Why Following Hedge Funds is a Terrible Investment Strategy

What Makes the “Smart” Money so Dumb?

Hedge – def: an investment to reduce the risk of adverse price movements in an asset.

Fund – def: a supply of capital belonging to numerous investors that provides a broader selection of investment opportunities, lower fees, and greater management expertise than investors might be able to obtain on their own.

Hedge Fund – def: a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains.  (While charging investors exorbitant fees)

Smart Money – def: Investments or trades made by sophisticated investors who have an understanding of the financial markets and can often spot trends before others.

“..before making any trading decisions, it’s usually constructive to first figure out where the smart money is headed.” – unnamed investment blog

The strategy of monitoring the “smart” money and copying their moves is one of the oldest tricks in the investment book.  Why do your own research and try to come up with your own investing ideas, if you can just piggy-back the best and brightest investors out there?  It makes sense from a logical stand-point, but is that really a wise move for your own investments?

A few years ago I read a book that profiled some of the most prolific hedge fund managers of our time, called, modestly, More Money Than God.  It was a great character study where each of the subjects is largely credited with earning their fortunes based on incredible investment skill.  The only issue is that the actual hedge fund business is not dependent solely on investing skill, but more so on gathering assets from investors.  Therefore, it’s not the investing skill that is the most important aspect of success, but rather the projection of investing brilliance that matters most.

Warren Buffett, as usual, put it best, saying at his recent annual meeting. “There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities.”

Obviously, getting potential investors to believe that you are a genius is much easier with a successful investing track record, but it also requires a huge amount of bravado and self-confidence.  However, this same required swagger is what has led to several major fund blow-ups as well.  Observe the following cases in point:

Long Term Capital Management (LTCM) –

This company was the quintessential smart money fund.  It had on its board two Noble Prize winners in economics, Myron Scholes and Robert Merton, who formulated a derivative pricing model.  This fund would look to exploit small pricing discrepancies in markets and utilized leverage to amplify the return.  For instance, you could find a 0.5% pricing error and borrow 50 times your principal to make a 25% return (not exactly but that’s the gist.)

Unfortunately, leverage works in the other direction as well.  In 1997 when the Asian currency crisis hit, these pricing discrepancies got larger instead of smaller and the leverage amplified the losses.  In order to keep the positions from getting away, they had to throw more money into the investments.  At this point other market participants knew that LTCM was in trouble, and would pile money into the other side of the trade putting further pressure on the company.  Finally, creditors wanted their loans back, and losses were too much to bear.  All told, LTCM lost $4.6 billion for investors and forced the government to intervene and put up money to help unwind some of their trades.

Sun Edison and Valeant –

A more recent episode of hedge fund folly shows that the above episode is not some wild one-off.  Sun Edison is a solar company that recently filed for bankruptcy and Valeant Pharmaceuticals is a bio-tech company that has lost over 85% of its value in the last 12 months.  The holder’s list of both of these companies reads like a who’s who of the Wall Street elite, which includes my Twitter friend Cliff Assness from AQR. (story here)

The first time I was called an ignorant troll by a hedge fund founder, but it probably won't be the last.

The first time I was called an ignorant troll by a hedge fund founder… it probably won’t be the last.

Other big hedge fund managers who took a beating investing in these companies include John Paulson, David Tepper, David Einhorn, and Steve Cohen.  That’s just to name a few.  Bill Ackman, the founder of Pershing Square, has been one of the hardest hit.   His fund was down close to 20% in the first months of the year, largely based on his Valeant bet.  (story here)

Everest Capital Management –

In January of 2015 the Swiss National Bank made a very surprising move by eliminating support for the Swiss franc’s peg to the euro.  This move sent the franc skyrocketing, destroying multiple hedge funds in the process who were betting on the continued support of that currency.  The largest and most public of these was Everest Capital Management, based out of Miami, who had to close their flagship fund and return whatever assets remained to investors.  (story here)

Each of these examples are episodes of smart money destroying investor capital.  And, there are many, many more stories just like these.  Even one among this group of smart money managers has acknowledged that his industry is in trouble.  Dan Loeb, founder of the hedge fund company Third Point, said in his recent quarterly letter to investors that he believes the recent closing of multiple hedge funds is just a sign of more to come.  “There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies,” he wrote.  In fact, more hedge funds had already closed their doors in 2015 than at any point since the financial crisis.  But what is that leads these managers and their funds astray?  In addition to a massive propensity for overconfidence bias, hedge funds also often suffer from severe bouts of group-think.


