Why Do People Hate Hedge Funds?

Updated on : January 21, 2022 by Declan Bailey



Why Do People Hate Hedge Funds?

Hege funds out here (not in) are basically the equivalent of a controlled crash, and no one wants to crash.

So, ergo. Hege funds are seen as a necessary evil. Nobody likes to pay for insurance either.

We're glad you're here, by the way. It's not hate, just an annoying reminder that the worst can happen.

I have worked in hedge funds for 8 years, 3 as an analyst and 5 as a PM. I mainly trade stocks, although I have also traded credit in the past. Before that, I worked in investment banking doing mergers and acquisitions.

It may answer why I choose to stay in the industry rather than why people want hedge fund jobs. I must admit that I stumbled upon this because I was looking to do something other than banking, which paid at least as well, so I interviewed both at PE stores and at HF. It's fair to say that, looking back, I had no idea what I was getting into. If it didn't work out, I'd probably go to business school or

Keep reading

I have worked in hedge funds for 8 years, 3 as an analyst and 5 as a PM. I mainly trade stocks, although I have also traded credit in the past. Before that, I worked in investment banking doing mergers and acquisitions.

It may answer why I choose to stay in the industry rather than why people want hedge fund jobs. I must admit that I stumbled upon this because I was looking to do something other than banking, which paid at least as well, so I interviewed both at PE stores and at HF. It's fair to say that, looking back, I had no idea what I was getting into. If it didn't work out, I'd probably go to business school or travel or do something different.

1. Meritocracy. At the PM level, it is a complete meritocracy. You are paid with formula and your nlp is on your screen, either in real time or the next day (for non-public instruments). At the analyst level, it is somewhat less transparent, as there is the added dimension of pitching in and convincing your PM who makes the business decisions.

2. Money. Money is good if you do it right. For me, money is a security blanket. I don't have a fancy lifestyle. Having enough money is simply knowing that if I don't want to do this, I can leave and continue to care for my family.

3. Intellectual satisfaction. It suits people who naturally ask questions, think about things, and draw logical conclusions. In equities, for example, companies report every 3 months, you want to have done the work and have a view of your positions before each earnings report. If you get the right actions, there is the satisfaction of having got the facts right and, hopefully, of making some money. And vice versa

4. General lack of bureaucracy. People are focused on making money and they are happy to do so.

5. People who speak frankly. I hang out with friends in the industry a lot. It is refreshing how unlikely they will be offended when we debate or discuss non-work issues such as politics, religion, social issues, etc. People enjoy listening to different points of view and arguing their points. When I'm with friends outside of the industry, I sometimes find how easily they get offended when someone disagrees with them. I guess when the market tells you every day that you are wrong about something or another most days, you learn to stop taking things so personally.

So let me try to contextualize things a bit. If I didn't have to work for a living, would I do this? Probably, but maybe not. The reality is that most of us have to work for a living (I come from a working class background) and since doing a job is for a living it is quite enjoyable. But I also have to be frank that it's not a job where you can expect to be mediocre and get ahead, it's pretty good or bad. Some people seem to be naturally good at it, while other equally smart or perhaps even smarter people don't seem to be able to consistently make money.

Since I started writing on Quora, this has become something of a mania of mine.

I think that unless you've worked in institutional finance, or maybe you're an academic with a deep understanding of financial risk management, you probably don't know what hedge funds do and why. Forget how.

More than that, unless you belong to the above groups, pretty much everything you think you know about it is probably wrong. And the more sure you are that you understand, the more wrong you are.

Everyone who has ever had their own trading account seems confident that they understand hedge funds. The great

Keep reading

Since I started writing on Quora, this has become something of a mania of mine.

I think that unless you've worked in institutional finance, or maybe you're an academic with a deep understanding of financial risk management, you probably don't know what hedge funds do and why. Forget how.

More than that, unless you belong to the above groups, pretty much everything you think you know about it is probably wrong. And the more sure you are that you understand, the more wrong you are.

Everyone who has ever had their own trading account seems confident that they understand hedge funds. The big money, the wild parties, the spontaneous decisions to buy millions of shares that translate into fabulous windfall profits, the supermodels, the private jets, the Caribbean islands…. everything is fine, right? Hit a few keys on a keyboard in Greenwich Connecticut, and poof, a Lambo appears in the parking lot. What could be better?

