Robert A. Bonavito, CPA PC

What Are Hedge Funds & Do They Work?

Welcome to another 'New Jersey Forensic Accountant' discussion. Today, we're gonna talk about something that I actually was in a forum up at Harvard University and it was on hedge funds and it was really interesting. And there's a good book a couple of years back that came out called ''More Money than God'' that really discusses hedge funds in depth. And it's probably, I think, the easiest way to become extremely wealthy. You just pick up the papers and you'll see some hedge fund guy became a multi-billionaire in the last year or so. So we're gonna talk about hedge funds today.

Now, hedge funds have fascinated people for the last three decades. I mean, it's one of the few things that, you know, you could hear and read about almost every day in the paper. The question is what is a hedge fund? How do they work and who runs them?

But first, let's talk about what is the premise of a hedge fund? What is the purpose of a hedge fund? Basically, the purpose of a hedge fund is that they're assuming that the market, the Efficient Market Hypothesis is not true, okay? So finance is built on that hypothesis, that the EMH is true, right? That all the information is in the stock price, and you can't get an advantage by using some technique, but that's not true because hedge funds have been able to show, at some points, that they can actually beat the market.

And if you look at the goals of a hedge fund, basically four of them, so one is reduced volatility. They don't want a lot of, you know, up and down. They wanna basically just have a nice, smooth, small volatility in their returns for the investments. They wanna use correlation. For example, if you see here, like this is correlation, and if you have, let's say, treasury bills here and you have high tech stocks here, if treasury bills go down, you'd expect the value of your tech stocks to go up. And by correlating them, it reduces the volatility, right? When one goes up, the other goes down and that's kind of what hedge funds try to do. They try to reduce draw downs. Again, they don't want these large fluctuations. They don't want these massive losses in masses amount of income. And lastly, they want to manage distributions of returns. They want to have a nice even keel. And again, you're gonna do that mainly through correlating investments.

Hedge funds were able to implement a variety of strategies that they think, at least, prove EMH is false. Hedge funds are able to increase returns at lower risk. Okay. These strategies include the following. Remember, they wanna have lower risks, but the same returns, right? And these are some of the strategies they implement.

The long short. This involves taking a one stock and going long and one going short. For example, you could go short the brick and mortar retailers like Sears and long the online retailers like Amazon, which a lot of people have done recently.

Relative value. Relative value is like when you have two assets that are the same, for example, Exxon and BP, one selling at five times earnings and one selling it like 20 times earnings. Well, eventually, you think that the one that's selling at five times earning will catch up so you'd invest there because eventually it's gonna be 15 or 20 times earnings. That's kind of what they're looking for in relative value.

Event driven strategies. Okay, this mainly has to do with acquisitions and stuff like that. So if someone's going to acquire a company for, let's say, a hundred dollars, right, and the price of the stock is only 95, well, you'd buy that stock, assuming it's gonna go to 100. And the reason it wouldn't be at 100 is because some people are assuming that may not go through and hopefully, because of your research and understanding of the market, you're making a good bet rather than a bad bet.

And the last one is tactical trading. Now, this is a global macro investment strategy, which is extremely complicated where you're buying treasuries and interest rates. This is kind of what George Soros did when he broke the Bank of England. If, for example, back then, in 1992, when he broke the Bank of England, if you're familiar with that, interest rates in England were very low, but he knew they were gonna have to rise because it was their fixed...their currency was not in line with the way the country was performing. And he was right. He made these massive bets. He made over a billion dollars on that bet. So this tactical trading is really interesting area, but it takes a long time to understand what's going on.

So the question is, do they work? And, you know, like I said, the goal of a hedge fund is to make average or above average market returns with less risk. So for example, if the S&P was earning 50%, you'd expect the hedge fund earn maybe 20% to 25%, but they would do this at no additional risk, which is very hard to do. And that's why they become very, very wealthy, those that are able to do it. Most hedge funds are not successful, but the ones that are, fabulously successful.

Let's just take a look at one, which is Steinhardt. And this one here is Steinhardt compared to the S&P 500. And you could see that when the market 23 quarters of rising returns, he earned 339% versus the S&P at 284%. And when the market was down, his loss was only 6.5% when the market was lost was 37.2%. So what this is basically doing is the four criteria we talked about earlier. He's hopefully has less volatility and his returns are greater. And that's the real goal of a hedge fund guy. Now, Steinhardt was...he had a special trading technique where he would do block trades and he became like a, kind of a private bank. So, but this is what he was able to do. And this is the goal of all hedge fund managers. Very few can do this over a long sustained period of time. In fact, eventually he couldn't do it, but this is the actual...this is the purpose of a hedge fund.