Most of these hedge fund managers are high-powered alpha (largely male) types.  They travel in the same billionaire circles and attend the same conferences.  They read the same highly technical academic reports and hire the same PhDs in math and engineering.  This leads to high levels of group-think and therefore, investing in many of the same ideas.  (Another current case in point is the many hedge funds betting on the decline of the Chinese currency.  This trade has also caused a lot of investment losses as the Chinese government has shown a willingness and capacity to continue supporting their currency despite proclamations to the contrary from Kyle Bass and other hedge fund managers.)  The problem is that when all of these investors pile large amounts of capital into the same trade, the risk of large losses increases.

In the book More Money Than God, there is a section about how certain quant funds (and again, AQR prominently) experienced this phenomenon.

“Selling by one big fund caused losses at other ones, especially since quantitative strategies had grown large enough to shove prices around.  Once rival funds started to incur losses, the logic of the hyperbolic curve would force them to sell too.”  The simple translation of this quote is just that selling causes prices to go down, which causes more selling.

Overconfidence Bias

Overconfidence is a psychological bias that makes an investor who has recently experienced an investing success assign a much higher portion of that success to their ability than to luck or circumstance.  They stop thinking in terms of “this is a probable outcome” and start thinking “this will certainly happen.”  When you expect a 100% chance that a certain outcome will occur you would be more inclined to bet the ranch.  Why not borrow 10 times what the ranch is worth if the odds are 100%?  If you could go back in time to just before the last baseball season, how much would you borrow to bet on the Kansas City Royals winning the world series?

It is this exact trait which is responsible for the terrible outcomes of investors who become famous after a hugely successful trade.  I outlined several examples in a past post (link here) of investors who got a major call right, and earned lots of fame and prestige, and then lost big on their next major trade.  For instance, John Paulson made over a billion dollars on his sub-prime trade (a very similar trade to the guys in the movie and book The Big Short).  After he got famous for that call, he then boldly bet big on gold and lost money.  The problem is that once you get a big call right, you seem to think you have some special intuition and become much more confident in your next idea.  After all, when the whole world talks about how brilliant you are, it gets hard to disagree.


Going back to Warren Buffett, back in 2008 he made a $1 million bet with a New York hedge fund manager that over the course of the next ten years, a simple S&P 500 stock index fund would out-perform a basket of hedge funds.  With 2018 coming up quick Buffett’s index fund has a massive lead and looks very likely to win.  (story here)

The point is that many people laud the hedge fund managers as master investors who can make enormous amounts of wealth through investing prowess.  As I stress in my finance class however, the first law of capital proves a hard one to beat –  You cannot expect to earn a higher return without assuming greater levels of risk.  Many investors who have either put money into hedge funds, or have tried to emulate their strategies, have learned that lesson the hard way.

While I think it is instructive on some levels to monitor the hedge fund world and see where capital is flowing, it can be a disastrous strategy to try and emulate these funds.  In fact, endowments, pension plans, and other large institutional money managers are beginning to reevaluate allocations to these high risk, high fee strategies and are pulling money out of hedge funds in record amounts.  Who can blame them?  The original concept of a hedge fund was to hedge against the risk of other investments dropping in value.  Now it seems the industry has gone completely 180 degrees as these funds more often magnify risk as opposed to reducing it.

Not all hedge funds are the same, but many share these same characteristics:

  • Charge exorbitant fees – often 2% of assets as well as 20% of any of the gains earned.
  • Utilize large amounts of leverage – Amplifies potential gains and potential losses
  • Often get the same investment idea and crowd into the same trade – increasing risk of a “run” or rush selling
  • Consider themselves geniuses and often assign high levels of certainty to inherently uncertain situations
  • Make a high proportion of wealth on the fees being assigned to the investment in their funds as opposed solely to their investment ability

So the next time you hear about a stock or an investment idea and part of the pitch is “the smart money is investing here”, tread with extreme caution.  You could be walking into a crowded, risky, death trap.  And that is why following the “smart” money can be the stupidest decision an investor can make.


Until next time…..

“Even the intelligent investor is going to need considerable willpower to keep from following the crowd.”  – Benjamin Graham


Photo Credit: Fabio Venni via flickr.com