Limitations of Hedge Funds

Often times, we may enjoy economies of scale, where more buying power leads to more efficiency. A good example of this would be with precious metal ETFs, where investors pool their money and this allows for far better pricing than investors could get on their own just buying a few ounces or even a few hundred ounces.

With securities though, while there may be minor improvements in efficiency, minor as far as the percentage that this impact would have on trades, we generally see the reverse here, where efficiency is lost with larger scales, to a very significant degree actually.

If someone only had a dollar to invest, we might want to say that this has to be scaled up to even allow one to trade this small amount, although nowadays one can hold positions with forex brokers and with contracts for difference trades, even with such a small amount.

It wouldn’t make a lot of sense to start out with just $1 of course, as a 100% return would only net you another dollar, but the idea that portfolios need to be scaled up to be put to work isn’t always the case. It may be the case with some assets such as stocks, where there is a fixed per transaction cost and one needs to cover that first and foremost, we can now trade without fixed costs and thus smallness of size does not need to be a concern.

How Size Impacts Trading

In any market, there will be a fixed amount of supply available if one is looking to go long, and a fixed amount of demand when one exits or looks to go short, and these serve as limitations on efficiency.

Limitations of Hedge FundsThe bigger size that we need to trade, the more inefficient our trades will be, for a number of reasons. When we pool our resources in a fund, including in a hedge fund, we become subject to these limitations, regardless of how skilled the fund managers are.

Whenever we seek to trade positions that exceed the market, the amount that is being offered for sale or the offers to buy, at the best bid and ask, we lose efficiency. The more we exceed these limits, the more inefficient our trading becomes.

It is not that difficult for even individual traders to exceed these limits, for instance if you are looking to buy 1000 shares of a stock that is being offered at a certain price for 100 shares, and at a higher price for 1000 shares.

The trader who is only looking to trade 100 shares will get a better price at the market than you will, and you will be faced with the decision of getting filled now at the higher price or wait until later to get the other 900 share order filled, where you may end up paying even more if the price of the stock increases while you wait.

If our positions are very large, the sort of size that hedge funds wrestle with, this is going to present a much more significant challenge, and we may not even be able to effectively put through trades on the same day or even on the same week in some cases, due to their size.

It’s not even a matter of whether this could be done or not, it’s more that trading with such large sizes moves the market itself, where the price of the security can be driven up considerably just from the weight of the demand or supply of the large trade itself if it is large enough.

This will always be an issue with very large trades, although funds do seek to look to minimize the impact of this. There is a price to be paid here and this is the additional risk of the poorer fills that may result from having to delay your trading by moving in and out of positions more slowly rather than with having them executed at the market price at the time of decision.

In a nutshell, while hedge funds do provide professional management to our portfolio, having it pooled with the portfolios of many others ends up handicapping their trading significantly, where they have to be much better than you as far as trading skills go to achieve similar results.

For the most part they are though, and most individual investors do not even possess the most rudimentary trading skills, therefore this is seen as a welcome trade off.

Having to move billions of dollars around is enough of a challenge that most mutual funds do not even produce returns equal to the buy and hold strategy though, but hedge funds do attract the best talent and many of them consistently beat the market by at least a decent amount.

While one may be able to produce much better returns on one’s own with less skill, simply because it is so much easier to do with a moderate sized portfolio than a massive one, actively managing one’s investments successfully does require the proper skills and mindset, and many investors simply aren’t committed or even cut out for making their own decisions. When you leave this all up to the professionals, you at least don’t have to bear the responsibility for the results, and a lot of investors simply do not want to or are not up for any of this.

Hedge Fund Compensation Models Encourage Risk Taking

When you share in the profits but do not share in the losses, this can become a real problem, at least potentially, if you allow this to influence your decision making that is.

Hedge funds typically charge investors 20% or more of their gains, while if the portfolio declines, they do not have to make up for any of the losses. This is charged over and above management fees, which are in the neighborhood of 2% of the value of one’s portfolio.

It was even the case with many hedge funds that they were able to make money on the way back up from a previous loss, although investors complained enough so that we usually see a high water mark being used and gains only charged over that amount.

The best performing hedge funds do tend to make a net profit for their investors year over year, in both bull and bear markets, and while they do have losing years the winning ones outnumber them by quite a bit.

There is still a concern that this compensation model drives excessive risk taking, and in some cases it very likely has, in situations where a hedge fund has exposed themselves to way too much risk and the downside ended up coming home to roost.

Given that hedge funds can pretty much invest in anything they want, this provides them the potential to manage risk very poorly should they choose. As we know, potential gain is very much correlated to risk, meaning that the more risk you take on, the more potential for gain you have, as well as a greater potential for losses.

This ability is what drives a lot of the concern over hedge funds, although in practice most hedge funds realize that they are in the game for the long haul instead of just going for quick profits, in the way that an investment banker might, seeking the big bonuses and not being too concerned about the bank’s overall risk exposure.

This is what happened with the credit default crisis when the housing bubble burst, and the feeling is that the banks were driven by short term profit because this was how they were compensating their people, right to the top, and this led to massive risk exposure. As long as everything kept going things were great, but when the defaults started to rise, billions of dollars were quickly lost.

To be fair, hedge funds don’t generally operate this way, throwing caution to the wind like some investment banks did, because hedge funds actually do tend to take a longer term view than this. Their specialty is managing risk not taking on excessive risk, and this is why they tend to be more stable than mutual funds or the market.

Meeting the Expectations of Investors

Still though, the sheer appeal of higher profits with more risk taking may influence things to some degree anyway. Those who invest in hedge funds do have a higher expectation of returns, although they also expect that these higher returns will be pursued while practicing sound risk management.

In a sense, hedge fund investors want both, more stability and better returns, and although both are possible due to the advantages that hedge funds enjoy, their greater flexibility of how they invest their money, investors also have to be wary of excessive risk taking.

Even with full disclosure, the nature of some of the investments that hedge funds engage in may be too complex for most investors to understand, particularly with derivatives trading. One can always look to how a fund performed in the past under more difficult circumstances to get a good idea of how they manage risk though, especially with using the market as a benchmark.

Funds use the difference between the stock market to measure their success, with the idea of producing better results, otherwise you could just invest in an index fund or ETF. Hedge funds do have the means to significantly outperform the stock market, as one would on their own if they traded their own accounts skillfully, but they need to deliver on this expectation in order to have people wanting to keep funds under their management.

While the upside with hedge funds is limited to both the size they need to invest as well as their high percentage fees, hedge funds still manage to produce better results than their actively managed mutual fund cousins.

Actively managed mutual funds are a huge challenge, more so than hedge funds, as you’re stuck riding out market declines and don’t have a good way to manage any of this. Hedge funds do, where you don’t really have to fear the market anymore as long as the people in charge are skilled enough, and that’s an advantage that many investors find very appealing, in spite of any limitations that hedge funds are subject to.

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.