Revealing peep behind the hedges

The author profiles more than 20 industry players to provide this insight – but how much of the time do hedge fund stars such as George Soros makes the right investment decisions?

The life expectancy of a crack dealer in Chicago is twice that of the average hedge fund. The crack dealer has a 25% chance of dying within four years, whereas an average of one of every two new hedge funds fails within three to five years.

This is just one of the many interesting and in some cases irreverent facts in Katherine Burton’s book, Hedge Hunters.

Rather than simply explaining in a textbook fashion how hedge funds work, Burton profiles more than 20 hedge fund managers to provide an insight into this growing and much misunderstood part of the asset management industry.

By describing the background and career paths of these individuals and their approach to running money, Burton provides a revealing view of how hedge funds are managed and what makes a successful hedge fund manager. For example, Mark Yusko says in the book that the investment decisions of even star hedge fund managers such as Julian Robertson and George Soros are right only 58% or 59% of the time. “That is frightening when you think about it,” says Yusko. “Most investors are right only about 30-40% of the time. If you can be right even 51%, the odds work in your favour.”

This is a well-written and accessible book, and readers with scant knowledge of hedge funds will be able to enjoy the interviews even if it is hard for investors to access their funds.

This approach to writing finance books is not new, of course. But Burton deserves praise for persuading so many publicity-shy hedge fund managers to be interviewed and to talk about their mistakes as well as their successful trades.

The profiles are succinct and engaging as Burton avoids getting bogged down in technical details and works in interesting stories and quotes.

Jeff Schachter found himself sitting next to LL Cool J, a hip-hop artist, on a flight and swapping views on investing in bonds. “I invest only in AA munis. I look at duration and I don’t reach for yield,” one of them said. Remarkably, it was LL Cool J who said it, not Schachter. During the flight LL Cool J pulled out from his bag a copy of Benjamin Graham and David Dodd’s Security Analysis.

Even top performing hedge fund managers admit in the book that it is not easy to generate large gains from shorting stocks. Potential losses are limitless, while the more successful a short position is the smaller a holding it becomes as its share price falls. Lee Ainslie reflects the view of other managers when he says he is biased to long positions because stockmarkets tend to go up in value.

Chapter 16, however, is devoted to Jim Chanos, who bets exclusively on stocks he expects to fall in price.

Burton tries to answer the question of what makes a successful hedge fund manager. Clearly, there is no identikit manager, but there are some common factors. These include a certain intellect, hard work, strong convictions, an ability to learn from mistakes, ambition and being a contrarian.

Self-confidence is an essential characteristic. This is illustrated by Bernay Box’s comment: “We believe the efficient market hypothesis is a bunch of crap.”

The book highlights the strong ties between many of the leading hedge fund managers, which exist partly because many spent their early careers at two or three hedge fund firms, such as the Tiger Cubs at Tiger Management under Julian Robertson. Mark Yusko reflects that the new generation of managers were not trained by the “masters; they don’t understand portfolio construction”.

Burton could have pursued in more depth several interesting and in some cases controversial issues. She covers all the issues, but I would have liked to learn more about what the managers thought of these subjects.

For example, studies suggest the best returns from hedge funds are delivered in the first two to three years of their existence. How did these managers cope with a growth in assets and continue to maintain outperformance?

Many hedge funds close not because of poor performance or fraud but because they fail to raise enough money. Burton could have provided more details on how some of the managers raised capital.

And how did the fund managers cope with running a business? This can distract from managing a hedge fund.

More than one manager detailed stock picks that went against them. In 2006 Dwight Anderson’s hedge fund was down 19% from the start of the year to May. Within nine months he had made back his losses, but I wonder how many investors redeemed along the way.

The managers stress the importance of sticking with their convictions. But what was the reaction of investors? How did investors view their lock-ins to the funds? Canyon Partners, for example, lets its clients withdraw every quarter from its offshore fund and just once a year from its US-domiciled fund.

It would have been interesting to get more views on how annual management charges of 2% and 20% or 30% performance fees can be justified. One hedge fund even levies a 50% performance fee.

The book notes how hedge fund investing has changed with the proliferation of managers. It would have been good to get further manager comments on whether investors should expect lower average returns in the future.

As the number of hedge fund managers increases so the average performance has to decline.

Furthermore, as more hedge funds chase the same mispricings in the market, those opportunities disappear quicker than ever before.

For instance, Roberto Mignone says shorting “in general has gotten dicier because more investors are betting on falling shares than ever before and many of them don’t have a huge amount of knowhow or talent”.

Despite these minor observations, this is an entertaining, informative and easy-to-read book. I would recommend it to hedge fund investors and non-investors alike.