One of the benefits of working at an investment bank is gaining access to a variety of investment opportunities that retail investors normally wouldn’t have access to. For example, if Goldman Sachs decided to create a special opportunity fund for institutions because they saw opportunity in the Argentinian debt market, employees would have the opportunity to invest alongside some of the world’s largest money managers like Fidelity, Capital, and Franklin Templeton. Random investment opportunities came up all the time.
After two years as a financial analyst at GS in NYC, I knew my days were numbered as the NASDAQ dotcom bubble burst in March 2000. I remember optimistically telling my VP in May 2000 how I was still bullish on the markets and he sternly told me, “We’re in a bear market. Stop kidding yourself.” Three years later, more than half of my analyst class was let go.
By June 2000, it was clear the NASDAQ was not getting better. I can’t remember exactly how things played out, but I think management sent out an internal e-mail to all employees about how we should keep focusing on our clients – that now was the best time to give them a call or take them out because nobody else was. In the employee memo, management also indicated they had added some new options to our 401k retirement plan, namely several hedge funds that looked to profit from the downturn.
Given some of our smartest and most profitable clients were hedge funds, I decided to do some research and invest half of my 401k into a technology hedge fund, Andor Capital Management, founded by Daniel Benton. Andor was one of Goldman’s largest clients, and they formed some type of partnership where they would let employees invest without needing the $1 million+ minimums. The flagship Andor technology fund ended up returning 35 percent in 2000, net of fees, and my 401k actually inched up in 2000 and 2001 as a result of the hedge fund investment instead of getting slaughtered.
I kept my GS 401k until 2003, despite moving to a new firm in June 2001, due to the investment selection. But after it felt like the markets were out of the woods, and since I could no longer contribute to my GS 401k hedge fund as an ex-employee, I consolidated my 401k balance at my new firm to keep things streamlined.
WHY INVEST IN A HEDGE FUND?
After my positive experience with Andor Capital Management, I never had the opportunity to invest in another hedge fund again. I didn’t have at least a million dollars to invest, nor did I have close friends who ran their own successful hedge funds who could invite me in at a lower minimum. My lack of funds and connections were unfortunate because I could have preserved a lot of capital during the 2008-2010 downturn, just like I did in 2000-2003. Instead, I lost about 35% of my net worth within a year in 2009, which led me to start this site as a way to deal with the pain.
When the housing market crashed in 2008-2010, John Paulson made his hedge fund $3-4 billion as he was long CDS (Credit Default Swaps) insurance that rose in value as CDO (Collateralized Debt Obligations) mortgages fell with the housing market. John became a billionaire overnight, and is known for making one of the best trades in one of the most difficult environments ever. He then proceeded to lose lots of money going long gold, but he’s still a billionaire. There are opportunities to make money in any environment, especially if you run a hedge fund that can go long or short securities.
As someone who has spent 16 years after college building my net worth to the point of achieving financial freedom, the last thing I want to do is lose any significant amount of money. If I lose 50% of my money, it takes a 100% return just to get back to even. As a result, I’ve been consistently investing in structured notes since I left Corporate America in 2012 because they provide downside protection in return for giving up some of the upside, e.g. no yield, or a 95% upside participation rate instead of 100% for 20% downside protection over five years.
The main reasons why I want to invest in a hedge fund are:
1) Capital preservation during volatile or bear markets. Money is meant to serve its owner, not the other way around. I never want to lose sleep again when the markets are taking a dive. I want my fund manager to lose sleep because he is up every night thinking about the best ways to manage risk. After you build a large enough nut, the goal is to grow it in a prudent way where it can last for as long as possible. I understand the importance of beating inflation, and personally shoot for a 3X rate of return on the 10-year yield in a risk-adjusted manner.
2) The ability to still make a positive return during bad times. So many people think they are investment geniuses in a bull market. I’ve invested through three downturns, and I can promise you that difficult times will come again. Sure, you can buy and hold forever, and probably turn out OK. But there will be a point where you’ll want to utilize your capital for life. Hedge fund managers are paid based on the expectation of making money during good or bad times. Losing money, but outperforming an index is not good enough over the long term.
3) Diversification. Hedge funds and other alternative investments aren’t a 100% replacement for your plain vanilla index and ETF funds. I am a strong believer in asset allocation and having a core of 60-90% of your investments in index funds. They are low cost and are the easiest way to provide the exposure you want to equities, which have traditionally increased by 6-10% a year. For the remaining 10-40%, I’m seeking alpha or looking to hedge based on the two points above. The issue was never having access at levels I could afford, until now.
Take a look at the chart below of how hedge funds have performed during historical downturns.
HEDGE FUND ACCESS BECOMES MAINSTREAM
Very few accredited investors – individuals who make $200,000 a year or more, or have a net worth excluding their primary residence of $1 million or more – have between $500,000 and $1,000,000 to invest in alternative investments such as hedge funds and private equity funds. Investment amounts of $10,000 – $100,000 are much more common. The only reason why I was able to invest in a venture debt fund last year for $150,000 is because my good business school friend of nine years is one of the managing partners. Otherwise, I would need at least $300,000 – $500,000.
There are new fintech companies using the crowdsourcing model to help democratize access into alternative investments nowadays. With the passage of Title III of the JOBS Act, all Americans will be able to invest in private companies starting in January 2016, not just accredited investors. The limit is $5,000 for income up to $100K and $10,000 for income between $100K – $200K.
THE NATURE OF HEDGE FUNDS
Hedge funds tend to underperform during a bull market because hedge funds hedge – they protect their downside by shorting a percentage of their portfolio. Sure, some hedge funds are closet index funds that may take on massive leverage to try and outperform the market. But if a hedge fund is run properly, they will have strict risk-metrics in place to ensure that capital is protected during down markets. The hedge funds that gain a bad reputation are those who take on too much leverage and blow themselves up like Long Term Capital Management did in 2000.
Anybody who has been around long enough knows that the good times don’t last forever. We’re in the fifth year of a recovery and the easy money has already been made in equities and real estate. I seriously recommended diversifying your net worth if it consists of mostly equities and real estate.
From 1990-2014, hedge funds (as measured by the HFRI Composite Index) have returned ~10.19% net of fees annualized returns compared to ~9.19% for the S&P 500 with half the volatility of 6.81%. $1 invested in the S&P 500 in 1990 would be $8 today. Meanwhile, $1 invested in hedge funds in 1990 would be $12 today. You can see the power of just 1% over the course of 24 years.
The most promising portion of my net worth is my Alternative Investment category filled with private equity and a venture debt fund. My goal is to build a principal protection allocation into hedge funds once more in order to smooth out my investment returns.
RECOMMENDATIONS TO BUILD WEALTH
* Manage Your Finances In One Place: The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month.
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In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being invested in the market. Wealthfront charges $0 in fees for the first $15,000 if you sign up via my link and only 0.25% for any money over $10,000. You don’t even have to fund your account to see the various ETF portfolios they’ll build for you based off your risk-tolerance. Invest your idle money cheaply, instead of letting it lose purchasing power due to inflation.
About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $210,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond.