4 ms·

I've always struggled to understand why hedge funds exist. As the author points out, the average hedge fund severely underperforms the market while charging a l

I've always struggled to understand why hedge funds exist. As the author points out, the average hedge fund severely underperforms the market while charging a large fee to do so. I was talking with a guy who works at a hedge fund over the weekend and he half-jokingly told me that his hedge fund survived on institutional investments and that most of their clients didn't really care as long as his fund "didn't lose too much money". If you take any finance class anywhere in the world, you are bound to come across the random-walk theory of the stock market, as well as strong, semi-strong, and weak market efficiency theory. The only way to reconcile these theories with the hunt for alpha is through differences in information - aka insider trading. The funds that consistently outperform the market are either 1 in a million lucky (how do you choose this firm as an investor? you don't), or they trade on information that others do not have access to. Insider information is the only logical reason to invest in a hedge fund in my opinion. If you know the managers of fund X are buddies with Janet Yellen, go golfing with fortune 500 CEOs on the weekends, and vacation in Europe with French politicians. Just hope that they aren't the 1/100 that the government decides to make an example out of. Otherwise, as most of my professors have advised, you should just invest in a portfolio of ETFs and only pick stocks for fun with money you aren't afraid to lose. On instavest: So why would I invest with a novice hedge fund manager who has none of these connections, who is competing with the thousands of hyper-intelligent grad students our system churns out into finance every year (rather than underfunded labs and dwindling academic positions), who is just trying to get his name out there placing risky bets in a bubble of a market?

skhatri11 11y ago
Thanks, Roy. I believe that the Index Fund approach is a good one - especially for novice investors - and Instavest definitely does not replace Index Funds. What we are, however, is a better to invest in the stock market. The problem with investing in the stock market is (i) where do I invest? and (ii) when / how do I get out? The Instavest platform is a curated research base that's meant to show you the ideas that our out there. There is no obligation to invest (or follow, as you put it). You can poke around and if something strikes your fancy, jump in. To come back to Index Funds for a second, I think that ~85% should be in Index funds unless you have an edge. The balance of your portfolio should be in higher returning assets. Its hard to do that buy yourself, however, and that's how Instavest adds value. On the topic market efficiency, I think Warren Buffett said it best" "If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” The reason why retail investors have a structural advantage is because they can invest small dollars in relatively inefficient parts of the capital structure. A large hedge fund or Goldman Sachs can't invest in a small cap company because that doesn't have high average daily trading volume because they have to put big dollars to work. This leaves a part of the market that is relatively uncovered with an opportunity to make substantial returns. Folks on Instavest are not investing in Google or Apple, they are looking for overlooked stocks or opportunities to make incremental return like this (scroll to bottom of this link): http://blog.instavest.com/the-17-investment http://blog.instavest.com/the-17-investment Hope that clarifies things :)
- bmajz 11y ago
  That's a really good way of putting it by Warren Buffet. This phenomenon of the bottom being ignored happens in software too of course: http://www.saastr.com/the-simple-reason-why-there-will-be-10-20-great-crm-ipos-in-the-next-few-years/ http://www.saastr.com/the-simple-reason-why-there-will-be-10... "Salesforce is now working on as many $100m+ deals as it can try to close. Because once you adding > $1 billion in ARR a year, you need a few Really, Really Big Enterprise deals to move the needle. And a handful of $50m-$100m deals are, by definition, the new target to really move the needle at that scale. Given that … does it make any sense to pursue the $9 a month market? Or the $2000 ACV market? I mean, not really. And Salesforce isn’t. So the bottom 10% of this $10 billion market, or $1 billion, isn’t even being addressed by Salesforce."
dkfmn 11y ago
I think you raise a few good issues but I'd like to poke, lightly, at the idea that the only information advantage available to hedge funds is "insider" information. Certainly some successful firms built their track record with illegal insider trading that but that's not the whole story. They have better access to research, they have better access to the analysts whose opinions help drive public understanding of the company, they have better access to management to ask clarifying questions on areas of concern. They spend every day steeped in the facts, perceptions, and research that are relevant to investing. In short, they have a massive information advantage over a casual investor or day-trader. This does not, necessarily, mean they're trading on "insider information." Finally, just to clarify, insider trading is often misunderstood. A violation depends on meeting all of the following criteria: 1) The information is material. 2) The information is non-public. 3) There was a breach of duty in sharing or trading on the information. As an oversimplification: if Joe overhears a conversation between the CFO of a Fortune500 company and his boss talking about losing a major contract... only the first two criteria are satisfied and Joe can buy/trade without fear of prosecution.
- roymurdock 11y ago
  Agreed that they have a massive information advantage over the casual investor, as this is their job. My argument is not hedge fund vs. casual investor, it's hedge fund vs. hedge fund. They are all equally-intelligent individuals with the same ivy-league degrees and expensive equipment. The only differentiating factor in this saturated market is network strength. Not arguing the legality of trading on insider information either. The laws are notoriously unclear, hard to enforce, and subsequently broken because information is harder to track than money, cars, and drugs. At the end of the day I would appeal to an ethical duty not to impoverish your fellow man and rend the fabric of the society that brought you up, rather than the flimsy and unenforceable definitions set forth in the legal code. On the last note, to lighten the tone: any budding hedge fund managers should consider taking time off to sunbathe more :) http://www.dallasnews.com/business/headlines/20131013-cuban-case-has-parallels-to-switzers-30-years-ago.ece http://www.dallasnews.com/business/headlines/20131013-cuban-...

