CJ Follini: I’m CJ Follini, founder and CEO of Noyack Wealth Club. Welcome to Inheriting the Future, our podcast where we are dedicated to helping young investors navigate the world of private investments and personal wealth management. Today we’re diving into hedge funds, what are they, demystifying them, and how beginners and investors of all stripes and levels of experience can approach alternative investing in hedge funds. Joining us today is our resident expert Herman Lorett, founder of Lorett Capital Partners, who brings a wealth of expertise and industry knowledge to this conversation. Herman, welcome to the show.
Herman Lorett: Thanks CJ, glad to be here.
CJ Follini: Great, so let’s dive in. It’s Friday afternoon, I’m not supposed to put a date on it because it’s supposed to be an evergreen, but it is Friday and let’s jump in because we all have places to go. Herman, hedge funds can sound mysterious, what exactly are they?
Herman Lorett: CJ, they are basically private investment vehicles which, unlike stocks, equities, they’re not listed on an exchange although some European vehicles might be. Some hedge funds actually are listed, but the big difference between stocks and hedge funds obviously are the transparency and also the accessibility. So they’re less regulated than mutual funds and ETFs and stocks obviously given that they are private vehicles. I guess one other thing I would add to that is they structure typically as limited partnerships, so when you invest in a hedge fund you become a limited partner. There are some other structures like I mentioned UCIT in Europe and then there are also things called SMAs which is when you’re a very large investor you get to have your own account with a manager and set up what’s called an SMA which stands for a separately managed account.
CJ Follini: I’m actually tempted to ask how limited is limited partnership but we’ll keep that for a later question.
Herman Lorett: One other thing I should have added is you do need to have a certain amount of wealth as it were, you need to be an accredited investor or an institution such like a pension fund or an insurance company.
CJ Follini: We discussed this offline and I said is there are there no hedge funds available to non-accredited investors. Alternative investments are getting democratized across every asset class, what about hedge funds, is it still only the purview of accredited?
Herman Lorett: That is true. You can also be a client of for example Morgan Stanley or one of the large investment banks and you can be a client of theirs in the private banking division, but by virtue of you being a client of the private bank you probably are an accredited investor. But let’s say theoretically, you could potentially get access through one of their vehicles through investing in smaller amount and you don’t need to invest a million dollars which I think is the perception out there is that you can only invest in a hedge fund if you invest a million dollars. You can invest less than a million dollars, you just need to comply with the various sort of restrictions.
CJ Follini: So you just touched on the second part of this question is why are they often described as exclusive, is because of the minimums but you’ve said that that’s a fallacy that you can do bundling of smaller investment amounts depending on who’s doing that bundling. But I still want to back up and harp on that question about accredited versus non-accredited. Do you think that even the wealth management banks at Morgan Stanley, Bank of America Private Bank, could you still be a non-accredited investor and invest in fund, is there anything legally restricting you from being part of a group as an investor to invest in hedge fund?
Herman Lorett: Actually CJ, that’s a good question and having been in finance for 34 years at this point I should know that answer. The only thing I can tell you is it’s accredited investors, qualified purchasers and institutional investors, those are the three requirements to invest in a hedge fund.
CJ Follini: I’m guessing that means no to non-accredited but I think the answer is no. We’re going to press on and why are they often described as exclusive, just touched on that, and complex, is it are they trying to keep everyone out by putting up this wall of complexity?
Herman Lorett: Given the fact that hedge funds are typically small from an infrastructure standpoint, if you can imagine if it was open up to retail and you had tens of thousands of investors, that would be a headache for a hedge fund because they wouldn’t be able to cope with that operationally just because of the complexities of some of the underlying instruments and so forth. So from that perspective, from a hedge fund manager’s perspective they sort of want to keep it somewhat exclusive so that they have as few investors as possible but they write big checks. That’s the most efficient way for them to run a business.
CJ Follini: Basically they don’t want to talk to a lot of people and they’re a bit lazy.
