Is Hedge Fund Investing For You?
May. 5, 2015 6:37 AM
- Why are "unregulated" hedge funds so "secretive"?
- Why are their managers so "reclusive"?
- Why do they make is so hard for people to invest with them?
Hedge Fund Investing, Democratized
What is a hedge fund?
There are many different types of hedge funds, but for the most part, they are mostly research operations. The research that hedge funds produce is primarily based on original sources. In this regard, it has more akin to investigative journalism or detective work than the media would have people believe. It involves an enormous amount of reading.
Prices, and more specifically, mispricing. They are in the business of finding flaws in the markets and fixing them for a profit. Here is where hedge funds really differ from traditional money managers, even though the basic description sounds similar. Conventional money managers pay a given price for stocks or bonds in order to expose their investors to that risk (aka beta).
What hedge funds do looks similar, but is completely different. They research lots of different securities and markets in order to wait for and recognize a flaw in the price system. Markets can operate smoothly, rationally and efficiently most of the time. But sometimes they don't. It has to sort out differences between views on what something is worth - value - but also sort out differences in terms of how much someone wants their money back - liquidity. Occasionally, the job that a single price has to do leaves it out of whack. That is when hedge funds swoop in.
Hedge Funds Regulate Markets
Unregulated? The short answer is that it is simply untrue. Hedge funds have regulators. The regulations that govern hedge funds are the primary reason they seem so secretive in the first place.
The longer answer is that hedge funds are market regulators. It is normal for hedge funds to spend hundreds, if not thousands, of man hours on a given investment, with research into every conceivable aspect of a potential investment. Due to the intense pressure for fund managers to operate on a timely basis, this work is typically done months or sometimes years before a government regulator has looked into a market.
What do fund managers find? Many of the accounting frauds of the past few decades were discovered by hedge fund research well before the government or auditors. Hedge fund research first drew attention to structural flaws within housing finance, bond insurance, and sovereign debt. Hedge funds have the motive, alignment, and resources to uncover and begin to fix market flaws in a way that is swifter and surer than any government.
Hedge funds are partnerships, both in structure and in substance in ways that few other industries still are. Fund managers usually have much of their wealth in the funds that they offer to investors. For better or for worse, they are on the same team. In the 1800s, private partnerships dominated the financial services industry, but they died out throughout the 20th century. And in 2008, when we went through the greatest financial crisis since the Great Depression, the epicenter of the crisis was our government and public corporations.
With so much of their own money at stake, most private partnerships behaved much as they have for centuries. There were few hedge fund failures, and none that threatened the stability of our economy or required a bailout. They were researching, waiting, watching, and finding price failures.
The problem with partnerships is that the structure limits those who can access these vehicles, as it is usually non-economic for a partnership to accept smaller accounts, because they have a limited number of slots, and regulations limit the investors who can invest to only those with a certain amount of capital. Hedge funds are a vehicle for the rich because the government requires it. Trying to take on that problem is Mike Furlong and Akhil Lodha, the co-founders of an interesting new company out of San Francisco called Sliced Investing .
Michael Furlong, Co-Founder at Sliced Investing
Mike and Akhil, first off, thanks for taking the time to answer a few questions about Sliced Investing. The hedge fund industry hasn't exactly been the darling of the press these last few years. There are lots of ways to make a buck in the investment management business. What made you guys want to focus on hedge funds and other private offerings?
We strongly feel that there is a need for active management in an individual's portfolio. Without active management, it is very difficult to achieve a well balanced portfolio that has low correlation to the broader market. Most institutional investors devote 20-40% of their portfolio to active management.
We focus mainly on hedge funds because they are historically exceptional investments. Average hedge fund performance (net of fees and expenses) going back to 1990 still well outperforms the performance of the S&P 500 (NYSEARCA:SPY ), with about half as much volatility. We found that there wasn't a centralized place where investors could learn about hedge funds and invest into them in a streamlined manner. We wanted to leverage technology to make hedge fund investing more accessible, transparent and efficient.
We also choose to be involved in late-stage private equity, most recently having facilitated an investment into a fund that was dedicated to Lyft's Series E. On average, late-stage investments that end up IPOing have had great returns. In 2014, private equity investor returns from the latest private round to an exit at the expiration of a lock-up was about 137% cumulative return, and about 191% for Technology, Media and Telecom companies.
And recently, companies are choosing to stay private longer. Do you know what the market capitalization was of Microsoft (NASDAQ:MSFT ) when they went public on March 13, 1986? A mere $500 million (
$1 billion in today's dollars). Compare that to Google (GOOG. GOOGL ) at $24 billion and Facebook (NASDAQ:FB ) at 100 billion. See a trend here? If you had bought just 100 shares of Microsoft at the $21 offering and rode it all the way up to its peak in 1999, you would have cashed out for $1.4 million. You'd still have around $1 million bucks today, despite the stock's downturn. Not bad.