It is a really interesting phenomenon. If you dream of being a software engineer, when you finish your studies and become a software engineer, it will probably be a bit like you envisioned it. But if you dream of being a hedge fund manager, then what you are dreaming of is as reality-based as being a wizard or a space pirate. Imagine a whole world that doesn't exist now and never existed before. The entire universe you imagine is totally fictional.

That is not the end either. People who wouldn't be caught dead running a hedge fund envision a completely different fictional universe filled with equally fictional villains and victims. In that world, all hedge funds are run by people who, if they had their way, would do so from a secret base under a volcano. These people are equally convinced that they know all about hedge fund management and believe that hedge fund managers should be blacked out and feathered for it. Some think that something worse should be done to them. That is so unrealistic.

This is the point in this article where I would tell you what the truth is. But honestly, now I'm convinced that it doesn't make much sense. It is an unfortunate problem of our day that people are not interested in the real and serious story, when the fantasy of a 13 year old boy (dark or not) is available instead. If you really want to know what it's like, go ahead and read the other 50 questions I've answered about it.

It is a relatively dry, extremely demanding, relatively well-paid but incredibly competitive field, where only the best of the best of the best of the best ever really succeed. Just to defend yourself in the industry, you have to be an outlier in intelligence, work ethic, risk tolerance, objectivity, and a dozen other criteria. Put so many demands on your character that even if you do it right, your chances of "real" success are still less than 50-50. It takes you a lifetime to get there, and when you do, you discover that it will take luck to really win.

And yet ... at universities around the world, smart STEM kids are still imagining Lambo magically materializing and visiting Sotheby's real estate site to decide whether to buy an island in the Caribbean or the Aegean. Everything is fantasy. Every part of it. And all without an iota of understanding of the job, its demands and its commitments.

I don't want to be arrogant about it or overly disdain the kids who ask these questions. The truth is that I don't care much about questions. What is that old line? The only infinite things that exist are the universe and human ignorance (and I'm not sure about the universe)? The people who ask these questions are children. Their ignorance is the reason they ask, and who could blame them for that?

What really bothers me are the totally misinformed responses. Art specialists who dream that every friend I have made in the last 25 years is being chased through the streets with pitchforks and torches. The 'personal traders' who argue that it is trying to use the system that has not yet made them lose money. Or the mercenary promoters telling you to think about options strategies, currency trading or whatever system you are using today because it is 'what all the greats use'. Shameful.

The world of hedge funds is not going to "crash." It will not 'explode'. He's not going back to the (again… totally fictional) days of wild parties and supermodels. It will continue the way it has, with moderately fewer chances to get to the top. And when you achieve that near-impossible goal of getting to the top, you'll keep looking back to 'what used to be' in terms of financial success. That's the reality of the hedge fund world.

You can't get there from your bedroom. You can't be hired right after finishing college in a PM position. It has happened before, but it won't happen to you. Can you still do it? Yes absolutely. But you will have to do it that way just as hard as the vast majority of us who have done it before.

It's an MBA, a big bank training program, and at least 5 years on the sales side. This is how you 'start a hedge fund'. All the rest is just legal and accounting, and you can pay people for that.

But the truth is that you really don't want to because it is not what you are imagining.

Here's a description of the thing, it's actually:

The Front Office: A Hedge Fund Guide for Retail, Day Traders, and Aspiring Quants: Amazon.com: Costello, Tom: Books

Hedge funds may appear to underperform the market. The real question is: given a specific measurable exposure, do hedge funds still perform worse than the markets?

In other words, if the risk of two investments is (roughly) equal and one is an investment in "the market" and the other in a hedge fund, does the hedge fund still underperform?

"The market" doesn't make any sense. If you consider the stock market "the market", we still have to narrow it down as there are many stock exchanges. If we bring it down to the Dow Jones Industrial Average, we have suddenly cut "the market" down to fr

Keep reading

Hedge funds may appear to underperform the market. The real question is: given a specific measurable exposure, do hedge funds still perform worse than the markets?

In other words, if the risk of two investments is (roughly) equal and one is an investment in "the market" and the other in a hedge fund, does the hedge fund still underperform?

