Love Your Hedge-Fund Manager - dummies

By David Stevenson

Preserving your capital is a vital aspect of any investment strategy in the UK and around the world. Your accumulated long-term savings are the product of many years of hard work and yet they can be destroyed in a matter of weeks, by forces entirely beyond your control.

You can always look to earn more or less, but your nest egg or pension fund has to last you for the rest of your life. If that money goes, you have to work a whole lot harder to rebuild your stash of capital, or accept that your twilight years may be blighted by poverty and low levels of income.

This gloomy way of thinking leads many investors to a central insight: preservation of capital is a primary consideration. Just as endowments have to keep funding lecturers’ fees and maintaining grand libraries, so you have to keep paying out for your retirement costs.

The idea of capital preservation has found a willing audience within the hedge-fund community. Many of the best professional money managers have built successful careers around the idea of absolute returns (making money whether markets rise or fall). Of course, cynical observers can easily denigrate successful hedge-fund managers as money vampires looking to impoverish investors through Ponzi schemes, excessive costs and duff trading strategies.

Ponzi schemes are fraudulent investment schemes in which higher-than-average returns are promised to investors and then paid using the investors’ own money. Named after Charles Ponzi who gained notoriety using the scheme in the 1920s, Ponzi schemes reemerge regularly. Recent schemes involve Nicholas Levene, who bilked investors of £32 million, and Bernie Madoff, whose massive Ponzi scheme cost investors billions of dollars.

But good hedge-fund managers are some of the best managers in existence today and many have concluded that private investors like you take too much risk with your accumulated savings. They suggest that you focus on preserving your capital and then look to grind out a steady, positive return no matter which direction the financial markets are going in.

These managers think that you should be aiming for a steady 4‒10 per cent per year return, year in, year out. They believe that you need to be brave, sometimes adventurous, and look to all manner of different asset classes and investment strategies including controversial practices such as

  • Shorting: Selling what you don’t own.

  • Arbitrage: Buying and selling an asset at the same time to make a profit from the price difference.

  • Leverage: Borrowing other people’s money to invest.

  • Structured instruments: Employing a simple risk/return trade-off that creates a series of options to increase your payout.

  • Shareholder activism: Pressuring a firm’s managers and Board to increase the value of the company’s shares.

  • Spread betting: Betting on the movements of financial markets.

The core investment mantra of hedge-fund managers is: if you’re willing to diversify ideas and strategies, you’re better able to produce an absolute return in all markets. The big university endowments certainly believe this sales pitch and many of the world’s wealthiest investors have also bought into this strategy — and so can you.