3 Lessons From Hedge Funds
How individuals can invest like a top-tier hedge fund manager
A couple of times a year I used to go to New York, Connecticut or Boston to meet with a number of top-tier hedge funds.
This was before most investors had heard of the term “hedge fund”. It was also before some of the top-tier hedge fund managers I met with (Bill Ackman, Seth Klarman, etc.) were well known.
The relative obscurity of these managers coupled with the fact that I had clients invested with them provided me the opportunity sit in their offices and pepper them with questions about their portfolios and investment styles.
Since I didn’t have near enough money to invest with them personally, I was always looking for how I could apply their wisdom to my own investment portfolio.
Here are three lessons I learned from top-tier hedge fund managers that individuals can apply on their own.
1. Don’t Lose Money
Hedge funds hate to suffer portfolio losses. Two things occur when hedge funds lose money. Their income plummets, and they eventually go out of business.
Hedge fund managers typically keep 20% of their funds’ investment profits annually. When they lose money, not only do hedge funds stop earning this incentive fee, but they have to make up all of the losses before they can start to again receive a percentage of the profits. This is called the high water mark.
Imagine if your salary was cut 80% after making a big mistake, and then you had to make up the lost company revenue before your pay was restored. If the mistakes continued, you would get fired. Or you might have to quit even before you got fired because you couldn’t live on your reduced salary.
Hedge funds are the same way. When they lose money, their income falls, and if they don’t quickly make up the losses their top traders leave because of reduced pay. Then the hedge funds’ investors begin to withdraw their capital because of the exiting talent, often forcing the hedge funds to shut down.
Individual investors who lost money in the stock market in 2008 know how long it can take to bring their portfolios back to even. Hedge funds can’t afford to lose that kind of money (nor can individuals for that matter) so hedge funds seek to earn investment profits only in ways that offer protection against losses.
2. Protect Against the Unknowns
One way hedge funds seek to avoid losing money is by hedging. Hedging simply means to give up a portion of the upside return to protect against portfolio losses.
Hedge funds often do this by entering into contracts where they pay small insurance-like premiums in exchange for receiving large payouts if specific events happen. These contracts can be privately negotiated or purchased on an exchange in the form of derivative securities, such as put options.
While many hedge funds won’t admit this, if you probe and ask what specific events they are hedging against, often they will say they don’t know. They are hedging against unpredictable, unknowable bad events.
Individuals hedge when they purchase home owners or auto insurance. Yet, when it comes to their investment portfolios, many individual investors are completely unprotected. Sure, individuals diversify into different asset categories in hopes that they won’t all fall at the same time.
Unfortunately, many investors learned the hard way in 2008 that diversified portfolios didn’t offer as much protection as they thought.
Diversification often fails because market losses can be far worse, happen more frequently, and cluster together more than what conventional financial theory predicts.
There is simple way individuals can hedge against portfolio losses that is often used by hedge funds and doesn’t require purchasing complex derivative securities. That is the third lesson.
3. Keep a Margin of Safety
Individuals can hedge against portfolio losses by keeping a margin of safety in the form of a cash buffer. I know several top hedge funds that at times will hold 40% or more in cash as they patiently wait for investment opportunities.
I call this Staying Close to Home Base.
Home Base is the target portfolio mix that minimizes the devastating impact of losses. It is your risk neutral position.
A target portfolio mix is the defined allocation between the various investment types such as stocks, bonds, and cash. This risk neutral position or home base can differ between individuals.
A 30 year-old investor with $30,000 in his 401k portfolio will have a different risk neutral position than a 55 year-old with close to $750,000 in her retirement investment portfolio.
Who will lose more money (in dollar terms) if their portfolios fall 30%? Who has a shorter time to recover from those losses? The 55 year-old of course.
The 55 year-old will have a home base position with a much higher margin of safety than a 30 year-old.
Similar to hedge funds, the amount of cash buffer you maintain depends on market conditions.
When markets are undervalued, investors are fearful and there are plenty of investment opportunities, then the margin of safety would be on the lower side. Those were the market conditions in the spring of 2009, which turned out to be a great buying opportunity.
Conversely, when markets are fair to overvalued, investors are bullish, but corporate insiders are selling then that is the time to keep a higher margin of safety in the form of a cash buffer. Those are the market conditions today.
Increasing your margin of safety when most investors are lowering theirs illustrates a final key attribute of every successful hedge fund manager I know. They are willing to zig when everyone else is zagging.
Want to learn more? Watch my video What Is A Hedge Fund and How to Invest Like One.