"The market" doesn't make any sense. If you consider the stock market "the market", we still have to narrow it down as there are many stock exchanges. If we bring it down to the Dow Jones Industrial Average, we have suddenly narrowed the "market" of the stock markets to 30 components that are traded in the United States. Do you realize that the exposure to the DJIA is completely different from the exposure to all the world's stock exchanges, and that the exposure to all the world's stock exchanges is completely different from the exposure created by a mixed portfolio of bonds? and actions?

The reason hedge funds are not in favor, at least in my business (Dutch pension investments) is twofold.
First we have a lack of transparency. Regulators are increasingly demanding that risk be fully understood, and a hedge fund is a kind of black box construction. Having a large exposure to hedge funds creates an administrative burden.
Second is public opinion, which works in two ways:
There are certain hedge funds on the Dutch market that bought bankrupt companies, reorganized them and put them on the market. Many jobs were lost in the reorganization and some of these companies did not survive. While this is how markets operate, it gave these hedge funds a bad name, and hedge funds in general.
Then there is the problem of the financing rate. Due to low interest rates and increased life expectancy, the funding ratio of many large pension funds is under pressure.
The typical hedge fund fee structure of 2% AuM + 20% performance fee is considered "too ambitious" when pensions are reduced.

As for why there is still investment in hedge funds, especially by big investors: diversification. It's about exposure. You don't want to have all your eggs in one basket and when you have a lot of money, even when you spread the money over multiple baskets, the individual baskets can be too large. This is not a retail investor problem, it only becomes a concern when you have a large amount of money to manage. With this amount of money that "performs worse than the market" is no longer a big problem (unless it is the entire portfolio, in which case you fire your investment manager), preventing the value of investments from decreasing is the challenge. .

Here's a new answer, which also happens to be my answer (why did I leave): because you realize that you could spend your entire career making the world worse.

I'm not even talking about the delicate ethical gray areas that come up from time to time, for example, that will fund polluters or dictators, or occasionally cause people to lose their jobs or things like that. I'm referring to the fact that your job in finance is to allocate capital efficiently and wisely, for the benefit of the broader economy, and there are legions of people on Wall Street who spend their entire career, or much of it,

Keep reading

Here's a new answer, which also happens to be my answer (why did I leave): because you realize that you could spend your entire career making the world worse.

I'm not even talking about the delicate ethical gray areas that come up from time to time, for example, that will fund polluters or dictators, or occasionally cause people to lose their jobs or things like that. I'm referring to the fact that your job in finance is to allocate capital efficiently and wisely, to the benefit of the broader economy, and there are legions of people on Wall Street who spend their entire career, or much of it, doing exactly what contrary.

Far? Not remotely. There is a critical mass of hedge fund managers, sales-side research analysts, and private equity professionals who make a very good living, but who, on the final count, will have delivered NO alpha after 5, 10 or even 20 years at it. And alpha is the only reason you exist. Period. Final point. Imagine how crushing it would be to be consistently mediocre, or have one or a few trades wipe out years of profit (it happens), and how fraudulent it would feel. High pay, money in the bank, high-status job, kids in private school, etc., but you come to work every day knowing that you've literally added less value to the economy than the guy who sweeps your floor.

Investment banking can be similar. Just over half of all M&A deals destroy shareholder value. Imagine that you have counseled on a number of those. Once again, he made a good living, he was able to tell people that he was an M&A banker etc, but the teachers, healthcare workers and other idiots who invested in the companies he counseled got a bit poorer thanks to you.

It is no way to go through life.

Absolutely. They are crying for market manipulation…. When people use the same tactics they have used to take money from ordinary people for decades.

They made a super risky bet. And they weren't betting on something they had, they were betting on something they LOAN. It got to a point where GameStop was leveraged 250% by hedge funds…. That means they bet more borrowed shares than existed, double. That's crazy. You can't loan a car and sell it, you can't rent a house and sell it ... why can you loan a stock and sell it?

Now that they made a terrible investment and exploded in their faces, t

Keep reading

Absolutely. They are crying for market manipulation…. When people use the same tactics they have used to take money from ordinary people for decades.

They made a super risky bet. And they weren't betting on something they had, they were betting on something they LOAN. It got to a point where GameStop was leveraged 250% by hedge funds…. That means they bet more borrowed shares than existed, double. That's crazy. You can't loan a car and sell it, you can't rent a house and sell it ... why can you loan a stock and sell it?

