How Do Hedge Funds Make So Much Money? An Inside Look At The Best Business Model In The World

888 Park Ave - Hedge Fund HQElephant hedge fund managers make $100 million a year CEOs look like mendicants. Guys like David Tepper from Appaloosa, George Soros from Soros, Ray Dalio from Bridgewaters Associates, and James Simons from Renaissance Technologies have all pulled in $1 billion+ paydays for one year’s worth of work before. Is there any wonder why some of the brightest minds want to rush into the hedge fund industry after getting their MBAs or PhDs in mathematics? Saving the world will just have to wait.

The reality of the hedge fund industry is that performance has been piss poor for a while now. Just take a look at the Hedge Fund ETF, HDG as one financial benchmark to gauge performance. The index is up a paltry 2% as of July 2013 while the S&P500 is up over 17%. To pay a 2% management fee and 20% of profits to underperform the broader index by 15% is a travesty. Investors need to demand better.

We only hear about the great hedge fund success stories and the spectacular failures like Long Term Capital Management and nothing in between. Much like in the startup business, most hedge funds fail because they are unable to outperform the markets over a three year period to raise enough capital to make a worthwhile profit. The industry is seeing fee compression given returns have been so poor. That said, all it takes is one or two years of hitting it out of the ballpark to make your mega-millions and retire.

I firmly believe the hedge fund industry has the best business model in finance, if not the world today. Those in the software industry might argue otherwise!


The DVD Rental Method to CD Investing: The Only Way To Achieve Max Yield

When we first bought our $1,200 HDTV six years ago, we told ourselves never to go to the movies again until we watched enough DVDs to pay for the purchase.  Every time we went to the movies, we’d have to pay on average $20 for tickets.  A promise was made that only after we watched 75 DVD rentals ($1,500 bucks in movie tickets saved – $300 for Netflix fee), would we treat ourselves out to the theater. We reached our goal within two years, and in the four years afterwards we’ve only gone to three movies!

We realized that once we went through the initial 6 month waiting period for the latest movies to come out on DVD, all was fresh again.  We’re now programmed to watch movies with a 6 month lag, bringing us the same opening night excitement.  The annoyance of someone sitting right in front of you in an empty theater and jabbering away is no more!  Furthermore, a 52″ screen and six point surround sound system sure helps replicate the big screen experience!


Dealing With Fear And Greed To Become A Better Investor

Black Swan Event InvestingThe first half of 2013 closed up an amazing ~15% despite the recent volatility in the markets. We are tracking way ahead of where I thought we’d be (+9% for the year) and if things keep up we’ll return 30% by Dec 31. It’s unlikely the second half of the year will be as strong as the first half but we can always dream can’t we? I’ll be happy if we get back to 1,650 on the S&P 500 (3.5% upside).

The markets are currently in a transition period as the Federal Reserve reduces its quantitative easing. I’ve taken the sanguine view that higher interest rates are a positive reflection of the economy due to rising demand for money. Interest rates don’t move in a vacuum.

Housing is the big question mark now. Will a 4.5% 30-year fixed mortgage rate start curtailing housing demand given the rate was 3.5% only a few months ago? Absolutely. Add on a 12% nationwide increase in housing prices year over year, and buyers are getting squeezed. If housing slows down so do the earnings for major lending institutions. You can see a cycle where layoffs occur if there’s a drastic slowdown causing a decrease in demand for credit that ultimately hits earnings some more.

What I suspect will happen is that greed takes over by both home buyer and financial institution. Home buyers will simply borrow shorter duration mortgages through adjustable rate mortgages to get a lower rate. I’m absolutely fine with ARMs as the spread between short and long duration loans is excessive. Unfortunately, we will inevitably see buyers borrow more than they can afford so hopefully everyone sticks with the 30/30/3 rule for home buying. Financial institutions will figure out ways for borrowers to get their loans and sacrifice credit quality to meet their numbers.


Diverse Interests Create Diverse Income Streams

cash-moneyThe more interests you have, the happier you will be. Imagine if one of your hobbies is analyzing clouds, or cumulonimbuses for the scientifically savvy. You could step outside any time during the day and entertain yourself for hours.  There are so many things around us that our minds tend to filter things out so we can focus on more important tasks.  If we stopped to admire everything, we’d probably never get anything done!

Income diversification is important during weak economic times since you never know when one stream might dry up.  However, the funny thing is that I’ve never purposely thought about creating new income streams for the purpose of diversification until this year.  Instead, my diverse interests have lead me to have a diverse amount of income!  It never occurred to me to count up my non-job income and figure out what percent it is of total income. But, as I started adding things up, I was amazed to realize some months would regularly achieve 25% and up to 50% of my gross base salary!


Where To Invest In A Rising Interest Rate Environment?

Rising Interest RatesAt long last stock market volatility returns due to rising interest rates. We’ve now seen a more than 60% increase in the risk free rate since its 2012 bottom and things are starting to get hairy. I’ve been wrongly waiting for a pull back since the beginning of May so it’s good to finally get some sanity back in the markets again.

Nobody knows whether rates will continue to move higher from current levels. However, it’s good to layout a what if scenario so we can be better positioned.

Rising interest rates do the following:

* Makes mortgages more expensive. The window to refinance at all time lows has passed.

* Makes car loans more expensive. One shouldn’t be borrowing money to buy a depreciating asset anyway, so all is good.

* Increases credit card interest rates to even more egregious levels. Nobody better have revolving credit card debt unless they are a financial masochist.

* Increases student loan interest rates, depending on what type of government subsidies you receive.

* Makes the stock market less attractive given the opportunity cost to own securities has increased. One of the main reasons why I aggressively invested in equities in 2012 was because the S&P 500 dividend yield was greater than the 10-year yield.

* Cools off the housing market as homebuyers are now hit with an increase in prices from a year ago and rising mortgage payments.

* Slows down consumption growth, which is the main driver for GDP growth in the Y = G + I + C + NI equation.

* Theoretically increases your savings rates and CD rates, but banks will move like molasses to adjust so don’t bet on anything great for a while.

* Leveraged buyouts will decrease at the margin due to more expensive debt financing.

* Makes bonds look more attractive given higher yields.

* Strengthens the US Dollar vs a basket of major foreign currencies.

* Makes you reflect on what’s next.

It’s important to realize that a rising interest rate environment often reflects underlying strength in the economy as the demand for money increases. Money demand increases due to better employment levels, higher wages, positive growth expectations and a host of other factors. It’s the short term adjustment, which which can be tricky to maneuver.