put society as a whole at risk
- the time when hedge funds get dangerous,
- or potentially get dangerous, or the most cited example of this
- is long-term capital management in the late 90s
- Let me write that down, LTCM, I'll do a whole series of videos on this eventually
- but long-term capital management controlled so much
- in notional funds, now we're talking about in the
- hundreds of billions or even trillions of dollars
- that this fund became too big to fail
- and I think you know from the recent financial crisis
- that this doesn't happen only to hedge funds
- and so you have this general notion
- that when any financial institution
- starts kind of controlling trillions of dollars
- or hundreds of billions of dollars,
- it can start a cascade through the entire financial system
- that's not a good thing. This is not a good thing,
- this is not good, because when something is too big to fail
- people don't let it fail
- and that goes against everything that we know about capitalism.
- Capitalism, when people do well, let them do well,
- but when people fail, let them fail.
- The thing I want to point out is that this is not unique to hedge funds
- AIG which is probably one of the main culprits of the last financial crisis
- they were an insurer, do you have the rating agencies,
- they weren't too big to fail
- but they helped kind of validate some of these other
- too big to fail actors. You had all of these banks
- that were too big to fail.
- So I think the general principle here is that
- a hedge fund can be good, it can be bad,
- what's unique about them relative to a mutual fund
- is that they tend to be a little bit more private
- they have more support, they should have more sophisticated investors
- but what they do with their money might be
- um, exactly the same thing as what a mutual fund
- might do, it might even be more conservative than a mutual fund,
- it might take on, it might use sophisticated instruments to take on less risk
- than a mutual fund,
- and I think the takeaway, or at least in my mind,
- is that any of these things, hedge funds,
- insurance companies, banks, even some corporations,
- they become bad when they become so big
- that failure doesn't just hurt their investors,
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