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Hedge Funds Additional Copies Available Upon Request Lookout Mountain Capital, Inc. © 1995 by Lookout Mountain Capital, Inc. A Primer on Hedge Funds Additional copies available upon request. I. The Model for Superior Performance . 2 Mediocrity (by definition) is the norm for money management, and a remarkable body of science has evolved to explain it. Academic analysis of the superior performance of non- traditional investments is distinctly lacking, because non-traditional investments cannot be neatly quantified under Modern Portfolio Theory and the Capital Asset Pricing Model. We contributed the following article on superior investment performance as the intro- duction to the book, HEDGE FUNDS, INVESTMENT AND PORTFOLIO STRATEGIES FOR THE INSTITUTIONAL INVESTOR. It is intended as an “investor friendly” overview of hedge funds. Hedge Funds: Perception and Reality . 2 Sources of Information Risk Management: Betting vs. Gambling A Brief History of Hedge Funds . .5 Alfred Winslow Jones The Jones Hedge Fund Model 1966 to 1969: Proliferation 1969-1974: Contraction The New Modalities Finding Superior Performance . 10 Motivation Opportunity Compass II. Non-Traditional Money Management . 13 III. Lookout Mountain Capital, Inc. 14 Consulting Services Direct Placement Service Publication: Lookout Mountain Hedge Fund Review 2 Lookout Mountain Capital, Inc. I. The Model for Superior Performance have been written by well-meaning journalists. Hedge Funds: The cumulative result is that “Hedge fund man- agers – those flamboyant, dice-tossing specula- Perception and Reality tors”1 have an image problem. How risky are hedge funds? Although There have been some glaring failures broadly perceived by the investing public to be among hedge funds, and the media serves a imprudent investments, in useful purpose in disclosing as much as possible about them. But in gen- reality, most hedge funds are There are three primary eral, the financial press grossly fails not. In order to gain useful reasons why the finan- insight into how hedge funds cial press so often mis- to convey how most hedge funds often provide superior leads the public about operate. Besides their focus on a returns with reasonable and the risk profiles of most small portion of hedge funds that are controlled exposure to risk, hedge funds: A lack of not typical of the industry, there are let’s begin with a better good sources, an abun- three primary reasons why the finan- dance of bad sources, understanding of why they cial press so often misleads the pub- and difficult risk man- are perceived to be so risky. lic about the risk profiles of most agement concepts. hedge funds: A lack of good sources, Put an apple on a hedge an abundance of bad sources, and fund manager’s head and call it “the truth.” difficult risk management concepts. Let’s con- The cumulative Then step off fifty paces and hand a crossbow sider each. result is that “Hedge to a well-intentioned journalist with a steady fund managers – hand and a mandate to “nail the truth!” As a Sources of Information those flamboyant, courtesy, we will presume the hedge fund man- Most hedge funds are private limited dice-tossing specu- ager is blind-folded. If the journalist’s best shot 1 partnerships, prohibited from advertising. For lators” have an just barely misses, what happens? More often legal and proprietary reasons, hedge fund man- image problem. than not, the journalist’s best shot ends up far- agers have traditionally been very reluctant to ther from the truth than the original fifty paces. disclose specifics about their operation, even Over the past three decades, relatively few to investors. They rarely spoke with the press journalists have nailed the truth about hedge until recent years, and now, they seldom reveal funds, while hundreds of misleading articles much. Getting reliable information on hedge funds requires a tremendous amount of hard work. Several advisory services have released sta- NOTE: A slightly different version of this tistics about the hedge fund industry over the article by Lookout Mountain Capital’s Ted past several years, and although such statistics Caldwell provides the introduction for the may provide a very general performance pic- book, HEDGE FUNDS: INVESTMENT AND ture for of a given segment of the hedge fund PORTFOLIO STRATEGIES FOR THE INSTITU- industry, considerable caution must be used TIONAL INVESTOR, [ISBN 1-55738-861-x] 1995, Jess Lederman & Robert A. Klein, EDI- TORS, Irwin Publishing Company. The book, with chapters from 14 contributors, is part of the Irwin Asset Allocation Series For Institutional Investors, and is recommended for anyone considering investing in hedge funds. 1 Riva Atlas & Dyan Machan, “George Soros, Meet A.W. Jones,” Forbes, 17 January 1994, 42-44. 