Tuesday, July 25, 2017

Efficiently Inefficient #2 : How to be your own Hedge Fund manager.

At this stage of my personal finances, I am edging ever closer to to becoming an accredited investor. But as of now, I am not there yet. Accreditation can allow a person to qualify for hedge funds but evidence of hedge funds outperforming the market are hard to find because many hedge fund managers simply do not wish to report their results to a central database.

It is probably easier to expect that investors of hedge funds would generally underperform the market because the fees are so high. Hedge funds can charge a management fee of 2% and 20% of their outperformance compared to a benchmark. Furthermore, the book mentions that hedge funds tend to have returns which have a large kurtosis and are negatively skewed. This is geek-speak for returns which can be very large and negative when the time is not right.

Thus, it may be safer for us retail investors to just see hedge funds as a sophisticated compensation plan for hedge fund managers.

For intermediate DIY investors, it may be better to get your hands dirty yourself and avoid paying ridiculous management fees by considering some of the key features of hedge funds and adopting it on a much smaller scale towards your own portfolio.

Here are some ideas for your consideration :

a) Leverage

I am fairly familiar with leverage as my margin account has will be invested in over $100,000 of SGX counters this week. Leverage allows investment gains to be magnified. A portfolio yielding 6.5% leveraged at 200% at a borrowing cost of 3% can yield 10% for an investor.

The problem is that leverage also magnifies losses so this feature need to be handled with care. I backtest my portfolio strategy and note the semi-variance of my strategy before committing my funds into my margin account. ( More will be shared in my talk this weekend. )

b) Shorting

Hedge funds also regularly short their positions so as to create portfolios that are market neutral. I am less familiar with this as I have yet to implement a portfolio of short positions. Previous blog commentators have explained how to implement some short investing ideas. The latest being Daily leveraged certificates which allow an investor the ability to take short leverage bets on the STI index making perhaps 3% or 5% gains when the index dips 1%.

c) Derivatives

I can do some mathematics behind derivatives but have very exposure to them. The only derivatives I have are long-dated company warrants on Second Chance stock. I bought them when they seemed underpriced a while ago.

d) Cryptocurrency

While not mentioned in the book, I think it is unavoidable that a new class of hedge funds would take up positions in cryptocurrencies in order to generate returns uncorrelated with the stock and bond markets. It is interesting area of development and something I am looking into closely.

In general, I think that for a retail investor, a basket of ETFs is enough to create some means of preserving the purchasing power of your wealth. I certainly would not risk my core portfolio on any of the strategies I mentioned.

The rest of the introductory chapter of the book would be dry for most investor readers but fascinating for lawyers who get some exposure in figuring out how hedge funds are structured.

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