Okay. So let's talk about my favorite hedge fund guy. And that's A.W. Jones or Alfred Winslow Jones. And the reason I like him so much, because he's the actual father of hedge funds. He started doing this in 1950, and he's the one who set all the trends you see and how they set up the hedge funds, he's the one who started it in 1950, which is absolutely amazing. Okay, he would use partnerships, he'd invite specific well-heeled investors in. He kept regulation and bureaucracy to a minimum, and he limited when they could withdrawal investments.

But here's some things that he did that the hedge fund still do today. Okay. He had a competitive system where he'd actually pay stockbrokers for good leads. Give me your best stock. And what's really unique is he also give me your worst stock. And he would short the worst ones and go long the best and they would be paid. So he always got the best recommendations.

The second thing is he set up, let's say, he had a, you know, this is 19...let's say $10 million, 10 investors, right. And he would charge them 1% to manage the $10 million, which would be $100,000. And let's say he earned 20%, okay, which was $2 million on that. He would get a fee of 20% of that, which would be $200,000. So that's a lot of money in 1950, real lot of money. And that's the way hedge funds work now. They try to have these same type of rates, which is amazing.

And then he also had beta ratios and he balanced risk, leverage risk parity, and alpha calculations and stuff like that. All these terms you hear today, he was doing back in 1950.

Like here's an example of something he would do. Let's say, in 1950, you invested $1,000. Back then, the average investor would go 80% stocks and 20% cash. But what Jones did was he went long 130%. He leveraged his portfolio and he'd short 70. Okay, let's say stock market didn't do well, okay? Stocks dropped by 10%. So what happens to the traditional investor? They lose $64 on the 800. They lose nothing on a cash, right? Now, what happens to Jones? Well, he loses 104 because he invested 130%, but on a short position, he makes 56, so he nets a loss of 48 versus 64. Now, return on capital, he gets negative 5% and the investor got negative 6%. You know, his loss was less. And you could see, this is a very simplified example, but, you know, increase by millions or billions of dollars, that's what you're doing out here. This is how they're doing it. This is one of the strategies that they're implementing to this day.

Talk about some famous hedge fund manners. Okay, the first one is George Soros. Now, George Soros has this thing called reflexivity, okay? And what it is is he says that, hey, investors take shortcuts when dealing with complex companies, right? And what that does is it drives up the prices. And when he said is no. He says, I'm gonna, instead of trading on investor sentiment or projected earnings, he'd wait for the moment when values became unsustainably high and crashed back down. And this is that reflexivity thing, because he's like, everybody's piling in. Like look at now, as we're doing this video, everybody's piling into these stocks. Once something comes ridiculously high, he would short it, okay? And that's what he did with the Bank of England, okay? The interest rates were way out of whack with what the currency was worth.

And his partner over there was Stanley Druckenmiller. And he's really the one who orchestrated it because Soros was semi-retired. But, you know, he again would bet against foreign currencies and governments, if they were mismanaged in the economy. And he made billions, billions of dollars in one trade.

Julian Robertson. He was a value manager, which means he would actually go and look at stocks. People say he was the best value manager ever, better than Warren Buffet. And what happened to him, what was pretty interesting, with the Dotcom bust in 2000, he was buying value stocks, which became out of fashion. He actually said, you know what? This is ridiculous. You know, people are buying these Dotcom companies that are selling, you know, 100 times sales, like they are now. And his value stocks were going nowhere. He actually retired. He said, "I had enough. It doesn't make any sense in the market." And he got out, but he was the best value manager that ever was.

Now, Paul Tudor Jones, he set up a script. What do we do is map out what would happen in the market, okay? You know, if there was a crash, what would happen? Okay. People would run into bonds and gold. And then what would happen? Well, the stocks would start...eventually, those prices would crash and they would run back into income. And he kind of had a script. He made a lot of money figuring out, based on psychological aspects, what people would do, and he would make bets against it. Very, very successful, and he had a unique investment strategy.

Now, let me just give you an overview of some hedge fund strategy. Now, remember the 10,000-hour rule. And what this rule says is you need to do something for 10,000 hours before you become really good at it. So if you're gonna try to do these strategies, okay, you gotta put some time in. You can't just assume you're gonna be able to do it. But the first one is this equity market neutral strategies where you're shorting like the S&P 500 and going long on stock, okay? Equity long short, when you're shorting, like, you know, Sears and buying Amazon. And this dedicated short bias is the one where many people don't bet against the stock going down. And if you do, if you're able to find those that do...will go down, you can make a lot of money. This was true in 1950, when A.W. Jones started these three, you know, strategies, and it's true now.

So listen, I hope that you enjoyed the hedge fund seminar. If you have any questions, just leave a comment below, one of our analysts will get back to you. Please subscribe to my YouTube channel. It helps a lot. And thanks a lot. Bye.

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