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Hedge funds are talked a lot about in the press
and usually with a slightly suspicious or negative tone
so what I want to do in this video is think about
or give us a way of thinking about
whether a hedge fund, or really any financial type of organization
or institution is good or bad,
and I won't try to take one side or the other
just give you some type of things to think about.
So the first thing that sometimes is complained about
when people talk about hedge funds,
is that the compensation structure,
because the hedge fund gets 20% of the profits
but if the fund were to kind of blow up and go to zero
the hedge fund manager isn't on the line for 20% of the losses
people would argue that that encourages hedge fund managers
to take disproportionate levels of risk
and that is true to some degree
but one thing that is true about hedge funds is that usually
it's expected that the manager or the general partner
has some of their own skin in the game
so as an example, I drew a Pete Capital Fund 1
the manager committed 10% of the funds
and what's more important, as apposed to just the
percentage of the total fund is
what percentage of Pete's total net worth is in the fund?
Some fund managers will put a significant amount
of their own personal net worth in the fund
so even though they get 20% of the upside,
if the fund were to really do horribly,
if it were to blow up,
that manager usually will really be on the line
and that's usually the job of the limited partners here
we've mentioned before that versus a mutual fund
the limited partners of a hedge fund need to be sophisticated,
they need to be accredited investors, they need to have a certain net worth
they need to show that they understand these type of instruments
and so it's really the job of the limited partners
and it's really in their interest
to make sure that they're investing in a fund
where one, Pete looks like a credible guy,
Pete has some skin in the game, and hopefully
a substantial amount of skin in the game relative
to Pete's net worth.
Pete has a reputation, and then they have to decide
their own comfort level with how transparent
Pete is, a lot of hedge funds won't tell their investors a lot of
what they're doing with this $100,000,000
sometimes they'll give a little bit more information
or a little bit less,
that could be a negative obviously, because who knows?
Maybe they're going to Las Vegas and they're gambling away this money
but that's where the reputation of the manager matters a lot
but also the secrecy actually could be good for the limited partners
because sometimes if everyone knows exactly what's happening inside of the fund
and that information goes out,
there could be other people that could somehow
trade against the fund, or make the same investments of the fund
or if this was a large fund, go ahead of that fund
and try to buy whatever this fund was trying to buy ahead of time
so there's kind of pros and cons to the secrecy,
but that risk is definitely there,
and, you know, one thing that I guess is probably interesting to point out
is that this idea of getting a percentage of the upside
but having very limited downside is not unique to hedge funds
in fact, this is probably true of most corporate executives,
in fact, most corporate executives probably don't have as much skin in the game
we've all heard about golden parachutes and all of the rest
if CEOs do really well, they usually get huge, huge, huge bonuses,
if they do horribly and they get fired, they still get golden parachutes
and that actually probably doesn't happen to hedge fund managers,
so this idea of a percentage of the upside
without the same percentage of the downside
isn't unique to hedge funds managers,
it happens to corporate executives, it happens to
heads of banks, it happens to bankers generally
where they get these huge bonuses in a year
but in the next year, if the bank goes out of business
no one asks them to kind of give back their bonuses.
So I'm not going to defend it, I'm just going to say that it's not unique to hedge funds.
Now the other kind of notion that sometimes people
talk relative to a hedge fund is this idea of secrecy
because it is not regulated, the hedge fund manager
kind of has its choice of what they do over here
and this secrecy, you know, I'll put a little asterix over here,
because in order for these people to be willing to commit their fund
the hedge fund manager has to tell them something about
what he's up to, so it's up to the hedge fund manager.
But some people work that the secrecy
the secrecy that the hedge fund has,
combined with the fact that they're allowed to invest
in more, I guess you could say, exotic things
they don't have to, and I want to be very clear
a lot of hedge funds, even though they have this whole structure
with the 2% management fee, and the 20% carried interest,
a lot of hedge funds, their actual investments
might look very similar to a lot of mutual funds
in fact, some of them might be more conservative
than many mutual funds, so it's not necessarily the case
that hedge funds are doing crazy things over here.
But some of them are, and so that combination
of the secrecy, that they might be speculating on this or that
or buying all sorts of crazy derivatives contracts
that makes people feel that hey, there might be something shady
going on over here.
And, the way I think about it is, if the hedge fund is relatively small
and $100,000,000 would actually be small in the scale of a hedge fund
or I guess another way to think about it:
if the assets that are controlled are relatively small
because with sophisticated derivatives, with $100,000,000
you can actually control much more than
$100,000,000 in notional assets, but if the notional assets
that the hedge fund controls are relatively small
then the secrecy, and kind of the, whatever the hedge fund might do
it really just puts the investors of the hedge fund at risk
and so it's really these people's job,
it doesn't put society as a whole at risk
the time when hedge funds get dangerous,
or potentially get dangerous, or the most cited example of this
is long-term capital management in the late 90s
Let me write that down, LTCM, I'll do a whole series of videos on this eventually
but long-term capital management controlled so much
in notional funds, now we're talking about in the
hundreds of billions or even trillions of dollars
that this fund became too big to fail
and I think you know from the recent financial crisis
that this doesn't happen only to hedge funds
and so you have this general notion
that when any financial institution
starts kind of controlling trillions of dollars
or hundreds of billions of dollars,
it can start a cascade through the entire financial system
that's not a good thing. This is not a good thing,
this is not good, because when something is too big to fail
people don't let it fail
and that goes against everything that we know about capitalism.
Capitalism, when people do well, let them do well,
but when people fail, let them fail.
The thing I want to point out is that this is not unique to hedge funds
AIG which is probably one of the main culprits of the last financial crisis
they were an insurer, do you have the rating agencies,
they weren't too big to fail
but they helped kind of validate some of these other
too big to fail actors. You had all of these banks
that were too big to fail.
So I think the general principle here is that
a hedge fund can be good, it can be bad,
what's unique about them relative to a mutual fund
is that they tend to be a little bit more private
they have more support, they should have more sophisticated investors
but what they do with their money might be
um, exactly the same thing as what a mutual fund
might do, it might even be more conservative than a mutual fund,
it might take on, it might use sophisticated instruments to take on less risk
than a mutual fund,
and I think the takeaway, or at least in my mind,
is that any of these things, hedge funds,
insurance companies, banks, even some corporations,
they become bad when they become so big
that failure doesn't just hurt their investors,
it hurts all of society.