What I Learned Working At A Hedge Fund

Note: This is part of my hedge fund series.  Click here for the intro

 

We got into the business of investing because we wanted to make money. We’ve seen the II Alpha rankings of the Top 25, where the minimum earner took home a cool $200 million in 2012. We’ve heard about the greats, like George Soros or Ray Dalio, with fortunes in the tens of billions of dollars and with a Zen-like calm about markets to match it. Naturally, we want the same thing.

What makes this all the more tantalizing is that everything else is shrouded in secrecy. We hear how much money they make and that’s it. While we know that they make tons of money, we don’t even know how they do it! And the biggest hedge fund gurus certainly aren’t about to tell us.

That’s what really intrigues us about the hedge fund rich list– what do they do in order to make such gobsmacking sums of money? Because deep down inside, if we’re trying to trade well to make money, then we don’t want just to read about how much money they make—we want to know what we have to do to make the same sums! How do get our names on to the list?

While I’m not going to appear on the II list anytime soon, I have spent seven years managing money at hedge funds. Hopefully I can shed a bit of light on what good hedge funds do so well and on what we can learn from them. A lot of it is not sorcery or some kind of “secret sauce”; rather, it is the logical extension of concepts that should be familiar to students of the markets and to readers of my writing.

First, a bit of background on my story.  I have been trading the markets since I was a teenager and my first job out of college was a trader at a big bank. You can read about that experience here. After being there for two years, I decided to move into the hedge fund world—at the tender age of 23. While I had my own ideas about the markets and my own experience, I learned a lot of what I know about investing money while on the job at a hedge fund. As a result, this will be about things that I myself learned at a hedge fund—but being at a hedge fund is not necessarily the only place you can learn these concepts or lessons.  For some people, you could learn a lot of the same lessons at a prop trading shop or a good asset manager. Nevertheless, this is what I learned from working at a hedge fund.

Approach Investing As You Would A Business

At a fund, you have to approach investing with a business-like attitude, because your business is based entirely around your performance. When I first started working at a hedge fund, the primary focus was on making good returns—as it should be, because it is the product that you are offering to current and potential customers. It is what sits in the equivalent of your shop window.

Typically, a hedge fund manager earns fees in two ways: through a management fee,  which is a fixed percentage of assets under management (usually 2%), and also through a performance fee, where they take a fixed percentage (typically 20%) of any returns that they make for investors. The big paydays that you read about usually come from the performance fee.

The reason for this fee structure is because you want everyone’s interests to be aligned and for the end investor to feel that they are in the same boat as you. One way is to ensure that the manager only really gets paid when they make money; second, that the manager is invested in the fund he’s managing; third, that you are telling him what you’re doing by issuing frequent reports outlining your thoughts, strategy and some of your biggest positions.

The manager takes a relatively small management fee as a fixed percentage of assets, which is used to pay expenses and salaries. These fees pay for the necessary tools, like price feeds, research databases, administrative and accounting support and keeping the lights on. These are necessary in order to do your job to a high, professional standard and to deliver the kind of returns that people want. The investor wants to give you a baseline revenue stream to pay your expenses so that you don’t starve and have all the necessary tools to do your job.

The performance fee is where the real juice comes from. When you make money for an investor, they are happy to pay you a cut. If you can generate performance even when the broader stock market is down, then that’s even better. Once you start managing a large sum of money, like $1 billion, then the performance fees can be mouth-watering. Imagine making a 25% return on $1 billion and then taking 20% of that – that’s $50 million. But if you just made $250 million for your investors, then they are happy for you to keep that. On the other hand, if you lose money, then you have to make back the losses before you start getting paid a performance fee—creating a very powerful incentive not to take too much risk and lose money.

Of course, you would want to tell your investors if you just made them a  25% return. But you also should disclose other information, typically in a monthly letter. This will include a writeup on your market views and what you have buying and selling in the fund. Obviously, you need to keep excellent records in order to be able to produce such a report and in order to meet your auditors’ requirements.

The takeaways for individual investors are quite clear. Treat your own trading like a business. Keep good records and notes at all times about what you are doing with your investments. Make sure that you are spending on the necessary things to trade successfully, like proper datafeeds, computers and a suitable workspace or working environment. You don’t want any false economy that deprives you of tools that would be necessary for your success. On the other hand, keep your trading-related costs in line such that they don’t eat into your returns. There is nothing worse than feeling you must make a certain level of returns just to keep your account size stable every year.

If it is just your money, make sure that your trading is aligned with your overall interests. For instance, don’t risk too much if losing it would imperil your overall wealth. Risk only the money that you can afford to lose. If you are pursuing trading full-time, either for yourself or as a business, then treat it like you would any job. Come to work at a regular time; put in the required preparation and diligent work during the day. And when you take money out of your trading account to fund your lifestyle, make sure that it is only a manageable percentage of your profits. If you are a profitable trader, then you want your capital to stay in your account and to keep compounding.

 

Focus  on What Matters Most

When you are talking about investments, there are a billion factors that could move the market. Just with stocks, you have to worry about earnings, management, dividends, margins, inflation, interest rates, politics and the competitive landscape. And that’s just to list the obvious ones! There are a million other factors you could identify that can influence an individual stock’s price.

At a hedge fund, you learn something different. Instead of paying attention to *everything* that could influence a stock’s price, you learn to pay attention to *what matters most* for the stock. Out of a billion potential influences, there could be just two or three that really matter, especially at the present. It’s your job to identify those and figure out what they are telling you. If the Street is paying attention to a company’s margins and free cash flow generation, and your forecast for both is negative, then that pretty much determines that you should short the stock—even if you think personally that their products are good.  Find the things that can potentially make the difference for the stock price, and you’ll know what to follow.

