Hedge funds are the rock stars of the investment world…for now

This post originally appeared at the newish Amazon Money & Markets blog. Last month I had a post up there on “must read investment books” that complements this post as well. Please leave a comment with some additional hedge fund-related books you think are worth a look.
AMZNMM 300x86 Hedge funds are the rock stars of the investment world...for now

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Today when hedge fund managers take the stage at conferences, like the Ira Sohn Conference, their stock recommendations, both long and short, are breathlessly reported to the financial world in real-time. It was recently reported by Hedge Fund Research that global hedge funds now oversee $2.2 trillion in assets, a record. The growth in hedge funds has not been lost on individual investors either. Another report shows that individual investors are looking to replace traditional investments with alternative investments. Presumably this would include allocations to hedge fund-like strategies.

Hedge funds are simply private investment partnerships with two main features. As I note in my book Abnormal Returns: Winning Strategies From the Frontlines of the Investment Blogosphere, hedge funds are designed to provide higher risk-adjusted returns available from traditional asset classes. The managers of hedge funds are typically compensated with annual management fees but also with incentive fees based on fund performance. That latter feature helps attract the best managers to the industry.

It wasn’t all that long ago that mutual fund managers were the rock stars of the investment world. Throughout the bull market of the 1980s and 90s it was mutual fund mangers, like Peter Lynch, who were the focus of media attention. In fact some good books on investing came out of that era including Lynch’s One Up on Wall Street and John Neff’s John Neff on Investing. However the end of the dot-com bubble seemed to end the era when investors looked up to mutual fund managers.

Today investors are supremely interested in what hedge fund managers have to say about their investment processes. In part this has to do with the astounding sums that the top hedge fund managers can take home in a year. A quick peek at the Forbes list of the highest earning hedge fund managers shows dozens of hedge fund managers who earned multiples of what the highest paid executive at a major bank makes in a year.

In a more positive light I think investors are genuinely curious about how these managers go about their business. Two of the best-selling finance books released this year have been collections of interviews with hedge fund managers. These include Hedge Fund Market Wizards by Jack Schwager and Maneet Ahuja’s The Alpha Masters. Hedge fund managers have also taken time out to write their own books as well. High profile manager David Einhorn chronicled his battle with a company in Fooling Some of the People All of the Time and a while back Joel Greenblatt wrote a great book with a silly title You Can Be a Stock Market Genius.

In addition to trying to take some lessons away from individual managers a review of the history of hedge funds can provide some greater insight into the financial markets in general. In our prior post we mentioned When Genius Failed, a history of the downfall of Long Term Capital Management, by Roger Lowenstein as a great example of this genre. Another newer book that covers the history of a number or hedge fund managers is Sebastian Mallaby’s More Money Than God. Indeed one can argue that the history of the financial markets over the past few decades is well-chronicled by the rise of hedge funds.

That is not to say that one should not take a skeptical look behind the idea of hedge funds. Simon Lack in his book The Hedge Fund Mirage is highly critical of the overall performance of the hedge fund industry. By his calculations the hedge fund industry has failed to even keep up with the performance of Treasury bills. Nor is it easy for even the best managers to stay on top of the world. John Paulson whose trades leading up the financial crisis were chronicled in Gregory Zuckerman’s The Greatest Trade Ever has by struggled the past few years.

Maybe it is simply the case that the hedge fund managers we know best are those that have also been the luckiest. Michael Mauboussin in his new book The Success Equation looks a the fact that in the realm of investing luck plays an important role in finance. In that light investing isn’t all that different than music. We are all well aware of talented artists who for whatever reason were unable to break into the limelight while other artists with seemingly less talent have flourished.

The fact is that the vast majority of individual investors simply don’t have access to high profile hedge fund managers. That may very well be a good thing. John Bogle in his latest book The Clash of Cultures: Investment vs. Speculation chronicles how a misplaced emphasis on speculation has been a detriment to investors and society alike. Investors should try and learn what they can from the history of hedge funds and from the strategies of individual hedge fund managers all the while recognizing that hedge funds have been net-net more successful in marketing than they have in their overall performance. It seems that some wealthy individuals have taken this lesson to heart and have pulled back on their hedge fund investments. This report notes how an institutional focus and relatively poor performance has gotten private investors to reconsider their hedge funds as a part of their portfolio.

Most of us will never become rock stars, and any one who has read a rock star autobiography recognizes that the life of a rock star is not all it is cracked up to be. In that same light most of us will never become hedge fund stars either. That doesn’t mean we can’t learn some valuable lessons along the way. Maybe our time is better spent following the fictional travails of a shady hedge fund manager played by Richard Gere in the recently released thriller Arbitrage. At least in this case of a movie you will know just how much time and money you are risking along the way.

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