FOOL ON THE HILL
A recent Forbes article raised some interesting questions about so-called "hedge funds." In this article, Whitney Tilson tries to answer them, discussing the funds' strategies, who can invest in them, and what investors can expect. For investors considering these instruments, careful due diligence about the fund and its manager -- and serious thinking about the implications of the fund's fee structure -- are required.
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I manage a private investment partnership -- commonly known as a hedge fund -- so, not surprisingly, I get many questions about these mysterious entities. I suspect that the cover story of this week's Forbes, The $500 Billion Hedge Fund Folly, will raise even more questions, so I'd like to address some of them. (Free membership is required to read the article.) Overview PIPs date back to the 1940s. Some of the most famous investors of all time have used them: Warren Buffett and Charlie Munger each had very successful partnerships (before Berkshire Hathaway (NYSE: BRK.A) became their investment vehicle), as did -- until a year or two ago -- Julian Robertson and George Soros, to name a few. The industry has grown explosively, Forbes citing an estimated 6,000 funds today managing more than $500 billion, up from a mere $15 billion in 1990. At the most basic level, PIPs are similar to mutual funds: In both cases, investors put their money in a fund to be managed -- for a fee -- by full-time professionals. In both industries, thousands of different funds follow a wide range of strategies in an attempt to achieve certain goals. High returns are a typical goal, but other major objectives can be preservation of capital (often the primary objective of a hedge fund, rather than beating the market), income, exposure to certain asset classes, and so on. There are major differences, however, between mutual funds and PIPs. Mutual funds vs. private investment partnerships PIPs also generally have far greater investment flexibility than mutual funds. They can short stocks, invest anywhere in the world, buy and sell options, make bets on currencies, and invest in privately held companies. PIPs can also invest in any industry, in companies of any size, and are not locked into so-called "growth" or "value" strategies. Importantly, flexibility is not necessarily an advantage or disadvantage: A high degree is beneficial in the hands of a prudent investor, but potentially lethal in the hands of a rash speculator. In exchange for less regulation of PIPs, the Securities and Exchange Commission (SEC) places limits on how they can market themselves and who can invest in them. PIPs cannot advertise or market themselves to the general public, which is why I have never discussed the specifics of my fund in these columns. Instead, they can only solicit and accept "accredited investors." Most PIPs fall into one of two categories, each of which has a different definition of "accredited." One type of PIP can have up to 499 investors before it is required to make public filings with the SEC, but every investor must have $5 million of investable assets. The other type is limited to 99 investors, but the accreditation test is far lower: either $1 million of net worth (the Forbes article incorrectly states $1 million of "investable" net worth), or $200,000 of annual income for each of the past two years and expected in the current year (or $300,000 for a couple). In addition, among these 99 investors, the fund manager can accept up to 34 unaccredited investors. Unlike almost all mutual funds, in which investors can withdraw their money at any time, PIPs generally have redemption restrictions. Some permit withdrawals quarterly -- generally with advance notice of 30 to 45 days, while others have three- or even five-year "lock-ups." It is common and, indeed, expected that PIP managers will have a substantial fraction, if not a majority, of their own net worth in the fund, alongside their investors' capital. This is a powerful incentive for a fund manager to act sensibly. I have never understood why mutual fund managers weren't required to do the same (though there are a few notable exceptions, such as Longleaf Partners). Compensation It's not impossible -- I know many managers who have done it -- but the odds are not good. There is little doubt that Vanguard's John Bogle is correct when he says in the Forbes article, "I think it's inconceivable that you could take $500 billion run by 6,000 different managers and expect these managers to be smarter than the rest of the world." Keep in mind, of course, that many hedge funds are designed not to beat the market, but to preserve capital, first and foremost (hence the term "hedge fund"). Incentives It is not uncommon, therefore, to hear of PIPs losing most or all of their investors' money due to the most rash investment behavior imaginable. Conclusion If one ignores the hyperbole, the Forbes article makes some excellent points, the most important of which are that PIPs have high fees, such that "most hedge funds can't deliver on their promise of beating the broader stock market over the long haul," and are, in general, riskier than mutual funds due to being unregulated and having a compensation arrangement that encourages risk-taking. This doesn't mean one should never consider investing in a PIP, but it does mean careful due diligence about the fund and its manager -- and serious thinking about the implications of the fee structure -- are required. -- Whitney Tilson
Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com.
The term "hedge fund" arose to describe private investment partnerships because many of these funds short stocks to hedge against a declining market or sector. Many private investment partnerships, however, don't short stocks or hedge in any way, so the term is inaccurate. For the rest of this column, I will use the correct name: private investment partnership, or "PIP" for short.
First, PIPs are not as heavily regulated as mutual funds (though they are far from unregulated, as the Forbes article asserts) and do not generally have to disclose their activities or holdings, which can allow managers to deviate from their stated investment strategies. Less regulation can also increase the risk of malfeasance (the Forbes article gives a number of examples), but on the plus side, it also means PIP managers don't feel as much pressure to please critics by following the herd or engaging in end-of-quarter "window dressing."
The most important difference between mutual funds and PIPs is the compensation arrangement, and the incentives it produces. Unlike mutual funds, the managers of PIPs earn a percentage of the profits -- the industry standard (there are many variations) is a 1% management fee plus 20% of net profits. Such a lucrative deal attracts some very talented money managers into the business (along with the usual smattering of charlatans and hucksters), but also imposes a high cost, making it hard for managers of PIPs to deliver market-beating returns to investors.
Earning a percentage of the profits certainly gives PIP managers encouragement to make money for investors, but can also provide dangerous incentives. Since losses are borne entirely by investors, yet the manager earns a meaningful percentage of the profits, there is an awful incentive to swing for the fences and take high risks. As the Forbes article notes, "heads, they win; tails -- well, it was your money." (The fact that PIP managers have their own money in the fund helps offset this incentive, but it may not be enough.)
It only takes a glance at the title to know the Forbes article stakes out the extreme position that PIPs are mostly managed by "racetrack touts" and the odds of picking a PIP that beats the market are incredibly small. That's just silly. The PIP industry is no different from the mutual fund industry, in that there are wise, disciplined, and prudent fund managers, and then there are all the rest.
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