3 Lookout Mountain Capital, Inc. when reviewing such figures. Even the best try by Business Week3 characterized the pat- performance statistics for the hedge fund tern more pointedly. “Bankers, security indus- industry are greatly skewed by asset weighting try professionals, mutual fund managers – all (or a lack thereof), voluntary (vs. random) are beating the drum…It’s no secret that Wall selection, inadequate sampling, and a strong Street hates hedge funds.” But why? “It’s not survivor bias. Reporting on such statistics has just jealousy or scapegoating that makes the done nothing to improve the investing public’s hedge funds anathema to the powers on Wall understanding of hedge funds, and is often Street. Fear is another possibility—fear that quite misleading. the public may demand incentive-based com- Decades ago, as a last resort, financial jour- pensation for their funds as well.” nalists came to rely on others in the financial The concept of performance-based compen- services industry for information on hedge sation may well be unsettling to an industry that funds. They failed to recognize several major charges according to the volume of transactions problems with this arrangement: To begin made or the total assets under management, Over the past with, industry sources can only speculate what regardless of whether the customer profits. few decades, a hedge fund manager is actually doing, even The investment services industry is highly hedge fund rumor when a source has direct information on some competitive, and although most professionals that is fed to aspect of a fund’s activities. Of greater con- exercise restraint in disparaging the competi- reporters one day cern, financial industry sources have some- tion, many have made hedge funds the accepted has become front times been slighted in their efforts to provide target. Over the past few decades, hedge fund page news services to a hedge fund manager, and quite rumor that is fed to reporters one day has the next! frequently, these sources compete directly with become front page news the next! As a result, hedge funds. Finally, many sources fail to millions of readers have developed strong mis- grasp the risk management systems that hedge conceptions about the risk profiles of most funds use. hedge funds. 2 In the mid 1970s, Institutional Investor There is a biting irony in the fact that summed up the relationship between hedge rumor is often generated funds and the rest of the about hedge funds on Wall securities industry like this: “Today, they [hedge funds] Street, because the opera- “Today, they [hedge funds] are still targets for an uncanny tions that most closely are still targets for an number of unsavory market resemble some large hedge uncanny number of unsa- rumors, the victims of smear campaigns accusing them of just funds are the proprietary vory market rumors, the trading desks of big banks victims of smear campaigns about everything short of pilfering the napery from the New York and brokerage houses. One accusing them of just about Stock Exchange dining room. main difference is that most everything short of pilfer- ...hedge funds are so often brand- hedge funds take on far less ing the napery from the ed as villains by other sectors of risk than many of Wall New York Stock Exchange the investment community.” Street’s proprietary trading 2 dining room. ...hedge funds -Institutional Investor , May’77 desks. are so often branded as vil- lains by other sectors of the Risk Management: Betting vs. Gambling investment community.” The other reason why so many journalists In 1994, an excellent overview of the indus- have misled readers about the risks of hedge funds is that the concepts of risk management used by hedge funds can be difficult to under- stand. Many of the tools, and the lexicon 2 Jack Thackray, “Whatever Happened To The Hedge Funds?” Institutional Investor, May 1977, 71-74. applied to them, imply high risk to the average 3 Gary Weiss & Joseph Weber, “Fall Guys?” Business Week, 25 investor and to the journalists who write about April 1994, 116-121. their use. Consider the word “bet,” commonly used by 4 Lookout Mountain Capital, Inc. hedge fund managers, but also by the entire Scenario #1 is pure gambling, and if you investment community. Managers do not use answered yes, you are reckless with your the word “bet” to imply “gamble,” but journal- money. Scenario #2 has an attractive payoff, Even though the ists often infer that is its meaning. Even though but the downside risk is too great, at least for inference of gam- the inference of gambling is not usually correct, most people. Scenario #3 is appealing because bling is not usually it is easily made when viewed in the context of your risk of loss on any single coin toss is correct, it is easily tools like leverage and short selling. These are acceptable, relative to your capital, and the odds made when viewed perceived by most investors as purely specula- heavily favor your making unlimited sums of in the context of tive tools, but many hedge funds successfully money from a continuing series of coin tosses.
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