In Part 1 we looked at characteristics of hedge fund investing. Most hedge fund managers are strongly incentivized to generate the highest possible returns (i.e. absolute returns). This incentive is in large part a consequence of how hedge fund fees are charged. Most funds charge two types of fees: a management fee and a performance fee. The management fee is usually based on Assets Under Management (“AUM”) and ranges from 0.5% – 3.0%. The management fee is charged each year on each dollar of invested capital independent of how the fund performs. Most hedge fund managers count on the management fee to ‘keep the lights on’ and pay for the basic costs of running the fund (rent, salaries, technology costs etc.). For a $50M hedge fund, a 2% management fee would generate $1M; a sufficient sum to run an office. Management fees tend to be boring and consistent; the same cannot be said for performance fees. Performance fees are what get hedge fund managers in the news, for good and bad reasons. Performance fees are charged as a percent of gains. Historically, hedge funds have been known to take 20% of all gains as performance fees. In good years when the fund generates strong returns, performance fees make the hedge fund manager and his/her team very wealthy. For example if that $50M hedge fund generates a 30% return, a performance fee of 20% would result in a $3M payday for the hedge fund manager. For a $500M fund, a 30% return with a 2% performance fee would result in a $30M payday; for only one year’s worth of work! Since hedge fund managers get paid 20% of gains (great upside) with little consequence from losses (no downside) and can count on management fees to cover the costs of operating their office, they are strongly incentivized to take huge risks and ‘shoot the lights out’ year after year. This is why hedge fund managers often employ the tactics discussed in Part 1: (1) Holding concentrated positions (2) Holding correlated positions and (3) Focusing on a familiar sector or asset class. In Part 1, we highlighted the risks of employing these tactics. Below we discuss alternative measures designed to invest less like a hedge fund and more like a diversified portfolio geared to generate consistent long-term growth.
Diversify your holdings
One of the risks in having only a handful of holdings in your portfolio is that if any one company underperforms, your wealth can be severely impacted. For example on February 4th, 2016 after issuing what was perceived as weak guidance for 2016, LinkedIn stock fell 40%. If you had a $100,000 portfolio split across five names and one of those names was LinkedIn, you would have been down $8,000 in one day. A diversified set of holdings is the best way to reduce the risk of any one company eroding portfolio value. The finance wizards call this reducing Unsystematic (or Diversifiable) Risk. Generally the benefits of diversification can be achieved with as little as 25-30 stocks in a portfolio. Investing in those 25-30 stocks with an equal weight also helps diversifcation efforts. If any position doubles relative to the size of the portfolio, trim back to equal weight and lock in gains. If any position halves relative to the size of the portfolio this could be an opportunity to buy low and build up the holding to equal weight. To reiterate, by diversifying your holdings across 25-30 solid companies and having a long investment horizon, there will be opportunities to buy low and sell high, the goal of any investor.
Reduce correlation in your portfolio
Diversifying across 25-30 stocks will have little benefit if these stocks are correlated. Positive correlation occurs when the prices of stocks (which reflect all future earnings discounted back to today) move directionally and proportionally together. Think about sunglasses and sunscreen, often these items are purchased and used together; that is positive correlation. In your portfolio, positive correlation might look like owning a trucking company, shipping company, airline and railroad that all service one region. Positive correlation might also look like owning an oil refinery, coal miner and a natural gas pipeline where all are impacted by global demand for energy. Segmenting the portfolio holdings into elastic and inelastic industries helps to reduce correlation. Elastic industries tend to outperform (underperform) in good (poor) economic times while inelastic industries tend to exhibit more stability. By selecting a portfolio of strong companies that exhibit reduced positive or negative correlation, the benefits of a 25-30 stock portfolio are amplified so that in the majority of economic climates, a portion of the names should perform.
Don’t put all of your eggs in one basket
In Part 1 we looked at Marc Lasry, the bankruptcy lawyer who started his own private equity fund dealing with the debt of distressed and bankrupt companies. As an aside, Marc shone in the 2016 NBA Celebrity All Star game scoring 8 points and pulling down 6 rebounds. It turns out Marc is skilled at more than just investing. Ultimately Marc ‘bought what he knew’, a phenomenon that is too easy to replicate. There is a certain comfort we get from investing in the stock of the company we work at: we know the management, we know how the business is performing and it feels ‘right’ to back the entity that helps put food on our family’s table. However, aligning your salary, bonus and investments with just one company has inherent risks. If your company goes through a rough patch, the stock price will likely fall, layer on top of that the risk of losing your job as a cost containment measure; now your income and your investments have been impacted. Another situation could arise where a non-correlated industry (e.g. dentistry) is impacted by the economic event of a region (e.g. Calgary). While the price of oil does not have a direct business impact on a Calgary dentist, the ripple effects of energy sector job losses and benefit cuts will reverberate through to the dentist’s patient base. Portfolios should be designed to minimize the impact of employment and regional economic risk. If a person works at a Canadian financial institution, they inherently have employment risk, and should minimize investment risk by reducing or eliminating Canadian financial institution holdings in the portfolio. If a person counts on a patient base primarily involved in one sector (e.g. energy), they should minimize regional economic risk by reducing or eliminating energy holdings in the portfolio.
When investing for yourself: hold diversified positions, ensure holdings exhibit limited positive to negative correlation and modify your portfolios to mitigate inherent risks from employment and your regional economy. With a long-term mindset, these simple principles should lay the foundation for consistent long term growth.