Hedge Funds Explained: Why Hedge Funds Aren’t Really Hedged

so you want to start a hedge fund maybe you envy the high-flying lifestyle of closing huge investment deals or maybe you've seen Bill Ackman on TV one too many times and like the idea of socially responsible investment or maybe just maybe you have seen the earnings of some of the top hedge fund managers and figured well they can do it why can't I and you know what maybe you can there really isn't anything too remarkable about these types of institutions but before you close your assorted 50 Google Chrome tabs of Wall Street bets coinbase and Robin Hood and start pitching your parents for seed capital to move to New York there are a few things that you need to understand firstly of course you should probably know what a hedge fund is beyond being a big building full of smart people with 20 monitors each then you need to understand the actual structure of these companies and how 90% of your work is going to be haggling with lawyers and accountants and finally you have to understand that these businesses are kind of dying off realistically the heyday for hedge funds is probably behind us but don't let that discourage you there are still billions to be made and perhaps it's time to put your red bull and gambling addiction to good use so let's start off with what a hedge fund actually is so hedge fund is a term that has really really lost a lot of its meaning in recent years these days it basically just means a managed financial institution that facilitates complex investment strategies that caters exclusively to high net-worth individuals but that wasn't always the case you see hedge funds actually have a really specific role in the world of high finance if you are investing into shares or really any financial security the number one tip that most people will give you is diversify and that's normally pretty good advice the idea of this is that one of your investments does really really badly or even goes bankrupt well at least you have some other shares or maybe even some bonds in your portfolio that are still rocking along it's not great but in general you won't yet be looking at a one night stay in a high story hotel room if you catch my drift some people go beyond this advice and recommend buying broad market index funds that give you exposure to hundreds of companies like say Vanguard exchange-traded funds and you know what that's the general advice that I'd normally give as well I mean it's what I do low-cost index funds over long periods of time generally return a stable 7 to 8 percent annualized return which when considering the powers of compound interest is actually amazing the thing with these types of funds is that you are more or less exposed to the overall prosperity of the entire market and by extension the prosperity of the global economy the risk you take is that if the markets do well you do well but if they do poorly you do poorly for long term investors this is fine you'll have good years and bad years but overall you will normally win out now in the world of the super-rich that sort of thing isn't necessarily acceptable the ebbs and flows of the global economy impact them directly they may already be exposed to that particular kind of risk in their own company so if a global recession comes around well it's doubly bad not only will their own company be doing badly but so too would their investment portfolio these massive ups and downs can be unsettling because sometimes business owners will need to pull cash out of their investment portfolio to keep their businesses afloat during these more trying times now if they sell their investments in the midst of a market panic that is literally selling low the opposite of the buy low sell high fundamentals of investing so what individuals like these need is some kind of fund that is hedged against the wider risks of the market let's call them hedge funds the first hedge funds were created by wealthy individuals simply as vehicles to invest into markets that would complement their primary business a horse farmer might want to put some money into that new Ford automobile company a kerosene lamp magnate might want to invest into light bulbs and will you get the gist from that they got more and more complex opening up to wider groups of investors and the actual structure of a true hedge fund came to form to understand hedging as its defined by conventional finance you have to understand short selling I will leave a link in the video description to go over short selling in depth those of you who are not yet up to speed button short what it means is effectively bidding against an investment if you short Tesla stock you want it to go down because you make money if it goes down if Tesla stock goes up well then you lose money so with that out of the way what a hedge does is allows you to expose yourself to different types of risk let's say you know that Samsung is in the final stages of developing a patented phone that never runs out of batteries well this would almost certainly lead to a huge price spike in the company's stock no worries I will just go out and buy some Samsung stock and I will be rich well yes but you didn't account for the greater market risk let's say the phone is announced but it comes out a week before I don't know the markets lose 17% of their value sure the news of this phone is good but it's not nearly enough to stop people panic selling their shares and the price of these shares will still fall well this sucks and if anything it was a waste of good research or insider trading tips or whatever what would have been a smarter play is this by Samsung shares just like you planned but also short sell Apple shares now in the same hypothetical scenario where the entire market tanks what would happen is say that your Samsung shares four by four percent because the news of their amazing new phone buffers them a bit but Apple shares fall in line with the rest of the market losing 17% of their value well because you actually make money off Apple losing money you will make a 17% profit and sure you still technically lost out on your Samsung position but the gains from your short position made up for that people often talk about hedges as eliminating risk from the portfolio altogether and this is nonsense they don't eliminate risk if you don't have risk you don't really have potential for profit what they do is expose the fund to a different type of risk instead of being exposed to the performance of the wider market in this example they weren't exposed to market risk but they were exposed to the relative performance of Samsung / Apple now these days hedge funds don't really do this kind of stuff exclusively they have kind of just evolved into higher risk trading houses trying to achieve better returns by actively speculating on this that or anything else okay but let's say you won't let yourself get sloppy and commit your fun to the promise that was the original idea of what a hedge fund should do how would you set one up okay so how you set up your hedge fund is actually probably far more important than what kind of stocks you trade or how many screens you have graphs on this is basically how you set it up first things first set up a partnership in the United States and make yourself the managing partner second thing is to set up an insurance company in say good old Bermuda an insurance company seems very odd but what it allows you to do is this if