This conversation has probably happened somewhere.
Two hedge fund managers walk into a bar. They need a drink.
Their returns are terrible. Their investors are mad. And they know they're in good company.
They're here to figure out what's wrong with their industry.
"Whisky, please," Jim says.
"There are 10,000 hedge funds in the world," Jim says to his friend, Paul. "Every one is run by a guy who thinks he's George Soros. No one thinks of himself as a mediocre hedge fund manager. Everyone thinks they're the Stephen Hawking of finance."
"Here's the problem," Jim continues. "Most of us went to the same schools, were taught the same theories by the same textbooks, worked at the same investment bank, read the same newspapers, and live in the same zip code. We take money from the same investors who demand the same short-term performance."
"Yet we deeply – deeply -- believe we have an edge over everyone else."
"It's Lake Wobegon on stilts," Paul says.
"A lot of us are smart people. Brilliant, actually. But when 10,000 people fight for the same prize in the same market, the results are totally predictable."
One dollar invested in the Barclay Hedge Fund Index in 2004 would worth be worth $1.88 by 2014. In the S&P 500 (^GSPC +1.15%), it would have grown to $2.32.
"Here's the problem. Most hedge funds are indistinguishable from mutual funds, other than the fact that they feel entitled to charge 30 times the fees."
"Two percent of assets for showing up in the morning, and 20% of any profits."
"There are probably 100 hedge funds that will consistently beat the market after fees. They won't take your money. They provide just enough hope for investors to keep the rest of us in business. We earn half the performance of index funds, charge 30 times the fees of mutual funds, pay half the income tax rates of school teachers, have triple the ego of rock stars, and fewer disclosure requirements than the NSA."
"We're basically a conduit between public pension funds and Greenwich real estate agents."
"Cheers to that."
"Part of the problem is there are so few barriers to entry in this business. You have to be drafted to play in the NBA. But any hooligan can start a hedge fund."
"And call themselves the next LeBron James."
"And convince investors they should be paid like a champ."
"Exactly."
Both take another drink.
"What do you tell clients who are upset with your performance?"
"We tell them we're not trying to beat the market. We're trying to manage risk."
"Jim, seriously, what the hell does that mean?" Paul asks.
Jim throws back his third whisky and bursts out laughing.
"Managing risk ... haha ... managing ri.... phhtt.... haha!"
Both cackle hysterically.
"Every time an investor asks why our returns are so bad I tell them 'we're managing risk,' and they shut up," Jim says.
"You convince them that we have less downside risk than the market. So even though your returns are terrible, you can tell them you have excellent risk-adjusted returns. Throw in some formulas with Greek symbols, and they'll leave you alone."
"Half of our investors are pension funds. They don't need most of their money for decades. Earning low returns is the biggest risk they can take. But we've convinced them that they're better off earning low returns in exchange for minimal downside risk."
"Wasn't your fund down like 57% in 2008?" Paul asks.
"Black swan, bro. Not my fault."
"I started using this line on my wife," Paul jokes. "Honey, I know the kitchen is a mess, but I'm managing risk."
"If you can dream it, you can do it ... in risk-adjusted terms. I'm pretty sure Walt Disney said that."
Jim spills a beer on his lap.
"In risk-adjusted terms your pants are still dry!" Paul yells, laughing uncontrollably. "Here's a bonus!"
"Look, you can get a lower volatility portfolio by putting 60% of your money in Vanguard stock funds and 40% in Vanguard bond funds," Jim explains. "This strategy has beaten most hedge funds with lower volatility. You pay basically nothing in fees. Everyone knows this."
"But how many Vanguard fund managers own a Gulfstream V?"
"I rest my case."
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