Herman Lorett: I’m not sure about the lazy component. Trust me, I’ve worked at a hedge fund, was a portfolio manager at Adron, it is 24/7 trust me. You trying to grind out returns for your investors at the end of the day and make money for yourself.
CJ Follini: I do believe you. Now apparently we’ve heard hedge funds make money in any market, you’ve told me that a couple times, but how do they do that behind the scenes?
Herman Lorett: Let me walk you through an example. You may have heard of multi-strategy hedge funds and that is really the all-encompassing hedge fund. Basically in a nutshell what a multi-strategy hedge fund, and you’ve read about some of the big names in the press and obviously I won’t mention any names on this call, but I can tell you what happens there is they basically have most of the hedge fund strategies out there in their business if it fits within their model. For example, a nameless over $50 billion multi-strategy hedge fund might have 160 teams working at the firm and they are trading most of the strategies. That would be equity long short, that would be event, that would be global macro, it would be quant systematic, it would be relative value arbitrage, and themselves the multi-strats but they include most of the strategies in their business. What makes them so successful is that they do perform in up markets as well as down markets and when I say up and down markets we’re always talking about the equity market. So we’re always talking about the S&P 500, that is sort of the universal benchmark. Of course it’s not the most appropriate benchmark for any of the strategies but that is sort of the universal benchmark.
Coming back to that, what happens is when one of these sort of we call them pods, we call them pod shops actually, when one of those pods hits their risk limits, and so when someone is hired they’re given all these different risk limits, and so when they hit that first risk limit which can be down 2, down 3% or depending what they’ve negotiated, half of that capital gets taken away typically, and then when they hit the next stop level they’re basically fired and then they’ll hire a new team. They just churn and churn and churn these guys, but what makes this model successful is these guys try to stay within these guard rails, these stop loss levels, and if they stay within those guard rails the firm is able to lever them up four, five, six times.
For example, if a PM gets hired, he says you’re going to be able to trade a billion dollar. Now if he only makes four or five percent on what he believes is a billion dollars that he’s running, that’s terrific, that doesn’t sound like a lot of money, but at the end of the day 4-5% on a billion is a lot of money for the firm. The reason is they’re not allocating him a billion dollars in the background, they’re only using $200 million, let’s say it’s five times leverage. So for example if he does 5% on a billion, he’s doing 25% on the 200. That’s how they generate the returns as long as these guys stay within the guard rails. Now of course a guy’s going to blow through his levels, during COVID guys get stopped out, they lose money, but in aggregate those firms are typically going to make money in up and down markets.
CJ Follini: So every hedge fund uses leverage meaning they borrow money from other banks in order to make bigger bets that gets them the return you just mentioned?
Herman Lorett: Not entirely correct. There are some what I would say distressed credit type funds that don’t use leverage and if they do it is diminimus. But for example, I can tell you a fixed income relative value fund that sounds incredibly complicated, a lot of what they do is just taking cash futures and then selling the underlying what’s called a deliverable against it and they’re levering that up. Those guys sound scary but they can be leveraged 50 times. So you go from the one extreme in the distress credit to the fixed income relative value guys it can be like 50 times leverage, and then there’s this whole swath of strategies in between that use varying levels of leverage.
CJ Follini: You answered my previous question of the complexity. Has anyone ever figured out how many total strategies there could be, like the totality of strategies that are possible?
Herman Lorett: That’s a good question. Most strategies get bucketed within a sort of a headline strategy. Even within what is the most common strategy which is the long-short equity strategy, basically what those hedge funds do is they look for stocks that they think are cheap, undervalued or have a great product pipeline, and then they sell stocks that they don’t own short. This is where the borrowing and leverage comes into effect. They sell companies that they dislike, poor earnings, against it. Within that universe of hedge funds there are many even just within that. They could be sector specialists, it could be pharmaceutical, it could be biotechnology, it could be TMT as it’s called, all these different strategies within that.