Now that they made a terrible investment and it blew up in their faces, they want a ransom. And I certainly hope they don't get it, that they stop encouraging this highly risky and downright illegal behavior. If the big hedge funds are bailed out for their gambling before the people get the government checks, the people will rebel. It will be the perfect example of putting the little 1% doing shady deals on the honest working class.

Retail investors didn't do anything surprising or new, they did exactly what Wall Street does, but legally. These funds manipulate the market, but it turns out that millions of investors who use technology to communicate can have the same result. But those are real people putting their own money at stake, not hedge funds gambling on teachers' pensions and illegally colluding when the going gets tough.

It's like hedge funds took people's pension money claiming it would be a risk-free investment, then they went to the casino and put it all on the road. When they lose and everyone else wins, they try to threaten the casino. They try to get the winners out by winning fairly. They took a huge risk, knowing full well what the consequences might be, but they did it anyway out of sheer arrogance and stupidity. Because at the end of the day, the money that they are losing is not there, it is the retirement fund for teachers, firefighters and other common people. And they take big risks because they think they will never have to do good, and they are driven solely by the idea of ​​making a profit like a massive bonus.

Wall Street claims they want everyone to invest. Why? Because there is more money in the pot to potentially win, knowing that they have the most unfair advantages. But when it turns out that their advantage is not as foolproof as they thought, they act as if the game was rigged against them from the start. The game was well arranged, in THEIR favor, and they still lost. Now they are acting like crazy, making a big "market manipulation" scandal as if this is not the "light" legal version of their normal operating procedure. They want people to invest and lose to fill their pockets and act like they are the only ones who can do what they do. The only reason they think is due to the large number of illegal practices that the SEC does not stop.

It turns out that now that you can trade stocks as easily as you can order a pizza, people are realizing that stockbrokers are magic. They don't know what they are doing any more than the average person, they have just rigged the game from the start. And now that they've lost the game they rigged, they're calling it foul play. They never did that when it was rigged in their favor, pure and simple. Statistics have shown that a monkey throwing darts at a dart board can have better stock picks than the highest paid stockbrokers. And just as an infinite number of monkeys on an infinite number of typewriters can write Shakespeare, enough people with easy options to invest can work together to make better decisions than so-called experts.

They lied, they cheated, they stole, and now that they're on the receiving end of that, they're making a big fuss. Using the former head of the FED who is paid a HUGE salary, and the media dominating people with blatantly false information, or inventing "technical problems" to illegally sell people's shares without their consent to lower the price. It's like they lost after playing unfairly, and they're redoubling doing ANYTHING possible (mostly illegal) to try and regain their dignity. They are willing to admit openly on television that this is "an attack on the rich" and that it is not fair for normal people to make money on the stock market. It's so crazy that you literally couldn't make these things up.

Also, for full transparency, I have no interest in any of these actions. I have never had GME option stocks, same for AMC, PLTN, Silver, etc. Also, there is a lot of misinformation from the mainstream media trying to pump up and dump other investments like Silver, or any new stock, or "new opportunity." Take any financial advice from a random person online with a grain of salt. They are blatantly trying to manipulate prices by spreading false information. And they are using mainstream media as a loudspeaker, trying to fool ordinary people who get into it because of press coverage. Be wary of anyone telling you what the "next big thing" is. As always, they are more than likely to benefit from your investment more than you. That has always happened,

Ignorance.

Most people get an idea of ​​hedge funds from movies or the media where all they see is greed and corruption. They also assume that hedge funds only manage money for a few wealthy elites.

Let's start with the last item first. Most of the money in hedge fund investments doesn't come from people with ultra-high net worth. It comes from large institutions that include, among other public and private pension plans. In practice, that means that many blue workers and government workers (city, state, etc.) have indirect investments in hedge funds through their pensions.

Media and entertainment in

Keep reading

Ignorance.

Most people get an idea of ​​hedge funds from movies or the media where all they see is greed and corruption. They also assume that hedge funds only manage money for a few wealthy elites.

Let's start with the last item first. Most of the money in hedge fund investments doesn't come from people with ultra-high net worth. It comes from large institutions that include, among other public and private pension plans. In practice, that means that many blue workers and government workers (city, state, etc.) have indirect investments in hedge funds through their pensions.