skhatri11 11y ago

Thanks, Roy. I believe that the Index Fund approach is a good one - especially for novice investors - and Instavest definitely does not replace Index Funds. What we are, however, is a better to invest in the stock market. The problem with investing in the stock market is (i) where do I invest? and (ii) when / how do I get out? The Instavest platform is a curated research base that's meant to show you the ideas that our out there. There is no obligation to invest (or follow, as you put it). You can poke around and if something strikes your fancy, jump in. To come back to Index Funds for a second, I think that ~85% should be in Index funds unless you have an edge. The balance of your portfolio should be in higher returning assets. Its hard to do that buy yourself, however, and that's how Instavest adds value. On the topic market efficiency, I think Warren Buffett said it best" "If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” The reason why retail investors have a structural advantage is because they can invest small dollars in relatively inefficient parts of the capital structure. A large hedge fund or Goldman Sachs can't invest in a small cap company because that doesn't have high average daily trading volume because they have to put big dollars to work. This leaves a part of the market that is relatively uncovered with an opportunity to make substantial returns. Folks on Instavest are not investing in Google or Apple, they are looking for overlooked stocks or opportunities to make incremental return like this (scroll to bottom of this link): http://blog.instavest.com/the-17-investment http://blog.instavest.com/the-17-investment Hope that clarifies things :)

bmajz 11y ago
That's a really good way of putting it by Warren Buffet. This phenomenon of the bottom being ignored happens in software too of course: http://www.saastr.com/the-simple-reason-why-there-will-be-10-20-great-crm-ipos-in-the-next-few-years/ http://www.saastr.com/the-simple-reason-why-there-will-be-10... "Salesforce is now working on as many $100m+ deals as it can try to close. Because once you adding > $1 billion in ARR a year, you need a few Really, Really Big Enterprise deals to move the needle. And a handful of $50m-$100m deals are, by definition, the new target to really move the needle at that scale. Given that … does it make any sense to pursue the $9 a month market? Or the $2000 ACV market? I mean, not really. And Salesforce isn’t. So the bottom 10% of this $10 billion market, or $1 billion, isn’t even being addressed by Salesforce."

dkfmn 11y ago

I think you raise a few good issues but I'd like to poke, lightly, at the idea that the only information advantage available to hedge funds is "insider" information. Certainly some successful firms built their track record with illegal insider trading that but that's not the whole story. They have better access to research, they have better access to the analysts whose opinions help drive public understanding of the company, they have better access to management to ask clarifying questions on areas of concern. They spend every day steeped in the facts, perceptions, and research that are relevant to investing. In short, they have a massive information advantage over a casual investor or day-trader. This does not, necessarily, mean they're trading on "insider information." Finally, just to clarify, insider trading is often misunderstood. A violation depends on meeting all of the following criteria: 1) The information is material. 2) The information is non-public. 3) There was a breach of duty in sharing or trading on the information. As an oversimplification: if Joe overhears a conversation between the CFO of a Fortune500 company and his boss talking about losing a major contract... only the first two criteria are satisfied and Joe can buy/trade without fear of prosecution.

roymurdock 11y ago
Agreed that they have a massive information advantage over the casual investor, as this is their job. My argument is not hedge fund vs. casual investor, it's hedge fund vs. hedge fund. They are all equally-intelligent individuals with the same ivy-league degrees and expensive equipment. The only differentiating factor in this saturated market is network strength. Not arguing the legality of trading on insider information either. The laws are notoriously unclear, hard to enforce, and subsequently broken because information is harder to track than money, cars, and drugs. At the end of the day I would appeal to an ethical duty not to impoverish your fellow man and rend the fabric of the society that brought you up, rather than the flimsy and unenforceable definitions set forth in the legal code. On the last note, to lighten the tone: any budding hedge fund managers should consider taking time off to sunbathe more :) http://www.dallasnews.com/business/headlines/20131013-cuban-case-has-parallels-to-switzers-30-years-ago.ece http://www.dallasnews.com/business/headlines/20131013-cuban-...