CJ Follini: There got to be a hedge fund trade association, is there anyone that has an actual full directory of how many hedge funds are out there with all their strategies?
Herman Lorett: There are many databases. I won’t be marketing any of those on the call but there are a number of large databases that have multiple thousands, 10,000 hedge funds in there with their returns, their historical returns, and this is where the due diligence comes into effect. So you can use these databases to do your comparable peer analysis return analysis if you will by subscribing to one of these databases. But you really do have to know what you’re dealing with because over the years there have been some very poor and bad actors. It’s imperative if you do get involved in hedge funds to really go through someone. If you’re very new to it, you can go through a fund of hedge funds which is a firm that invests, their job is to invest on behalf of investors in hedge funds.
CJ Follini: Interesting, and so that actually gives you a diversification within that hedge fund asset class because it’s like a fund of funds where they’re picking, it’s almost like an ETF of hedge funds in a way?
Herman Lorett: Effectively, the only thing that I would say is that you are adding another layer of fees. We all know about the proverbial 2 and 20. If people say it’s a 2 and 20 fund, what does that mean? It very simply means the fund charges 2% management fee. Each month one-twelfth of 2% gets taken out of your capital and is used to manage the firm, and then on top of that at the end of the year returns are crystallized as they say. Some people crystallize quarterly, I’ve never invested in a quarterly crystallization fund. End of year the returns, the profits are crystallized at year end and then 20% of those returns are taken out for the manager and the investor keeps the rest.
CJ Follini: I love that word crystallization though, crystallizing profits, it’s great. I always wondered if they got that 2% taken monthly or quarterly or just at the end of the year.
Herman Lorett: They take their overhead fees monthly.
CJ Follini: Interesting. All right, so many options available to the retail investor. We’ve talked about what I do as a retail asset manager democratizing other asset classes, real estate, fine art, venture capital, no hedge fund, and actually in full disclosure I’ve never invested in hedge funds because I didn’t fully understand them and I already had my brain was full. I’m not going to invest in something I don’t understand. So there’s so many options available, crypto, ETFs, private market alts like I mentioned from real estate, why should the young investor even think about who may not have sky-high, should they even be involved in hedge funds, is this just an investment too far for them?
Herman Lorett: I would say it really depends on where you are in your life cycle. If you’re 30 years old you should probably be 80% in equities at the end of the day. Now the big question is what do you do with the other 20%? Obviously the traditional 80/20 is 80 in stocks and 20 in bonds, but theoretically could you diversify some of that 20%? I would say a multi-strategy hedge fund for example is a lot better than a cash surrogate or a fixed income surrogate especially when rates were zero, and of course we just came out of a very very long period where rates were 0%. If you invested in a multi-strategy hedge fund doing anywhere from call it 8 to 15%, you were doing very well. So from that perspective if you had 80% in stocks and you diversified your 20% into some alternatives and into hedge funds within that space, you would have done very well.
I would say yes, and obviously as that 20% grows and the 80% declines you probably want to increase your diversification as you approach your retirement age, and within that I think hedge funds are a good diversification asset class because as you mentioned they typically do well in up and down markets. Now I would preface that not all strategies do well up and down markets, so you have to be selective within that space because there are some hedge fund strategies, for example high yield, if you’re just long high yield and they’re picking all the best high yield bonds, there is an equity component to that. So the beta or the correlation if you will of some of those strategies to the fixing to the equity markets can be on the higher side.
CJ Follini: So if you are an accredited investor, and as an accredited investor that probably in this country puts you into a little bit of a high net worth category, and there’s many slices of that, and if you’re going to invest not a ton but you do have a wealth manager at one of the large banks, you could say theoretically hey can you bundle X dollars into some hedge funds you have access to as part of a diversified alternative investment strategy, that’s sort of what I just heard you say?
Herman Lorett: I completely agree, and actually I just circle back a little bit to your question about should young people be investing. If you think about what people are going through in their lives, for example my daughter just recently bought an apartment.