The representation of hedge funds by the media and entertainment industries is also far from the truth. There are thousands of hedge funds in the US alone, the vast majority of them are small companies that have nothing in common with the large funds that the general public sees in movies and newspapers. Many hedge funds consist of "two boys / girls and a Bloomberg". (Bloomberg is a business and market data application.) It takes an incredible amount of work (and luck) to go from “two guys and a Bloomberg firm” managing money for friends and family to a fund with $ 100 million under management.

While $ 100 million in management may seem like a lot of money, it is not so in the world of hedge funds. Hedge funds make money by charging two types of fees from investors.

  1. Management commission. That is the fee charged on the amount of managed capital.
  2. Performance commission. Performance commission charged as a percentage of profit.

The historical model has been 2% of assets for management fees and 20% of performance for performance fee. So here is a simple math.

A fund with $ 100 million under management would generate a maximum of $ 2,000,000 in management fees. Those 2 million dollars are used to pay rent, legal, market data, salary and other expenses.

If the fund works well, you can pay bonuses to employees and partners. Let's say the fund makes an impressive 20% or $ 20 million. So you can collect 4 million in yield. That's a decent amount to spread between partners and employees, especially if the number of people is small.

Now the problem is that it takes a lot of work to get to 100 million. Take the numbers above and divide by 10 to get an estimate of what an initial hedge fund will face. $ 200,000 per year in administration fees may not be enough to pay for all expenses. $ 400,000 in performance fees is not enough to retain good talent, let alone enrich members.

I agree with Gregg Lutton that it is due in part to regulation and in part to hedge fund economics. But I really disagree with the implication of the question and your answer that it is a particularly bad thing.

The regulation that prevents unrich people from investing is not there to prevent you from reaping all the glorious rewards of the hedge fund industry; It is to prevent you from being exploited by scammers and scammers. HFs have been prohibited from promoting themselves to smaller investors because they are not regulated as to what they invest in themselves and it is actually not socially desirable to do so.

Keep reading

I agree with Gregg Lutton that it is due in part to regulation and in part to hedge fund economics. But I really disagree with the implication of the question and your answer that it is a particularly bad thing.

The regulation that prevents unrich people from investing is not there to prevent you from reaping all the glorious rewards of the hedge fund industry; It is to prevent you from being exploited by scammers and scammers. HFs have been prohibited from promoting themselves to smaller investors because they are unregulated in terms of what they invest in themselves and it is actually not socially desirable for people to invest their life savings in what could effectively be banknotes. Aggressively marketed lottery. Nobody wants to have to bail out the HF industry because Grandpa has lost his pension by investing in plans to bring icebergs from the Arctic to California to provide "cheap" drinking water.

Remember that the typical HF charges a fee based on the assets it manages and the returns they earn. If they get it right, they earn both fees - you win and so do they. If they get it wrong, they still earn the administration fee - you lose, but they win. Your incentives are not as aligned with yours as you would like. In fact, they are often more incentivized to increase assets under management (AUM) than to perform well.

I'm not saying that all HF is a scam. I'm saying that if there were no restrictions on the sale of HF to unsophisticated investors, a lot more people would be trading "hedge funds" that were little more than scams.

Economics argues that it is simple. Investors are a headache for HFs. They are demanding, they want to know what you are doing and why, they need to submit reports ... they are costly to administer, both in terms of money and time. The only good thing about them is that they bring in all the money *. HFs are not set up to deal with these things on a large scale, they don't have many clients. "Not many" can be a couple hundred, or a couple dozen, or a couple. When half a dozen clients have invested $ 250 million, you really don't want someone knocking on your door asking for a $ 1,000 investment. It is a hassle that you do not need and from which you are not going to make a lot of money. So they impose minimum limits, like $ 100k because that's the point where that investor is worth having. Keep in mind that mutual funds can take much smaller amounts because that's what they're set up for - getting small amounts of money from millions of customers. It's a different business model, and it's not one that most HF managers particularly want to follow because that route involves a ton of regulation and competing with people charging fees of 0.1% instead of 2%.

