Hedge funds get a bad wrap. due to relative underperformance, high fees, and huge paydays for hedge fund managers. However, investing in a hedge fund helped save my retirement portfolio during the 2000 dotcom collapse.
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.
Investing In A Hedge Fund Saved Me
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 Goldman Sachs 401k until 2003. This was 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, I consolidated my 401k balance at my new firm to keep things streamlined. Besides, I could no longer contribute to my GS 401k hedge fund as an ex-employee.
The Allure Of Investing In Hedge Funds
After my positive experience with Andor Capital Management, I never had the opportunity to invest in another hedge fund for years.
I wasn't an accredited investor, which mean I didn't have at least a one million dollar net worth or earned at least $250,000 a year. 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. 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.
My Desire To Hedge Downside Risk
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.
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.
If a hedge fund properly hedges, investors should outperform during a downturn.
Why Invest In A Hedge Fund
Here are some of the main reasons why you may want to invest in a hedge fund. Yes, the fees are high. However, a hedge fund could save you money during the downturn and make you money during an upturn. Further, you aren't allocating the majority of your capital to a hedge fund either.
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. I 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.
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 through growth stocks. Or I'm 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.
Investing In A Hedge Fund Is Becoming 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.
Just know that hedge fund managers make a lot of money. Here's how hedge funds make so much money and what the hedge fund pay is. The more hedge fund managers get paid, the less investors in the fund gets paid.
The Natural 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.
Hedge Fund Performance Versus The S&P 500 In 2021
Below is a chart highlight how some of the top hedge funds performed in 2021 versus the S&P 500, which was up 28%. Only three of these hedge funds outperformed the S&P 500. But I can assure you that ALL the hedge fund managers made a lot of my for themselves.
The founder of Melvin Capital, -41.5%, bought himself a $50 million fat pad in Miami in 2021. It's great to be a hedge fund manager!
Achieve Financial Freedom Through Real Estate
A great way to hedge is through real estate. It is a tangible asset that is less volatile, provides utility, and generates income. By the time I was 30, I had bought two properties in San Francisco and one property in Lake Tahoe. These properties now generate a significant amount of mostly passive income.
In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. With interest rates down, the value of cash flow is up. Further, the pandemic has made working from home more common.
Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.
Invest In Private Growth Companies
In addition to investing in a hedge fund, consider investing in private growth companies through a venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment.
One of the most interesting funds I'm allocating new capital toward is the Innovation Fund. The Innovation fund invests in:
- Artificial Intelligence & Machine Learning
- Modern Data Infrastructure
- Development Operations (DevOps)
- Financial Technology (FinTech)
- Real Estate & Property Technology (PropTech)
Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!
The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum. In addition, you can see what the Innovation Fund is holding before deciding to invest and how much. Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments.
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.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He is aggressively investing in real estate crowdfunding to arbitrage low valuations and take advantage of positive demographic trends away from expensive coastal cities. Investing in a hedge fund can help you outperform in a down market. But we're in a bull market for the foreseeable future.