Akhil Lodha, Founder at Sliced Investing
A lot of institutions and big investment firms have access to the biggest and best-known hedge funds and private equity offerings in the industry. Where does Sliced fit in that food chain? Do you think smaller individual investors have a fighting chance? Do smaller investors
have any advantages in this space that they can use to their benefit?
Sliced Investing is market place that offers investors a variety of hedge fund investments. On Sliced, you can find funds that are accessible through the institutions and big investment firms, as well as smaller funds that are very niche and less known, but have done extremely well. In fact, we started Sliced on the premise that hedge fund investing is actually better for smaller investors. The best hedge funds aren't, and have never been, the largest. Smaller, niche hedge funds have historically outperformed larger ones, but they're especially hard to find. Intuitively, opportunities in the public markets are often supply-constrained and can only take so much capital. Inefficiencies often exist for a very short period of time, and investment managers need the ability to be flexible. In short, it's a lot easier to double $100,000 than it is to double $10 billion.
At Sliced, we focus on funds that are clearly exploiting a certain inefficiency in the market, and as a result, can generally only take so much capital. This works well for our investors, whose average investment size is roughly $75,000.
In terms of picking and choosing alternative investments, what do you see as some of the biggest differences in due diligence and research that investors should do versus what they might do before allocating some of their money to a traditional wealth manager or a mutual fund?
I generally like to say that hedge funds aren't an asset class - they're more of a way to express a certain view on the world that you can't do with traditional investments or advisors. When you're investing in a hedge fund, you're really investing in a manager that has a view on the world that you agree with. Let's say you believe that the coming year will be ridden with M&A, but are unsure about the direction of the S&P 500 or volatility. That's a tough view to execute on your own. However, there are many neutral event-driven hedge fund managers that work all day trying to capitalize on that exact thesis. Investing in a hedge fund should be personal and customized - something that makes sense thematically and logically in the greater context of one's portfolio.
Another important point to keep in mind is that alternative investments generally tend to have longer lock-up periods when compared to traditional investments. At Sliced, we've found that in order for investors to be comfortable with longer lock-ups, they need to be able to track and monitor their investments easily. The Sliced Investing platform solves this problem by providing an intuitive dashboard with streamlined reporting, so that investors can stay on top of their investments.
You must have pretty good visibility into what some of the hedge funds you work with do. Can you share some of your favorite investment ideas you've encountered thus far, or themes that you've seen emerge, to give folks a glimpse into how hedge funds are positioning their portfolios in this market environment?
Given the increased volatility in the markets, hedge funds have performed very well thus far in 2015. As a whole, however, I think most are still (cautiously) bullish on the market.
One interesting trade I heard recently was a longer-term trade based on the emergence of the ride-sharing economy. The trade is a short on Avis (NASDAQ:CAR ) and Hertz (NYSE:HTZ ), as Uber and Lyft plan on moving into that area. The idea is that many travelers (particularly business travelers) prefer the ease and efficiency of Uber over renting a car.
Another interesting trend is in the semi-conductor sectors, which has shown significant appreciation in the last 24 months. Semiconductor gains have been due to a lot of M&A - but the M&A is resulting in interesting outcomes. For example, the share prices of both the acquirer and the acquiree have been rising in takeovers. This phenomenon has been caused by a number of macro factors, such as low interest rates which allow acquiring companies to fund deals that, in many cases, become immediately accretive. One of our managers was long Freescale Semiconductor (NYSE:FSL ) and NXP Semiconductors (NASDAQ:NXPI ), as both shares rose significantly upon the announcement of their intent to merge, and benefited tremendously on the trade.
Finally, an Apple (NASDAQ:AAPL ) a day seems to still be keeping the doctor away. A number of Long/Short Equity funds we see still hold AAPL as a core or semi-core position. That stock has been fantastic, and most funds are still generally bullish about it.
A lot of us look at the financial industry from the perspective of what's happening in New York. From Silicon Valley, where do you see the industry going, and what changes do you think technology will play?
Having previously worked as a trader at Citigroup in New York, people often ask me how it feels to have left finance to switch to Silicon Valley. I usually respond by telling them that I have never felt closer to finance. This is because of the vast number of financial technology companies in the Valley focusing on making all the areas of finance/banking (lending, investing, savings, etc.) more efficient. Fintech investments have been one of the main focuses of VCs, and will likely continue to be.
The greater impact of technology on finance is that it's enhancing user experience. Finance is supposed to be about the customer and, at root, about keeping people's money safe. In light of the financial crisis and the Great Recession, public trust in banks has plummeted. Technology helps to improve transparency, reduce fees and democratize investments - each of which can clear the fog of mistrust over time. The rise of technology has enabled a resurgence in traditional finance value propositions: protecting and empowering the individual.
Gentlemen, thank you for taking the time to answer my questions, and thanks for making alternative investments more accessible.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.