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Lose 6% and you lose your job

Hedge funds are the big beasts of active investing

When you’ve got ridiculous amounts of money, the usual rules of wealth go out of the Georgian windows.

If hedge fund manager Michael Platt wants to buy himself a waxwork gorilla nailed to a wooden cross, who am I to argue? I suspect the Micawber principle still applies.

Platt, 41, is the co-founder of BlueCrest Capital Management, a London-based hedge fund group with over $16 billion under management. Its main fund rose 41% and earned over $400 million in fees in the year to October 2009.

Hardly monkey business – and it turns out Platt’s gorilla is just a sideline in sponsoring young British artists, in this case an imaginative chap called Paul Fryer.

Platt’s looking for a profit, of course. To the same end he also has a Fiat painted by British artist Damien Hirst sitting in a garage. Who doesn’t?!

Yet to me, the most striking thing about Platt isn’t the bonkers BritArt or the billions under management, but rather a very tiny thing indeed.

Platt claims he’s never seen a 3% drawdown in his own trading portfolio.

Moreover, if his traders suffer such a decline, they’d best look out:

If a [BlueCrest] trader loses 3 percent of the money he has under management, the firm will cut his capital allocation in half. If the trader’s portfolio then drops another 3 percent, he loses his allocation.

Risk managers will then […] decide whether to recapitalize him. If not, he’s out.

Anyone who saw their portfolio down 30% or more during the bear market might be amazed at losses of 6% being grounds for dismissal.

What is Platt doing, and can we have some of it, too?

Hedging the case for hedge funds

The short answer is yes, it’s perfectly possible for us to use some of the techniques employed by hedge and absolute return funds to minimize our losses.

The long answer is more complicated.

First, the hedge fund gains might not be sustainable.

Hedge funds have a habit of blowing up. Every year the media discovers some manager with a strategy that’s worked for five years, then moves on to someone else when it stops working and the fund is wound down.

I’m not saying that’s the case with Platt’s company, which seems to have irons in every fire – and I’ve no deep knowledge of his business, anyway – but you only have to Google the sorry fate of hedge funds in the bear market to find plenty of examples of trend-following funds that ran off a cliff, or funds whose excess returns were based on over-borrowing in the good times like some ingénue Buy-To-Let investor.

Secondly, Platt has teams of Phds constructing and tweaking models based on tiny movements in the markets. One aim might be to anticipate what even bigger hedge funds are doing, dart in to buy assets before these competitors push the price up, and then nip out again at a profit.

Clever, but it has about as much to do with conventional investing as a night at the Hilton does with kipping on my sofa.

Thirdly, hedge funds manage billions.

A £1 billion hedge fund that returns on average 8% and never has a down year will soon turn its founders into millionaires.

In contrast, if you’re a private investor with £10,200 in an ISA, it’ll take you nine years to even double your money at 8%. Taking fees from managing money is where the real returns are!

Finally, hedge funds churn assets with even more gusto than Pamplona’s washing machines deal with the aftermath of a bull run.

Get frequent trading right and it will greatly magnify your returns, but the evidence is most frequent traders lose money.

While I do trade some shares myself (instead of putting all my money in index trackers as I really should) I’m not a day trader. I find it fascinating, I’ve got an open mind about it – I’m even reading a fun-sized book about how to make money trading right now – but I’ve no reason to think day trading would make me richer.

As such, I’m not convinced that everything hedge funds do has a place in my own investing.

Still, if you salivate over Platt’s 3% maximum drawdown and want to achieve something similar, read my article on how to run your portfolio like a hedge fund.

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{ 9 comments… add one }
  • 1 Financial Samurai January 8, 2010, 1:53 pm

    It’s a tough business, absolute return, that is. Don’t cry for him.

    What happened to 500 words or less posts?! 🙂

  • 2 Faustus January 8, 2010, 2:51 pm

    Loving these daily posts – thanks for keeping it up!

    Looking forward to reading those hedging techniques, especially now that many bonds seem so overvalued.

  • 3 The Investor January 8, 2010, 3:04 pm

    @Faustus – Glad they’re hitting the spot! I’ll get onto part 2 next week, but I’ll only be covering pretty broad brush stuff – no equations!

    @Sam – Hah, this post is a typical case in point. I meant to just flag up the Platt’s 3% maximum loss hurdle. 1,000 words later I realized I had to split it into two posts, and yes this part is 700 words. I’m the James Joyce of personal finance blogging. 🙁

  • 4 Matt S. January 8, 2010, 7:13 pm

    An asset price that drops three percent may be poised for a big run-up. A trader may be missing those returns with this type of discipline. It may also lead traders from the one extreme of taking too many chances to taking no risk.

  • 5 The Investor January 8, 2010, 7:50 pm

    @Matt – The 3% loss will be across a portfolio / account, not one particular security. That said, active traders do usually immediately cut losing positions. As an investor, on the other hand, I tend to like falling prices (but not failing businesses, of course!)

  • 6 Financial Samurai January 8, 2010, 10:00 pm

    Monevator – You didn’t get inspiration from my 236 word “An Ambulance Screams By…… Do You Feel Happy or Sad?” post? Just try it out!

  • 7 George January 8, 2010, 11:00 pm

    Fascinating. Making 41% with a 3% drawdown is pretty awesome. I would love to invest with them!

    The reason hedge funds blow up is that the managers are always trying to make big profits. Their strategies work for a while, and they increase their bets. The money starts to flow like crazy. And they just keep going and going. Until, one day, everything starts to reverse. But they are taking large risks and they can lose a ton of money in just a few days. Which is not really a big problem because it is not their money. They can take their fees and invest.

    That’s why only having a 3% drawdown is really outstanding. I think the chance of that particular hedge fund blowing up is very small.

    By the way, what’s a kipping?

    Can’t wait to see part two!

  • 8 The Investor January 9, 2010, 12:42 am

    @George – Kipping = sleeping, with the emphasis on it being a kind of last minute affair. What’s the US equivalent… crashing maybe? Or that may be British, too. (I have just learned that the origin of the word kipping may come from the Danish word for an alehouse, Kippe. Which is more than I usually learn after a night in a Mayfair hostelry!)

  • 9 The Investor January 9, 2010, 12:43 am

    @Sam – I did, and from half of what Mike writes on Oblivious Investor. I was just born to waffle.

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