CJ Follini: Congratulations.
Herman Lorett: Thank you. In that situation would she invest in hedge funds, probably not because she needs her money back. The reason I bring that up is because the other thing that we haven’t talked about is the fact that hedge funds have these things called or potentially can have these things called lockups which means you might not be able to get your money back for a year or two years. Most hedge funds, the liquid hedge funds, the long short, the global macro hedge funds are typically monthly liquidity with what they call 30 days notice. So you have to give 30 days notice and then you can get your money back at the end of a month.
CJ Follini: That’s something else I didn’t know. I thought there were a lot less liquid, that’s interesting. I mean, listen, you talk about real estate, as a real estate guy as well as venture capital, that’s 5 to 7 years, forget the one to two years.
Herman Lorett: Having said that though, some of the large multi-strats have gone the other way. One of them we had money with had quarterly liquidity, so not monthly but quarterly, they’ve gone to a five-year program now. So if you are young and you need your money because you want to buy a house or you have some big expense that you want the cash for, then hedge funds are probably not for you unless you’re in something that’s maybe monthly liquidity. UCIT in Europe, now these have additional restrictions in terms of what they can trade and liquidity and transparency, these are the European versions, and many hedge funds have a UCIT program where you can invest, you get a lot more transparency, you get a lot more liquidity, but it’s sort of the B player of the strategy. So typically those returns are not going to be as good as the main strategy.
CJ Follini: The whole point in even taking on all this complexity and doing the due diligence and maybe engaged in the lockups is because of the returns, they’re better than you’re going to get elsewhere, and if they’re not, forget it. There’s a lot of work involved, you have the due diligence, it’s not like you can look at a stock and look at its balance sheet and income statement and cash flow statements and assess whether it’s a great stock. We all know Apple stock, Microsoft, I mean I’m wearing an Apple Watch, I’ve got an iPhone, I got an iPad, we know they make terrific products. A hedge fund, you got to do a lot of due diligence and you don’t really know what they own for the most part. You get a newsletter at the end of the month talking about oh we did this that and we bought this bond, we sold this stock, but at the end of the day you’re not going to see every single line item that they own or are short, unlike an ETF, you know exactly what you own.
Herman Lorett: That’s a good point about opacity and transparency.
CJ Follini: That’s something else that people should know about hedge funds is that they are not required to do the types of reporting that a regulation A fund or a regulation D fund that is registered with the SEC has to do a 506c exempt type of fund, they don’t have to do this type of reporting, is that correct?
Herman Lorett: They’re private investment vehicles, they can basically do what they want. Now once you get over a certain hundred something million dollars you become SEC regulated, there’s some additional cost for the manager to bear, there are some things that they have to comply with, but they don’t have to show all their positions or anything. Now if you’re a growing hedge fund and you’re trying to raise assets, your back is somewhat against the wall. If some big investor comes in and says hey I’m going to write you a $250 million check but every month I want to see the portfolio, what are you gonna say to that as a manager that’s trying to raise capital, has been struggling to raise capital and has gotten to a 100 million and some guy comes along and says I love your strategy but this is what you need to do to get my check?
CJ Follini: I’m not concerned that some of those $250 million whales are listening to the Noyack Wealth Weekly personal wealth management podcast, it’s more the rest of us who are wondering are hedge funds for us. I mean, listen, I know you definitely think yes, bit talking your own book, but there is an element here and there’s definitely things I just learned especially about the liquidity. I knew about the lack of transparency and the complexity. Anyway, what should retail investors look out for to avoid the common pitfalls? If you could succinctly put in the top three due diligence items, what would they be?
