Hedge funds have been able to amass a staggering amount of capital -- once an estimated $2.5 trillion -- all in a relatively short lifespan. And though this information is interesting on its own, the important questions to ask here are:
- What, exactly, explains the massive attraction to these funds?
- What natural strengths do these investment vehicles have over more traditional choices?
- How can we do better than them?
Answers to come shortly. First, let's dispense with the popular notion that hedge funds are some brilliantly successful creation.
The best there is?
According to the Hedge Fund Implode-O-Meter, no fewer than 109 major funds have gone completely bust since late 2006. The Morningstar 1000 Hedge Fund Index, a good proxy for the overall hedge fund industry, lost 22.2% in 2008. Granted, the S&P 500 lost 38% last year, but if these are the handsomely paid super-elite of investors, count me among the unimpressed. I can lose money, too, folks.
These days, funds at industry titans such as Blackrock
Names like Madoff remind us that hedge funds don't automatically equal great success. But I'm still curious: What is it that attracted all this money in the first place?
Golf courses and the SEC
Is it the sexy, exclusive nature of the funds themselves that drew so many investors? Perhaps. The concept of joining a super-secret club is vaguely appealing to me -- hey, Augusta National, call me! -- so that's probably some of it.
Is it their ability to operate autonomously, beneath regulatory oversight, that lured in the big bucks? Maybe a few years ago, the answer to that was yes. Today, however, we have learned what happens when a few inherently greedy people operate outside the jurisdiction of watchful eyes.
But there's got to be something bigger.
One theory
Ramius, a global investment firm, has begun to scratch the surface of what has made the industry so attractive. In a recently published white paper, the firm identified one advantage of hedge funds that reveals an unexpectedly significant statistical effect: activism.
For those unfamiliar with the term, activism describes situations in which hedge funds control large stakes in public companies and, as such, have a say (often large) in deciding the corporate strategy of a given company. Big stakes equal big voting power -- power enough to shape a company's future. And, according to Ramius, this influence is a massive competitive advantage for some hedge funds.
Show me the money
What we know about activist hedge funds is that they are able to overcome a common problem facing shareholders of public entities, namely:
Corporations do not always do what is in the best interests of their shareholders. It is the classic agency problem of public corporations, whereby ownership and control are separated.
We've seen it before in the ridiculous pay packages at places like Home Depot
Fortunately, however, when an activist investor gets involved, it generally leads to success.
Here come the numbers
According to data cited by Ramius, of nearly 800 activist events between 2001 and 2006, nearly two-thirds experienced successful or partially successful outcomes. In the two-month period before and after actions were announced, firms outperformed the market by 7%.
More interesting is that the best of these brief interventions generally led to long-term improvements in returns on equity and assets, in addition to increased dividend payouts and reduced CEO compensation. That's some good work.
Another study cited by Ramius suggested that even the perceived threat of activist intervention often was enough to encourage successful outcomes.
I want you in my corner
What we can conclude from this data is that much of the power that hedge funds hold comes from their ability to shape companies in ways that are beneficial to the shareholder.
Today, we see these types of campaigns regularly; recent notable examples include Yahoo!
So what?
In theory, many of us would like to replicate these processes, especially if we knew precisely what the company was doing wrong. But most of us don't have the kind of money necessary to create change. So what can we do?
Think backwards.
We may not be able to influence change when things have already gone wrong -- at least, not without a good deal of effort. But we can outmaneuver the market by solving the same critical agency problem that hedge funds face all the time: executives not caring what happens to shareholders.
There's a simple way we can avoid throwing money, time, and effort toward a massive proxy fight with entrenched management.
Figure it out yet?
The smart action is to invest with executives that maintain significant personal investments in their own company. These are the same folks that wield enormous amounts of day-to-day power over a company. Your potential advantage is (drum roll, please) alignment.
When insiders are only screwing themselves over by making poor strategic decisions, we find that they make fewer of them.
This doesn't mean investing with execs that are milking the company for boatloads of options every year. It means getting behind the men and women who are shaping the long-term future of a company when they have a significant vested interest in it.
In practice, then, you'll want to look for executives with a significant ownership stake in the company, long tenures, and what we'll call a reputational risk. These executives are their own biggest activist investors!
Foolish bottom line
Individual investors like us have our own advantages over hedge funds. We're much smaller, we don't need to meet short-term performance goals, and no one can force us to sell (unless we owe them money). But if you want to beat the hedgies at what they're really good at, identify management that wants precisely what you want: long-term capital appreciation.
At Motley Fool Hidden Gems, we typically find the strongest owner/operators in small-ish companies that few large institutions have heard of. We've discovered that when you align yourself with these types of investments, you outperform ... big-time. If you'd like to take a look at our stock recommendations and best bets for new money, you can try the service free for 30 days by clicking here.
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Nick Kapur humbly requests admission to the Augusta National Country Club. He has no positions in any company mentioned above. Home Depot is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.
