Thinking About Investing in a Hedge Fund?

The hedge fund industry, through negative media attention and the occasional jaw-dropping paydays we hear about, has cultivated an air of mystique for the average investor. Many assume these privileged money managers simply know things others don't or have superhuman analytical skills, a la Warren Buffett.

There is no question that some of these professionals have incredible stock-picking abilities or are fierce traders. But if you look at the top stocks attracting hedge fund capital, it's startlingly boring.

The winner is...
If you started reading this article thinking that Apple (Nasdaq: AAPL  ) would be the No. 1 holding among the biggest hedge funds...you'd be right.

Out of the 50 biggest funds, 12 of them have Apple as their largest holding. Well, we already know that Apple is a good company that is a relatively safe hold for the next few years. In fact, I would say that if you were to ask a random person on the street which single company he or she would choose to invest in, the vast majority would say Apple. So, the Harvard MBAs, the two and 20 fee structure that eats your profits, the potential Ponzi schemes -- they all get you into the same stock you probably already have in your portfolio.

I don't hate hedge fund managers. I respect many of them for their innovative techniques and amazing success. Take David Einhorn, for example. The manager of Greenlight Capital is undoubtedly one of the best money managers of our time. Whether long or short, he makes compelling arguments that are often spot on. One of his most recent short attacks was on Green Mountain Coffee Roasters (Nasdaq: GMCR  ) . Einhorn, among others, pointed out the company's total lack of transparency and its senseless run-up in stock price throughout 2011. His fund was short the stock and has since made a pretty penny.

But even Einhorn, the sleuth, seems to believe there is no better place for his money than Apple. In Greenlight's latest 13-F, Apple is by far the largest holding.

It is necessary to keep in mind that there is a difficulty with assets under management. Once a fund grows well into the billions, it becomes impossible to invest a meaningful amount in small caps, where I believe the most talented fund managers find their most lucrative quarry. You just can't buy enough of a company to move the needle on the fund's returns without having a material impact on its share price.

They're famous investors -- but why?
John Paulson is one of the most well-known money managers around. His bets against the U.S. housing market right before the collapse earned him billions personally. The man is surely talented, and he was able to see the iceberg right before we hit, but his fund's biggest holding is the SPDR Gold Trust. Of all the options in the equities markets, Paulson says, "No, I want gold." I'll never forget Buffett's comment on gold in a recent Berkshire letter:

Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce -- gold's price as I write this -- its value would be about $9.6 trillion. Call this cube pile A.

Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 ExxonMobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

As usual, Buffett makes perfect sense to me on this matter. So how could the talented and able John Paulson consider gold to be the absolute best place for his investors' money? I don't get it.

It gets better
This is my favorite one. Bridgewater Associates has $122 billion under management and is listed as a value fund. How did the fund reach such a staggering size? With unbelievable analysis and genius investing techniques -- right?

Bridgewater's top holding: SPDR S&P 500 ETF (NYSE: SPY  ) .

I wish I were kidding. For a mere 2% of whatever you invest and an additional 20% of your investing profits, you can access a group of money managers who, by some astonishing talent, can put your cash into the S&P 500. Sarcastic analysts want to know: How did they even find such a remarkable ETF?

Keep on keepin' on
If you're tempted to hand over your investing to professionals, do so with caution and know that these "professionals" are probably doing the same thing you are -- if not worse. The air of superiority cultivated by the financial elite is similar to the air you smell when you walk over a New York City subway vent.

Keep on doing your own homework, and let us help. Take a look at the premium reports for both Apple and Green Mountain Coffee Roasters. These reports will help you determine whether these stocks are good for your portfolio in the coming years.

Fool contributor Michael Lewis owns none of the stocks mentioned above. You can follow him on Twitter @MikeyLewy. The Motley Fool owns shares of Green Mountain Coffee Roasters and Apple. Motley Fool newsletter services have recommended buying shares of Green Mountain and Apple, as well as creating a lurking gator position in Green Mountain, a bull call spread position in Apple, and a bear put spread position in SPDR S&P 500 ETF. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (9) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 27, 2012, at 5:32 PM, Mega wrote:

    Looking at their largest holding actually tells you next to nothing about their overall strategy.

    Greenlight, Bridgewater and Paulson are not doing anything remotely similar to the average investor in terms of long/short, credit derivatives and macro trading.

  • Report this Comment On August 27, 2012, at 6:07 PM, XMFMadMardigan wrote:

    Article was about stock picks. Not interested in credit swaps or trades. Thanks, though.