Herman Lorett: Well first of all you need to do a background check on the manager. You can spend 75 bucks on a website to get a background check on someone, that’s a really cheap $75. The other thing I would say is speak to someone that’s already invested in the fund and has been invested in the fund, so a reference if you will. Talk to someone that you may know who was a portfolio manager, so another reference. This is what we typically do, we go down, we have a checklist of things that we do when we do due diligence on a hedge fund. You’re talking about the operational due diligence, how good are the operations, do they have a good administrator, do they have a good lawyer, do they have a good system, are they using external trading systems and most importantly what are they using for pricing, are they using their quote internal models, external pricing.
A lot of hedge funds will send these instruments, they won’t show the whole portfolio, but the banks around the street at month end will get these inquiries from these hedge funds and they’ll ask three or four banks for quotes on these instruments and they’ll take the average of those quotes, and then they use those quotes for that pricing at month end.
CJ Follini: That’s how they mark to market is they’re doing basically ping surveys?
Herman Lorett: Stocks obviously are exchange traded, they we know exactly what the closes are in the stocks. So if you’re investing in a long short hedge fund they can give you the month-end returns basically at month end. But if you’re a derivative heavy hedge fund, if you’re fixed income relative value fund, then you’re trading a lot of derivatives, swaps and swaptions and CDs and all these sort of derivative products, those are obviously more complex and they take a day or two potentially to get those prices from the dealers as they’re all closing their books at month end. So those month-end returns you won’t get on month end, you’ll get those over the course of maybe the next week or two weeks after the closing of the month.
CJ Follini: Last question. If you’re a younger investor, we talked about this, we made some ideas with if you’re curious about hedge funds, we know how you can get started, you gave us the due diligence points, when should you start thinking about it? Is there a net worth number that you want to start thinking about hey I got to go beyond this the same old same old and look at hedge funds? I mean are you saying, we’re talking about retail, is it 500, is it 100, is it 5 million, when do you think it is even worth someone’s time to start thinking about hedge funds if they have a net worth of X?
Herman Lorett: I would say if your net worth is $5 million and above you should probably have some hedge funds in there because the whole thing about hedge funds is it allows you to gain access to strategies that you ordinarily would not be able to get access to. For example, me as an individual, could I go out and get an ISDA in place and get derivative documents and start trading swaps and CDs? It’s not so easy for an individual to do that. But if I want to get access to someone that has great access to high yield issuance, so they’ve got a great relationship with the banks and in these deals and they’re getting the deals as they’re issued, the equivalent of IPOs but in fixed income, that’s a way for me to get access to something that is ordinarily only accessible to the large institutional investors. You’re in the same pool as essentially large institution investors by going through a hedge fund and getting access to those types of deals. You’re getting access to things that as an individual you would not be able to get access to. That’s really at the end of the day why you should probably invest in hedge funds as well as the things that we’ve discussed which is the diversification benefits.
CJ Follini: Great, to summarize: available to retail but only accredited investors, they’re really there for higher returns if you want to get that alpha aka the higher returns, but primarily there for portfolio diversification. Do your due diligence, you gave some top three great tips, doing a background check on the portfolio manager, that’s a great idea actually we should use that tip for all types of funds and managers. Last but not least, probably you should have a minimum net worth of $5 million, that’s not $5 million investable assets, that’s a total net worth that you want to start looking to get access to type of strategies you’re not going to be able to do on your own, you’re not going to be able to do at ETFs or anywhere on the Merrill trade or Merrill Edge, these are things that go beyond the norm but they can be very valuable, agreed?
Herman Lorett: I think you hit the nail on the head CJ.
CJ Follini: All right, well hey Herman I want to first thank you and also everyone. Herman’s our guest contributor, if you look at this Sunday’s newsletter he will be, he wrote the demystifying hedge funds which is basically a hedge fund 101 primer. I want to thank all of our viewers for tuning in. If you enjoyed today’s episode please click the link and subscribe and there’s also a QR code, whichever way you want to get to the subscription page please do so and share with a friend. We’re doing some referral awards, we’re giving some swag and for more stay with Noyack Wealth Weekly and we’ll be here to bring you access granted. Thanks.
Herman Lorett: Thank you.
CJ Follini: Bye bye.
