To many investors, the term “hedge fund” conjures up images of master-of-the-universe celebrity managers whose investing prowess and intelligence is unapproachable by the common person. From my experience though, the axiom about celebrities that my father was fond of repeating to me is true for these masters of the universe as well: “They all put their pants on one leg at a time.”

No matter what strategies are used, at the end of the day, a hedge fund manager’s real job is consistently making good decisions on behalf of their pension, endowment, and other clients. In my experience, while hedge funds do employ very smart and capable people, these people fall prey to many of the same hard-wired biases in decision making that non-institutional investors do. In addition, because hedge fund managers are “agents” working on behalf of “principals” (i.e., owners of capital) in return for compensation, compensation structure ends up having an effect on the decisions the agents make.

For example, a hedge fund employee often has a vested interest in investing in very risky assets; the employee’s compensation is structured such that they will enjoy a proportion of profits from a gain, but will not necessarily be penalized when a risky strategy produces a loss (the careful reader will realize that this structure is exactly that of a call option. In essence, a hedge fund employee’s employment contract grants him or her a free call option on the performance of the principal’s capital). The results can be terrible.

An article in Inside Sources entitled As Some Hedge Funds Falter, Others Prove Staying Power looks at the degree to which hedge funds are successful at making good investment decisions, and hints at some of the structural issues inherent in the agent-principal model. I don’t want to ruin the punchline, but one quote early in the article stood out to me:

“Plenty of hedge funds have no real ‘edge’ — if you strip away the marketing hype and occasional flashes of dumb luck, there is no distinctive investment insight that allows them to beat the market consistently.”*

In fact, my standard reply to people asking about my my experience with hedge funds is that over time, many of them end up using risky assets to generate risk-free returns on behalf of their clients.

As you may have guessed, the article is generally critical and talks about the recent decision of large and influential principals like Calpers to cease allocating capital to hedge funds. However, it also describes a bit of the history of the original hedged fund and also has some pearls of wisdom that are applicable to intelligent option investors. One of the pearls that stood out to me was this quote:

Any investor can make big bets, like buying a broad range of stocks and using borrowed money to make the bet many times over, but winning hedge fund managers don’t do that. They look for good risk-adjusted returns, opportunities to make profits out of proportion to the risks they take. In other words, the best ones make a high return without taking on the high risk that defines truly reckless gambling.

The emphasis in this quote is mine as it highlights exactly the operative process of intelligent option investing: tilting the balance of risk and reward in the investor’s favor. The insights that we offer as part of our 100-series courses are precisely the process of tilting the balance of risk and reward in your favor:

  • Understanding the behavioral biases and structural factors that can lead to poor decision making and developing a framework to make better decisions
  • Building a strong, testable, and repeatable foundation for estimating a company’s value, and
  • Understanding how to use options to generate income, boost growth, and protect gains

I’ll close with one of my favorite investing quotes (courtesy of Peter Lynch) apropos to the question of how good hedge fund investments are:

Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert.

In my opinion, the only thing that a “normal person” needs to do this is a bit of training and a sensible, repeatable framework for making good decisions!

* Quoted from Sebastian Mallaby’s 2010 book about the hedge fund industry More Money Than God.

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