you make 10 billion dollars in profit well normally you'd have to pay tax on that income but instead you can do this get your insurance company to charge you 10 billion dollars in insurance premiums this shows up as a business expense in the United States and now means your hedge fund has made no profit and hence no tax is necessary the insurance company then has this big pile of money and does what insurance companies do with it they invest it where do they invest it oh I don't know how about this promising new hedge fund here in the United States sounds great the actual structure is a little bit more complex and involves a lot more lawyers but that is effectively the gist of it okay beautiful you have you set yourself up to avoid taxes now you actually need to make some money and not pay taxes on that hedge fund managers make money in two ways firstly by investing their own money and generating returns on that investment but they also make money by charging management fees from other investors who they introduce into the fund you may have heard of a two-and-twenty what this refers to is the 2% fee for total assets under management and a 20% cut of any extra profit you make beyond that benchmark so for example if you attract an investor to invest say 1 billion dollars into your fund well then you would make 2 million dollars a year just for watching over their money but you would also earn another 2 million dollars for every 1% over market returns you achieved so with for example you generate a return of 10% in a year that the market only returned 5% well you would make your 20 million dollar no matter what but you would also get an extra ten million dollars on top of that as a management bonus the investor doesn't mind paying this because you have made him fifty million dollars more in that year than he would have just by investing in the markets themselves and even after paying your fees he is still out twenty million dollars ahead you can start to see how this all gets pretty profitable and here is where it all gets that much better you see these hedge funds are set up as partnerships not a company which means that they are technically not a separate legal entity from their partners investors into the fund a broader board as limited liability partners but you yourself are a direct managing partner and what that means is that your assets are effectively one and the same with the hedge funds so if you make all this money in a given year normally you'd have to pay the top marginal tax rate of thirty seven percent if you were just to pay it out yourself but no instead what you can do is this just claim the assets of the business as your revenue hold onto them and suddenly you aren't making cash income you were just holding assets that appreciate in value if you do end up selling these business holdings to buy yourself a penthouse or a jet or a super yacht or whatever well then you have to pay tax on that Shore but not income tax capital gains tax which is much much less than the top marginal tax rate which means Udyr hedge fund manager get to hold on to a lot more of your precious pennies this is called the carried interest principle or loophole depending on who you ask and it means that with some careful accounting that hedge fund managers often pay a lower percentage of tax than the janitor that cleans their office at the end of the day so this is morally questionable but who cares you're going to be rich let's go find some investors and hold up their Tiger finding investors kind of neatly segues us into the last part of this video today hedge funds have grown a long long way from their roots hedge funds that actually hedge to minimize risk are probably very few and far between and most of these types of funds simply try new and exotic forms of investing to try and beat market returns there are high-frequency trading firms cryptocurrency firms developing nation funds it's all very diverse but really it has just become a rat race to achieve the best rate of return which again was not really the point of a hedge fund the average return of the largest 100 hedge funds in America was almost exactly that of market returns which means it was pretty much just luck with a pretty standard deviation around the median with market returns right there in the middle long term these funds will pretty much match the seven to eight percent return the market gives they will also charge you that two and twenty which means that most investors are going to be better off long term just investing into the market themselves and sure once in a generation there may be a brilliant manager that can consistently beat the market but actually finding and betting on that manager would be just as hard as finding and betting on the next Amazon so you may as well just go out and do that if you are a risk seeking investor beyond this hedge funds aren't independent of the market anymore if the market does badly they do badly if the market does well they do well so their original purpose of stabilizing a portfolio has kind of been lost and the thing is most wealthy investors today know this and no longer invest into hedge funds but don't worry you are a morally onerous financial manager maybe you'll just go after less wealthy investors sure you may have to get more of them but money is money right well no hedge funds are considered sophisticated investments which means that legally only surface scattered investors are allowed to invest in them sophisticated investors are defined as someone with an annual income of over 250,000 US dollars or a net worth of over 2.5 million US dollars and the truth is because of the incredibly complex structure involved in hedge funds most of the time it is not even worth paying the accountants and the lawyers to fill out the paperwork for an investment that is less than 10 million dollars a year so yeah what all of this means is that hedge funds are very very costly to start up it's very very hard to find investors and even major established funds seem to be on a bit of a decline sure if you can get it working you are likely to make lots and lots of money but realistically there are much easier businesses to start but you know what don't let your dreams be dreams if becoming Bobby Axelrod is your life's aspiration who am I to tell you that you can't do it at least now you know the process hi guys if you do manage to get your hedge fund going and make billions and billions of dollars please consider sending some of that money back to your good old buddy economics explained by our patreon page just like these lovely people did our discord server is linked in the video description so feel free to jump onto that to participate in our Q&A sessions and also enjoy the discussion amongst other economics nerds like myself thanks guys bye

Channel: Economics Explained

Views: 593,242

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Keywords: hedge funds, hedge funds explained, hedge funds economics explained, masters of the market, why hedge funds arent really hedged, fund management, what is a hedge fund, hedge funds vs private equity, hedge funds vs investment banking, hedge funds for beginners, hedge funds vs mutual funds, fund management explained, what is a hedge fund company, what is a hedge fund and how does it work, hedge fund vs private equity, hedge fund vs mutual fund, economics explained

Id: Yygwaln14sU

Length: 15min 57sec (957 seconds)

Published: Thu May 21 2020