Risk is a word that all newbies should always be aware of. Most investors seem to focus on return. They often read about xyz hedge fund that earned over 1000% over the past 5 years only to lose it all back in the credit crisis of 2008. The sad truth of the matter is that most hedge funds do not hedge.
Incentive structure
The problem with hedge funds is the fact that their incentive structure is wrong. Hedge Funds collect their 2/20. A typical hedge fund has a 2 percent management fee an also collects 20 percent of total profits earned.
Hedge Funds are asset managers that collect a management fee of 1-2% a year as well as 15-25% of the profits. Portfolio managers of these funds are trying their best to have better results than their competitors.
Why HF don’t hedge
Assume you are a professional racer that has the choice of three different cars.
Car A is your muscle car, great horsepower, no real control. This car would be great in a straightaway track. (in a hf world it’d be your long only fund that invests in high momentum, high beta with enormous leverage of course). A straightaway track would be a market environment that only seems to head in one direction, up.
Car B is your 4 wheel drive, medium horsepower car with great handling. (This would be your long/ short, relative value fund that tries to balance out it’s exposure) car B would be great in a period where the track has twists and turns (volatile market)
Car C is actually not a car at all but instead it’s a tank. Slow steady but pretty much invincible. You can assume that Car C is your treasury or investment grade bond fund. The tank usually doesn’t win unless if there is a market calamity (think late 2008, when treasuries rose 40% that year)
What car would you pick? I’d say most people would pick either car A or car B. However the choice really depends on what type of track and weather conditions will be present on race day.
Before we continue in our theoretical example, we will assume that skill level of the three race car drivers are equivalent.
If the race occurred on a straightaway. car A would win hands down. If the race were on a track with a lot of twists and turns then car B would win. If the track were in a war zone, car C would win by default because it would be the only one that survived the race.
The problem with the markets is that we do not know what the environment we will encounter in the future (going back to the race track example, we dont know what track we will race on before the race occurs). To be “safe”, we ideally would need to play it conservative.
The HFs that do not hedge are similar to car A on a track with twists and turns. When obstacles appear, they are usually due for a bad accident.
Why you should hedge
Risk Management is like having brakes on your bike. You generally don’t notice that you are missing brakes until you really need it. 99.9% of the time, people without brakes and or risk management usually get injured pretty badly.
Don’t put all your eggs in one basket. If you do make sure to watch the basket and/or hen very carefully.
