Secret Diary of a Hedge Fund Allocator
What I’ve Learned From 25 Years of Investing in Hedge Funds
Before we get into it, a reminder that paid subscribers get exclusive access to my podcast series, Net Interest Extra, where I interview experts in the field of finance. Coming soon, interviewer turns interviewee as I turn the microphone on Ted Seides, host of the popular Capital Allocators podcast. Ted has a lifetime of experience in and around the asset management industry and I look forward to talking to him about it. If you’re not already fully subscribed, you can do so here.
Now to today’s topic.
For all my analysis of hedge funds as businesses – their fee structures, capital raising challenges, and operational hurdles – I’ve never shared my personal experience investing in them. As you know, I worked at a hedge fund for almost ten years but for longer than that I’ve also allocated my own capital to these vehicles, experiencing the industry’s transformation from a consumer’s perspective as well as a practitioner’s and analyst’s.
My introduction was via funds of funds. It was the early 2000s and I’d just witnessed equity markets tumble from their peak. The S&P 500 index ultimately lost 50% of its value and the Nasdaq Composite 78%, leaving me deeply shaken. Finance writer Morgan Housel has a riff on the old Napoleon Bonaparte line that to understand a man, you must know what was happening in the world when he was twenty. Housel argues that, like politics, money is emotional, and emotional fields tend to be rooted in views formed at a young age. As I exited my 20s, I’d seen enough market drawdowns to push me toward alternative investments.
Julian Robertson had already made hedge fund history by then. His Tiger Management fund had generated returns of 31.7% per year after fees from inception in 1980 through to its peak in 1998. Although he’d since shuttered it, through my work as a research analyst I had the opportunity to meet many of his ‘disciples’ – so-called Tiger Cubs. They were some of the smartest investors I’d encountered. But like many top-tier hedge funds, their vehicles were capacity constrained with high minimum investment amounts, putting direct investment out of reach for most individual investors. The only way to access this talent was through funds of funds.
By the time I started looking, funds of funds had grown from their roots in Switzerland into a substantial industry. In 2002, they collectively managed over $200 billion of assets, with UBS emerging as the largest player. The appeal was straightforward: funds of funds solved several key challenges facing individual investors. They had the resources to identify and access top managers, many of whom were closed to new capital. Their teams conducted extensive due diligence and maintained ongoing oversight that would be impossible for individual investors to replicate. Most importantly, they offered diversification across multiple managers: a single fund would grant exposure to around 40 underlying hedge funds.
The price for this access was an additional layer of fees. On top of the hedge funds’ typical 1-2% management fee and 20% performance fee, funds of funds charged their own fees – often 1% of assets and 5% of profits above a threshold.
Warren Buffett would famously later criticize the model, arguing that its layered fee structure made it impossible for investors to win in the long run – “Performance comes, performance goes. Fees never falter.” But my experience was different. My UBS fund delivered over 50% between May 2001 and August 2007, providing exactly the kind of downside protection and diversification I was looking for in those turbulent times.
Hooked, it was time to advance to something purer.
Brevan Howard
Alan Howard was well known on the trading floors of Credit Suisse, where I worked. A proprietary trader in fixed income, he and his team generated profits of $500 million for the bank in 2001. When he left in 2002 to launch his own firm, he went with the bank’s blessing. “Like all good traders, Alan knows the value of risk, how much risk he can take and the availability of capital. That’s the main differentiation between a good trader and a bad trader, and he was exceptional,” said senior executive Oswald Gruebel. By 2006, he was managing $10.5 billion of assets, $2 billion of which were from Credit Suisse private banking clients.1
Unlike the Tiger Cubs, Howard’s focus was macro. He launched his flagship macro fund in April 2003, and I was in on the ground floor. To this day, the fund’s objective has been to “produce compelling, asymmetric returns to its investors, independent of the market environment.” The strategy relies on a deep bench of talent. The core focus is fixed income and foreign exchange, though the fund also trades commodities, credit, equities and even digital assets. Today’s operation is massive: over 140 investment professionals, 25 risk officers, and 23 strategists collectively manage $34 billion. The flagship Master Fund accounts for $11 billion of that.
In many ways, the approach is an extension of the funds of funds model – rather than diversify across firms, the fund diversifies across traders. Currently, its top three traders each manage around 10% of the fund’s capital, with the top ten collectively managing around 60%. In addition, around 20% of fund capital sits in a center book which makes tactical trades based on the aggregation of risk factors across the fund as well as investment opportunities.
Like other multi-manager funds, Brevan Howard excels at managing risk. Over its 20+ year history, the fund has suffered only a single down year in excess of a 5% loss. It’s also a diversifier from equities: Across the 20 worst performing months for stocks, the fund has produced 17 positive monthly returns. All-told, returns have compounded at an annual rate of around 8% after fees.
Brevan Howard Master Fund isn’t Renaissance Medallion Fund – you won’t gain status from admitting to owning some at cocktail parties. It’s also widely available. Like some other funds we’ve spoken about – Bill Ackman’s Pershing Square, Dan Loeb’s Third Point – a feeder is listed on the London Stock Exchange. It currently trades at a 7% discount to net asset value – not as wide as Bill Ackman’s, but it’s not like investors are clamoring to get in. One thing the fund does have going for it, though, is longevity. It has been running for 22 years and is structured to continue running for longer. Not all funds have that kind of staying power.
With hedge funds suddenly back in vogue – enjoying a rare third consecutive month of net capital inflows in March, after years of steady outflows – it’s worth examining some other funds in my portfolio. My experiences with Paulson & Co, BlueCrest, Thélème and others reveal the highs and lows of backing star managers. To see what these war stories taught me about picking managers and surviving the inevitable ups and downs, read on.