But despite all this, he really shouldn't care. The people who get the money from the HFs are not the investors, they are the HF owners and the portfolio managers. When was the last time you read a story about how much money an HF manager has made for his ** clients instead of himself? Advertising is all about billionaires, and most of those guys became billionaires by getting a significant chunk of investor returns rather than because they were producing an astronomical return. Some of them have done very well for investors, but good luck figuring out what they are going to be ahead of time.

Barclays publishes the average performance of all HFs in its database. Here it is for the last few years.

Annual returns of 8.25%, 11.12%, 2.88%, 0.04% and (YTD) -0.01% during the last 4 and a half years.

In comparison, the S&P index and I will intervene here to point out that this is NOT a fair comparison because many HFs are investing in other asset classes with different profiles *** has returned 16.00%, 32.39%, 13.69%, 1.40%, and 1.74% during the same time periods (from here on).

Therefore, the question is not why you are not allowed to invest in HF. That's why the hell you want to do it.


* It is true that this is an important good thing.

** Sorry, but it's usually his and not hers.

*** I don't think HFs look particularly good if you make a fair comparison, but that's a more complicated calculation than I'm willing to try to do here - it turns out that Cliff Asness, whose work I highly recommend, has done some work more complete here Hedge funds: the defense (somewhat tepid)). A proper comparison would take into account both risk and return. You've hardly ever seen anyone do this, which is a shame because comparing the returns of one asset class to another without taking risk into account is like saying that your 12-year-old is a better hitter than Sachin Tendulkar because he has an average. 70 for his school team. and Tendulkar averaged less than 54 in Test Matches. ****

**** I was agonizing here on whether to opt for a cricket analogy for Indian readers or a baseball analogy for Americans. I guess hardly anyone will read this far so I should probably pick one up and move on.

Two reasons.

The first is what most people gravitate towards, and Mr. Styllis tipped me off: Why do people still put their money in hedge funds when there is no evidence that they are superior? - that is, they use really good advertising.

If you have $ 100 million, are you going to invest in your local Charles Schwab office on the corner of Main Street, staffed by a 28-year-old who just got his RIA license? Or are you going to talk to the guy who makes a few million a year, with a nice office and a great marketing division? There are exactly zero people who have made $ 100 million who take the first option.

But that's because

Keep reading

Two reasons.

The first is what most people gravitate towards, and Mr. Styllis tipped me off: Why do people still put their money in hedge funds when there is no evidence that they are superior? - that is, they use really good advertising.

If you have $ 100 million, are you going to invest in your local Charles Schwab office on the corner of Main Street, staffed by a 28-year-old who just got his RIA license? Or are you going to talk to the guy who makes a few million a year, with a nice office and a great marketing division? There are exactly zero people who have made $ 100 million who take the first option.

But that's because that's not what they need. If you're investing $ 100 million, it won't just put you in index funds across 3 asset classes with maybe a "wild" international ETF included. You are going to be infinitely more diverse and you are going to want to protect your wealth.

Get into hedge funds. When people say "there is no evidence that they are superior", I immediately think that they do not know what they are talking about. Sure, if you take the Barclay Hedge Indices (BarclayHedge) index, you'll quickly notice that it almost always underperforms the S&P 500. But it should underperform. Very few hedge funds actually use the S&P 500 as a benchmark.

What if a particular fund specializes in international government bonds? What about real estate funds? What about funds that invest in the S&P, but are they covered against losses?

There are tons of high-yield funds (read about the Medallion Fund if you really want to blow your mind), many of which have been topping their benchmarks for decades. The term "hedge funds" encompasses not only the daily movements of the stock market, but encompasses "anything you can make money on." There are hedge funds that invest in private bars and clubs. Those who buy and sell debt. Those who invest in extremely lucrative, but risky projects. That oil wells run. The list is endless.

Sure there are tons of funds that are scams. But guess what, there are tons of mutual funds that are too, and I don't even mean how big of a scam and bad deal most 401k plans are for employees.

But you can't say there is "zero evidence" that they outperform without even knowing what "performance" means.

That is equivalent to saying "there is no evidence that professional athletes are better at singing than non-athletes." They are not a valid comparison.

TO make such an analogy, you would have to say "why would someone invest in this set of hedge funds, which have not met their benchmark indices and / or ETF equivalents for a period of time?"

The long-term underperformance of active investment is often presented as evidence that it is fundamentally inferior to passive investment. But there is a flaw in that logic.

