Topic: ETFs

The pitfalls of hedge fund investing and other market innovations

Hedge fund investing

Hedge fund investing may sound good on paper but in actuality, it requires superhuman timing, and the inevitable mistakes can be super expensive.

Hedge fund investing aims to buy good stocks and sell bad stocks “short” (that means borrowing bad stocks, selling them, and only buying them back to repay the loan after prices have dropped) in hopes of making money regardless of the market’s direction.

Here’s the strategy of hedge fund investing: If the market goes up, the good stocks should rise more than the weak ones, so the gains on the good stocks should exceed losses on the short sales. If the market falls, the bad stocks should fall more than the good, so gains on the short sales should exceed losses. But profitable short selling requires superhuman timing, and the inevitable mistakes can be super expensive.

Investors are often surprised when we tell them that we see nothing inherently wrong with the basic concept of hedge fund investing.

In essence, hedge-fund managers are supposed to buy stocks they like, while simultaneously selling short in stocks they feel are unattractive.

This aims to put their fund in a “market-neutral” position. By buying good stocks and shorting bad ones, you have hedged your stock market exposure. Theoretically, this means you make money regardless of which way the market moves.

If the market goes up, all or most of the stocks you own or have shorted are likely to gain as well. However, if you have chosen your buys and short sales wisely, and diversified, the stocks you own are likely to gain more value in total than the stocks you’ve sold short.

You are unlikely to make as much profit in a rising market as a so-called “long-only” investor (one who only bought stocks but didn’t do any shorting). But you are still likely to make money.

If the market goes down, all or most of the stocks you own are likely to go down. But the stocks you’ve sold short are likely to fall more than your buys. That’s because bad stocks—those with high risk and/or little investment appeal—are particularly vulnerable to a big decline when the market as a whole is falling.

That’s the basic concept of hedge fund investing, but it’s hard to apply consistently. This is mainly due to the difficulty of making money as a short seller. Timing—getting in and out at the right moment—is vastly more important for a short seller than a stock buyer. But bad stocks tend to be more volatile and unpredictable than good stocks.

Short-selling is not a long-term investing strategy

Hedge-fund managers use the above maneuvers to offset (or, in some cases, amplify) the risks of investing in stocks. This combination can work well for years, but the speculative element of hedge fund investing carries a hidden risk. At unpredictable moments, this risk flares up and the strategy backfires. This can turn a seeming investment haven into a financial nightmare.

Hedge funds did well in the soaring markets of the 1990s. Their returns stalled in the last decade. In the past few years, they failed to keep up with the rising market.

It’s a common pattern with investment innovations. As the innovation becomes better known and more widely available, it quits working. Sometimes it turns from a strong performer into a guaranteed loser.

While basic hedge fund investing performance faded, investment marketers broadened the product line.

In recent years, a number of well-respected financial firms launched so-called “liquid alternative” mutual funds. The name may suggest something safe, like T-bills or other liquid investments. But these funds aim to generate income using a milder dose of risky hedge fund investing strategies. When these strategies began to backfire last year, the respected sponsors of some liquid alternative funds did the right thing: they shut the funds down while investor losses were still modest, even though this shut off a source of fee income.

Investors still lost money, of course. But losses were far less than in earlier hedge-fund failures. That’s progress, of a sort—a little like the invention of filter cigarettes.

Downplaying marketing when investing in hedge funds

Hedge fund marketing tends to focus on the investment manager’s professed motives and methods, rather than on the investments themselves. But success in marketing simply means big sales for the product. The outcome for hedge fund investors is a separate matter. Any kind of investment marketing can lead to unsuccessful investing.

To succeed as an investor, you need to disregard or at least downplay any marketing messages. Instead, focus on where your money is actually going. This determines how much risk you take on, and how likely you are to lose or make money.

Hedge fund investing and funds have long been associated in the public’s mind with reclusive offshore millionaires, and are still a prestige item for some investors. In addition, they’re hugely profitable for the sponsors because of incentive fees — investors pay extra if the fund performs well. Brokers are also happy to earn commissions by selling the funds. Hedge funds trade heavily, and they usually trade through brokerage firms that sell them to investors.

It’s a common investment situation. The hedge funds make money; the broker makes money; sometimes even the client makes money. Of course, some investors lose heavily because of the fees and risks. Our advice: stay out.

Have you ever tried hedge fund investing? Was it profitable? Share your experience with us in the comment section.


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