Hedge Funds

Dante's Inferno*

Client (“C”): I’m thinking about starting a hedge fund.

Advisor (“A”): Do you even know what a hedge fund is?

C: It’s where the manager makes a lot of money.

A: A lot of people make a lot of money. Drug dealers make a lot of money.

C: Yes, but those are criminals.

A: Exactly.

C: C’mon.

A: A hedge fund is a partnership where the limited partner, like you, gives the money and the general partner, the big honcho, makes the decisions. You can only invest in a hedge fund if you are an accredited investor, which is someone who makes at least $200k per year and has at least $1m in the bank or in their house.

C: Do bitcoins count?

A: Last year, maybe. This year, no.

C: Easy come, easy go. Anyway, I give the money and they make the decisions? That’s not fair.

A: That’s the way it is. They take 2% to manage the partnership and then they get 20% of the profits, leaving you with the other 80%. If they make a lot of money, you make your 80% and they make their 20%. If they don’t make any money, you don’t make any money, but they still take their 2% fee.

C: I don’t like where this is going.

A: They use many strategies. “long/short” is where they simultaneously buy and sell stock; “activist” is where they buy the stock of a distressed company to make it better; “quantitative trading” is where they use very fast computers to figure out tiny differences in stock prices. Pretty neat, huh?

C: Who says neat? What are you, a centennial?

A: I’ll ignore that. Reuters reported (03/23/18) that at the end of 2017, there was $3.2 Trillion invested in 9,754 hedge funds.

C: Okay, I’m counting on my fingers. That’s an average of $328m per fund, or $6.5m at a 2% fee for the manager whether or not the investor makes money, right?

A: Good math. Anyway, what’s good for the general partner is not always good for the limited partner. Let’s review some terms: Hedge Fund; 2 and 20; Redemption; Side Pocket; Gate; High Water Mark.

C: What are these, circus rides?

A: Let’s get started. What’s a hedge fund?

C: It’s what I look through to see my neighbors skinny dipping.

A: Be serious. It’s a partnership that uses different strategies to try to make money.

Again, what’s 2 and 20?

C: Jail time and parole?

A: What is the matter with you? It’s the 2% management fee they take and the 20% of the profits they make.

What is redemption?

C: It’s praying I don’t go to hell for looking at my neighbor.

A: I’m about to give up on you. It’s a hedge fund telling you when you can get back your money.

What’s a side pocket?

C: It’s on the pool table. If I play too much my mom says I’ll go to hell.

A: Why are you doing this? No, it’s a hedge fund that puts some of your money aside and tells you how much you may someday get back. I’ve seen it.

What’s a gate?

C: My prayers didn’t work and I’m in hell?

A: Do me a favor and close the gate behind you. It’s when a hedge fund tells you when or if you’ll get any money back at all.

C: WAIT A SECOND, A HEDGE FUND CAN TAKE MY MONEY AND DECIDE WHEN OR IF I‘LL EVER GET IT BACK?

A: Hey, you signed the partnership agreement.

What’s the high water mark?

C: It separates heaven from hell?

A: In a manner of speaking. When a hedge fund goes above the high water mark, or reaches “heaven,” they make their 20% of the profits and you make your 80%. When the fund goes below the high water mark, or descends into “hell,” you both make nothing, but the fund still takes their 2% management fee.

C: I make my 80% in heaven and I make nothing in hell. What’s so terrible about that?

A: Nothing, except sometimes the hedge fund goes below the high water mark and it’s lost money and cannot make a profit. If they can’t make a profit then they can’t pay their traders big bonuses. The traders then go to another hedge fund that is not below its high water mark where they can, again, make those big bonuses.

C: They lose some traders, so what? All they do is look at six television screens and watch Naked and Afraid.

A: Good traders can make a lot of money for the hedge fund, and can sometimes make $1m bonuses for themselves. Bad traders can lose money for the hedge fund and not make any bonuses. To keep giving the good traders bonuses, sometimes the general partner will close the old hedge fund and open a new one doing the same thing, but at a lower high water mark. I’ve seen this. In the meantime, you have lost money in the old hedge fund.

I know this can be a little confusing.

C: CONFUSING, SHMUGUSING!!! YOU’RE TELLING ME THAT I’VE LOST MONEY IN THE OLD FUND AND IT’S “SO LONG, CHARLIE” TO ME?

A: I’m afraid so.

C: Still, if the hedge fund makes money, then we both make money, correct?

A: Yes. However, Warren Buffett…

C: The guy who carves the steak at brunch?

A: Please be serious for a change. Ten years ago, Warren Buffett bet $1m that you would make more money investing in the stock market than you would investing in some hedge funds.

C: And?

A: The market beat the hedge funds, annually returning 7.1% vs. 2.2%, respectively. Very few hedge funds actually beat the market.

C: So, if hedge funds are only for accredited investors, wealthy people who might be smarter than me and make more money than me, why would they invest in something that does worse than the stock market?

A: I have no idea.

C: Now do you see why I want to be a hedge fund manager?

A: No, why?

C: Because even if I lose money, I still take $6.5m in management fees and you get nothing. Ha Ha. I’m outta here.

A: That’s a pretty lousy attitude. You know, you could go to hell.

C: Hey, that’s where the money is. Show me the way!

*A topic suggested to me by a member of Hedge Fund Investors Anonymous.

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