Hedge Funds vs. Investing on Your Own

The Allure of Self-Management

Personal investing, managing your own portfolio instead of investing in a fund, has some big potential advantages over the very large scale portfolio management that hedge funds wrestle with, although doing so effectively is not such a simple matter either.

When the size of the portfolio you are managing is measured in the billions of dollars, you are quite limited as far as what you can do with it. Large funds are much like an oil tanker, which do not travel particularly fast, cannot adapt to change quickly, and take a long time to change course.

Individual investing on the other hand can be compared to a speedboat, at least when enough skill is used to drive the boat, and these much smaller boats can travel at much greater speed and also can be much more agile.

Hedge Funds vs. Investing on Your OwnThere are some investors who, out of a lack of knowledge about what it takes to direct a portfolio successfully, assume that the skills to do so are well out of reach, and that for instance one would have to have a combination of a lot of talent and experience together with a lot of time to devote to the practice of managing their portfolio.

That may be the case if one is looking to trade for a living, but if just beating the market by a meaningful but fairly modest degree, the aim of hedge funds actually, is the goal, then this goal is not so lofty provided one understands what needs to be accomplished and has some fairly suitable strategies to achieve the goal.

Some underestimate this and may have managed their portfolio in a way that seems to make this appear pretty simple, buying stocks during a bull market and watching them go up and thinking it is this easy. When things turn around, they are often left exposed to too much risk, take losses too big, and wonder what to do.

Speedboats can go fast but they can also crash as well, and if one decides that they wish to take control of one’s boat rather than boarding a much bigger ship run by professional crew, one must be prepared to control their boat in all weather.

How Individual Portfolios Can Significantly Outperform Funds

Some may wonder how it is that an amateur investor, devoting only a few hours per week to managing their positions can contend with some of the world’s best talent in managing investments. Hedge funds do attract the best talent to be sure, and are also able to get involved in several investment strategies that aren’t really within the reach or acumen of private investors, such as arbitrage.

Hedge funds are generally too large to take advantage of shorter term trends though, as well as not being all that nimble to react to changing market conditions. This is where the real advantage is with private portfolio management, because its much smaller size can easily adapt to market changes.

This is not a small matter, provided one has the skill to adjust to these changes, selecting the right assets to trade, having the right strategies, and executing their trades properly. Getting this all right is more of a challenge than a lot of people think, and few investors have much of an idea of what they are doing when they attempt this.

What usually happens is that people look to trade not only without a good plan but without much of a plan at all. When you do this, you are just going to get yourself in trouble sooner or later. In order to trade securities successfully, one must have a solid plan that is both on the side of probability, meaning that the trades will produce more gains than losses over time, and also manage the risk side of trading, so that they don’t get hurt along the way.

The Two Main Elements of Portfolio Management

Hedge fund managers, as well as most professional traders, the ones that have proven themselves over time that is, understand that succeeding is not just a matter of making the right trades, as risk management is at least as important.

Hedge funds in particular get their name from the fact that they put so much weight on the hedging side of trading, the risk management side, and hedge funds can use a lot of different tools to achieve this.

Since risk and return are so strongly correlated, when one hedges against risk, this will affect the potential return as well. The goal is to take care of both sides in a way that returns can be sought that can be both fairly reliable over time and also protect enough against drawdown risk.

Mutual funds for the most part do not and cannot manage risk properly because they are committed to a certain strategy and don’t really have any alternatives in situations where this strategy isn’t appropriate at the time.

Hedge funds approach this problem as a skilled professional investor would, mixing their investments and positions to both seek to take advantage of market trends and protect enough against market reversals.

Individuals can do the same thing, perhaps not with anywhere the same precision and ingenuity as a good hedge fund would attain, but one need not attain such stringent criteria because their investments don’t really need to be left hanging out there in the market in the same way fund investments do.

It is enough in fact to just use proper timing to hedge against risk, and in fact this approach is the most efficient way to manage risk rather than looking to offset the risk of holding something by holding something else. Ideally, you just don’t hold it past its time.

One cannot always anticipate market changes, but one can surely react to them, and this is why professional traders always monitor their trades and exit when the probability of their going down over a certain period of time exceeds the probability of going up.

While this is not an exact science by any means, there are technical indicators that can be used to monitor all this, and one can also rely on fundamental indicators as well for use for longer timeframes like several years, or a combination of both as desired.

Proper timing is therefore the cornerstone of portfolio management, managing both growth and risk, and while we may also want to diversify to add further risk control, it’s even more important to always seek to be on the right side of a trade and exit when that is no longer the case.

Successful Investing Takes Some Real Dedication and Skill

There are people who think that all they need to do is open a brokerage account and pick a few stocks or an ETF and they are off to the races. It is not that simple though, and this is not something you ever want to do from the seat of your pants, where you do not have a good plan for your trades or often no plan at all.

It is important to look to simplify though and if one is looking to play the stock market so to speak, not having to pick stocks is certainly an advantage, and a pretty big one at that. Actively managed funds do seek to select stocks this way, but they have a lot more resources, skill, and money to devote to this to make sure that their positions are fairly balanced.

If you can just go with an index fund that is also easily tradeable such as an ETF, and look to time that, including being on the short side when appropriate, then you have reduced your decision making to just three possibilities, long, short, and in cash.

Making trading much more complicated than it needs to be is a mistake that a lot of amateurs make, and this applies to your trading rules as well. There are a lot of different criteria you can use but it’s most important to have a set of rules that will clearly guide your decisions, not be left with indecision in deciding between competing reasons.

While having at least some discretion in your trading is probably ideal, this requires one to be able to use this discretion wisely, and that’s something that really only comes with experience, and plenty of it. In all cases, one needs to trade by way of reason, where the reasons to do something become better than the reasons to take another action.

These aren’t skills that one is born with, and even very bright traders need to learn how to trade or to invest. To manage one’s own portfolio, at a minimum, one must be willing to devote a fair bit of time to it, and understand that there is a learning process involved, even to aspire to modest success.

The Alternatives

If one does have the means to invest in a hedge fund, and does not wish to manage one’s own portfolio, then going with a hedge fund can certainly be a good idea, especially compared with mutual funds. Index funds where no discretion is used at all outperforms active funds on the whole, but hedge funds generally outperform both, even after the steep fees are deducted.

One can also seek to have their portfolio managed by a professional, although this is something that only the real well-heeled can take advantage of. There are a number of options here, but hedge funds do offer real alternatives to hiring someone to manage your funds as well as having those who manage it be of a higher or much higher caliber.

Probably the most challenging part of individual portfolio management is the psychological side of the game, where you’ve put yourself in charge of making all the decisions and have to deal with all the pressures that come with this.

This is the area where individuals struggle with the most, and the first place that one should start when looking to trade on one’s own is some good books on the psychology of trading, to at least get an idea of what challenges they are in store for and to look to at least hit the ground running with this.

This part of trading can be mastered, but like everything else related to trading, there is a learning curve here and some people never get there, insisting on hanging on to positions longer than they should or beating themselves up for making bad decisions.

On the other hand, if you give this and everything else over to a hedge fund, then you won’t have to worry about any of it, and for many investors, this is probably the right way to go and one that is also appreciated.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.