For individual investors, the lessons are clear. Find what really matters the most in your market and trading style and focus on it like a laser. For instance, if you are a swing trader who trades soft commodity futures based on price/volume analysis, then find the two or three indicators that help you most to make money. Then you can drop the 10 other indicators that you track, because they are probably diluting your focus or even confusing you. Instead of trying to over-optimize yet another indicator through backtesting, go back and look at your last few months of trading records and at the markets you’re trading. Chances are you’ll find only a couple things that really, really matter. Distill those and focus on them like a hawk.

It’s About Making Money, Not Being Right

Often, you’ll hear people on CNBC or in the press talking about their positions and their reasons for investing or holding on to it. They can offer a million different rationales, such as thinking that “the stock is cheap” or that “it’s a great long-term story” or that it “a fabulous growth stock”. Often times, they repeat those rationales without paying attention to the performance of the stock or how the markets are moving. It’s fine to have reasons for investing – actually, you should! But there’s more to it than that. You have to make money.

The problem comes when they wrap bad trading practices around it. For instance, if a stock is cheap and then falls, the same person will come on TV and say “well, it’s even cheaper and we’re averaging down”. Let me translate: the position is losing money but we’re so stubborn that we’re going to keep throwing money at. While the sound bite does a good job of ignoring the loss and preventing him from looking bad, the reality is at odds. He lost money. His investment thesis or his timing, or both, were wrong. The position is a dog and it should be cut.

At a hedge fund, people only care about one thing: performance. Make money, cut losers and you’ll be OK. If you “had the right idea but were too early”, it means one thing: you lost money. If you “had a good stock pick but the overall market doesn’t care about fundamentals”, you lost money. If you “took a ton of ‘heat’ on your short but the market finally caught on”, it means you should have been stopped out. If you “picked a good long-term growth story that the market finally woke up to”, it means you made money. P&L is what matters, not the story that you attach to your actions. And if you’re relying on crutches like “I was early” or “the market just doesn’t recognize my thesis” to excuse your losses, then you’re too busy defending your ego and not busy enough generating performance and practicing proper risk management.

Focus on what matters most. Have an investment process and stick to it. Proper solid risk management. And above all, don’t worry about being right or looking smart in front of TV audiences. Focus on making money.

You Absolutely Need A Process

If you talk to a trader who is starting out, they are often grasping for something, anything that works reliably. They are probably looking to find a style that fits their personality and is profitable. While that is expected when people are just starting out, this is absolutely unacceptable when you work in an institutional environment.

If you are starting a hedge fund, then you should already know what your “edge” is. After a few years of working in the market, then you know what you need to do to make money consistently. Instead of searching for something that works, you possess all the confidence of knowing that you have an advantage. If anything, like most famous investors, you can simplify your process into a few simple points on a checklist. You have documented it.

If you can’t document the process, then it means one thing—that you are not sure what your edge is. Maybe you haven’t thought hard enough about it to define it properly. Maybe you haven’t tested adequately or looked enough at your records to make a real judgment. Or maybe it’s become intuitive and you’re not really sure. Nonetheless, if you don’t have or can’t define a process, then you have an uncertain edge. When market conditions are favorable, then you may do okay; when they are against you, then you don’t have anything clearly defined to fall back on.

Now think about it if you have a lot of money to manage. There will be more capital to manage, meaning more people. These people have to know what the game plan is and where they fit into it. This is where having a process is absolutely key. Having one guy sit in front of the Bloomberg and punting can be a lot of fun. It can even be profitable. But it’s not a business. Besides, what would those other people do? What are their responsibilities? How do they support the senior investment professional? And what happens if, God forbid, he goes on vacation—let alone gets hit by a bus!? What game plan is everyone else to going follow then? Having one guy doing everything by the seat of his pants can potentially be profitable, but it is most assuredly not a business. And people are only going to invest in a real business.

Another way of looking at it is to compare with a real business. Imagine something basic like a dry cleaner. If you go to drop off clothes, things get taken care of with responsibilities clearly defined and divided up. One person receives your clothes, discusses any potential problems and issues you a pick-up slip. A second person in the back takes all of the clothes in the space and cleans them. A third takes them out of the cleaning machine, shrink wraps them and gets them ready for pickup. A fourth person mans the desk when you pick it up. At every stage, it’s pretty clear who is doing what and the overall plan is for rendering service and generating profits. Why should a fund be any different? It’s a business after all.

As an investor or trader, you also need to get your process in order. You need to figure out what your edge is and try to write it down. If you’re not sure how to verbalize it, then just the act of writing it down a few times will help you to get closer to the mark. Even if a checklist sounds simplistic, you will nevertheless want to reduce it a simple list of bullets points to understand what matters most and what you need to be doing.

Just understanding this has helped me in evaluating investments and preparing my own strategies. If I am thinking about a new strategy or approach and can’t reduce it to a few bullet points or define a process, then it’s a no go. This has also helped me to work with analysts—I can tell them how to come up with ideas, what the criteria are, how they should think about investments—and then what I do on top of their work to figure out if it’s a portfolio position or not.

 Conclusion

While the inner working of hedge funds can seem shrouded in mystery, they turn out to be mundane. Surprisingly for outsiders, there is a real emphasis on the business aspects. While there is so much more than just this, hopefully this list gives the best of what I learned at a hedge fund that can help you to be a better trader.

Hurry up. The II Alpha list is waiting for your name to appear on it.

By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading

 

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