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, it hurts all of society.