  • Report this Comment On August 27, 2012, at 9:09 PM, daveandrae wrote:

    It seems to me that, if the basic idea of a hedge fund is to "hedge", than by its very nature, it is going to underperform the "market" during a long, secular, bull run, such as has been the case over the last twelve & thirty-six months.

    Combined with this irrefutable fact is the undeniably obvious; most, if not all, "hedge" funds charge you an exorbitant amount of money to do so. Thus, for the life of me, I do not understand why anyone, that has a basic understanding of sound logic and arithmetic, doesn't simply invest their hard earned money in a vanguard s&p 500 index fund.

    Not only will you "outperform" most investors, as well as most "hedge" funds, but you will do so at a fraction of the cost associated with the investment.

  • Report this Comment On August 28, 2012, at 1:08 AM, XMFConnor wrote:

    Michael,

    I think you miss MegaShort's point.

    Take Bridgewater's SPY holdings. Just looking at their top position and coming to your conclusion of "we are paying them 2 and 20.. and they put us in the S&P 500 index fund" is the wrong one.

    What they are doing is strategically hedging their longs (on a daily, often real-time basis to monitor net exposure).

    Therefore, while I think your Paulson example makes sense, your Bridgewater example does not. Overall, your thesis is too simple and extreme in my opinion-- hedge funds on average do things much differently than the average individual investor and the fact most of them hold Apple does not change that fact.

    Foolishly,

    Connor

  • Report this Comment On August 28, 2012, at 2:39 AM, XMFMadMardigan wrote:

    Connor,

    You're right, and megashort as well for that matter. It is an oversimplified view of what the average fund does. Part of the error in the article is that the term hedge fund applies to a thousand different strategies these days. I worked for a long/short equity-only fund. In a fund like that, putting a bunch of money in Apple and calling yourself a fund manager (ie charging the typical fee structure) is, in my opinion, robbery.

    To play devils advocate (I might be the devil in this conversation, but oh well), Paulson could see something in gold the rest of us are missing, who knows. To me, though, I dont mind paying a fund manager who is digging deep into thousands of companies to find one or two gems with 3 or 4 (or 10 , thats ok too) bagger potential. More over, I dont mind paying a fund manager who loses less than the S&P in down years, and stays near it during up years.

    What I don't like to see is a fund with $50 billion AUM bringing in a bilion in profit regardless of how the fund performs. When your management fee pays the salary of everyone on board, as well as admin and legal, why even strive for more than 5-6% return? For the investor, why pay someone 2/20 for the S&Ps average?

    Yes, this article was simplified and my argument could have been made more clear. But I stand by my thesis that the average investor can at least match if not beat 95% of professional money managers in the world with less than 10 hours/week of analysis.

  • Report this Comment On August 28, 2012, at 3:40 AM, daveandrae wrote:

    ^

    " I stand by my thesis that the average investor can at least match if not beat 95% of professional money managers in the world with less than 10 hours/week of analysis."

    Hell, ten hours a week of analysis is an insult to the average investor.

    Try ten minutes.

    Year to date the s&p 500 is up 12.51%. As of August 14th, the credit suise hedge fund index is up 1.5%.

    Nuff said there.

    In 2011, a year in which the s&p 500 was more or less flat, more than 78% of professional money managers STILL managed to underperform the index....and charged you, the investor, a ridiculous a fee to do it.

    For the life of me, I do not understand why any reasonably intelligent investor in his right mind would give his hard earned money to someone who claims they can beat the "market" when we all know damn well that these people ARE the market!

  • Report this Comment On August 28, 2012, at 4:15 PM, portefeuille wrote:

    my biopharma "hedge fund".

    http://caps.fool.com/Blogs/fund-trades/755654.

    http://twitter.com/portefeuillefun.

    all fees = 0% ;)

    feel free to fund the missing 95% or so ...

  • Report this Comment On August 29, 2012, at 3:59 PM, cruzn59 wrote:

    same ol' gmcr slam zzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzzz

    sorry I fell asleep

  • Report this Comment On September 01, 2012, at 5:10 PM, Mega wrote:

    Mike,

    In general I agree with you. But I think these 3 funds are not great examples of the idea that hedge funds are overpaid for not doing anything special, since they actually seem to be exceptional investors with complex, differentiated strategies. (Paulson's recent performance notwithstanding.)

    And sometimes, an obvious idea like Apple or gold is a really good idea. Apple is my biggest holding, it may not be 12 months from now though.

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