Ignore the fees and transaction costs for now. Passive investors get the same return as the market. As a group, all the remaining investors, that is, the active investors, also get the same result as the market. Why? Suppose that 10% of the world's wealth is passively invested. The other 90% are actively negotiating, but with whom? By definition, they trade with each other. So, for all the internal activity that goes on, active in

Keep reading

The long-term underperformance of active investment is often presented as evidence that it is fundamentally inferior to passive investment. But there is a flaw in that logic.

Ignore the fees and transaction costs for now. Passive investors get the same return as the market. As a group, all the remaining investors, that is, the active investors, also get the same result as the market. Why? Suppose that 10% of the world's wealth is passively invested. The other 90% are actively negotiating, but with whom? By definition, they trade with each other. So despite all the internal activity going on, active investors as a group can be seen as one giant passive investor. But the fees and transaction costs for active investing are much higher than for passive investing. So collectively, passive investors outnumber active investors, and the difference in return equals the difference in these expenses.

But, this is not the damning criticism of active investing that is generally believed. All that has been established is the nature of the beast to play the game of active investment. It is a zero-sum game with fees, similar to a game of poker where the house collects a small rake on each round. Would you walk up to a poker table, select a player at random, and ask if you can invest in his game? Of course, no; you better not play at all. But similarly, the fact that active funds as a group underperform liabilities only tells us that we would be better off with a low-cost index fund than with a randomly selected active fund. Research suggests that, furthermore, in the long term, only a small minority of active funds outperform their ratios,

On the other hand, a small minority of the best poker players could beat not only their competition, but rake as well, and be profitable in the long run. Perhaps the best of the best poker players could not only beat you on rake, but could also charge you a fee for working on your behalf and still earn extra money for you. Similarly, the best active fund might be able to beat all the competition and all the transaction costs and other costs of doing business, and the fees it decides to charge investors.

Can you identify the best of the best from active funds? Even if it were that simple, another problem is that if other people also think that a particular active fund can beat the market, they will all want to get in. In response to skyrocketing demand, the fund may close new investors, raise fees, or find itself with a lot more money to manage (which generally lowers returns).

I don't see any case with any of the above that active investing is completely worthless. But the deck is heavily stacked against active investors trying to beat the market. Going back to your question why one might choose a hedge fund over passive indexing - a person who has made a career in finance, is currently fully wired across the industry and is simply one of the best when it comes to to investment. savvy is an example of someone who could identify the rare hedge fund open to new investors that could generate excessive risk-adjusted returns. I'm not talking about hiring such a person to find a hedge fund for you, I mean if you are that person.

All that said, hedge funds can offer types of diversification not available with traditional asset classes that could be helpful even if the hedge fund can't beat the market, but the hurdles outlined above still apply.

Here's a little background on myself: I completed my bachelor's degree when I was 17 and graduated from one of the top 5 universities in the US, all my studies were in math. I have worked in the financial sector, specifically for quantitative hedge funds, since I finished graduate school. Do I consider myself intelligent in relation to the population as a whole? Sure (probably not the humblest thing to think about). My colleagues have similar backgrounds, so to the outsiders we sure look like a bunch of math geniuses.

However, I think it is considered the keyword in your question. There'

Keep reading

Here's a little background on myself: I completed my bachelor's degree when I was 17 and graduated from one of the top 5 universities in the US, all my studies were in math. I have worked in the financial sector, specifically for quantitative hedge funds, since I finished graduate school. Do I consider myself intelligent in relation to the population as a whole? Sure (probably not the humblest thing to think about). My colleagues have similar backgrounds, so to the outsiders we sure look like a bunch of math geniuses.

However, I think it is considered the keyword in your question. Is there a difference between considered and really correct? Unfortunately, I don't think anyone I've ever met in the finance field can even come close to the definition of genius, even in their best days (myself included). Certainly none of them would have solved any millennium awards problem had they not been in finance. My general feeling is that there are only a small number of deep models out there. The rest are simple methods combined with a lot of very hard work.

IMHO, the reason people seem to get that impression is a combination of their own inability to gauge what smart really means, the ego of hedge fund people and marketing (I use this term loosely ) implemented by funds.

Other Guides:


GET SPECIAL OFFER FROM OUR PARTNER.