Article Highlights:
- Hedge funds manage around $3 trillion — about 10% of the stock market’s value.
- Funds’ fee structures incentivize managers to target large gains.
- This setup means hedge funds drive booms and busts.
Let me take you behind Wall Street’s curtain to look at hedge funds.
Here’s one secret about the funds: While investors must meet certain requirements, anyone can start a hedge fund.
Until funds manage $100 million, the Securities and Exchange Commission doesn’t require any documentation. State regulators might want details. But at least one state doesn’t.
I’m not revealing that state here. I don’t want to give bad actors any help.
Because regulators are lax, you must protect yourself.
It’s simple to avoid many frauds. If you invest in a hedge fund, never give checks to the hedge fund manager.
Legitimate hedge funds don’t accept checks made out to managers. They require deposits to go to a custodian such as Charles Schwab.
Bernie Madoff’s investors lost billions not knowing this.
The next secret of the industry is that great funds don’t want your money. They set high minimums to keep you out.
This is especially true for funds with great returns. Renaissance Technologies’ Medallion fund has averaged gains of more than 71% over 20 years. It doesn’t accept new investors. Other Renaissance funds require a $5 million minimum.
Even though you can’t participate in those great returns, you should still pay attention to hedge funds.
That’s because hedge funds drive booms and busts. Watching the funds helps investors avoid crashes and only buy at the right moments.
The Center of Market Crises
Hedge funds manage about $3 trillion. That’s around 10% of the stock market’s value. But their impact is larger than their size suggests.
Many funds borrow money to increase their exposure to markets. Borrowed funds increase potential gains. Of course, when hedge fund managers are wrong, borrowed money increases risk.
Wrong bets lead to crises.
In 1998, one wrong bet pushed the global financial system to the brink of collapse. In 2008, funds’ wrong bets were the first sign of trouble in the global financial system.
That’s why analysts follow hedge funds. They’re consistently at the center of market crises.
Behind Day-to-Day Operations
A hedge fund is like a mutual fund or an exchange-traded fund.
Many funds charge 2% a year in management fees. Better funds charge more. Management fees can top 5% a year.
Managers also charge incentive fees. Some managers earn 20% of the fund’s market-beating profits. Great managers charge more, up to 50% of profits.
For example, consider a fund with $1 billion in assets.
If the manager makes the wrong bets and underperforms the S&P 500, they only get $20 million. That’s a nice payoff ratio. Managers win no matter what happens.
This setup incentivizes managers to target large gains. After all, personal risk is limited.
This structure means hedge funds drive booms and busts. Watching the funds helps investors avoid crashes.
Where Hedge Funds Are Now
Because hedge funds control so much money, it makes sense to see what they’re buying.
Large funds, those over $100 million, are required to report which individual stocks they own. All funds report their trades in futures markets.
Funds usually follow trends. This means they buy as prices rise and sell during declines. The chart below shows what the funds are doing in futures markets right now.
Large Funds Are Becoming More Bullish
The indicator at the bottom of the chart uses data from the Commitments of Traders report. It’s published by the Commodity Futures Trading Commission every week.
The indicator converts the number of contracts individuals own into an index. The index shows how bullish investors are relative to the past two years. Jumps in the index show an increase in bullishness.
The chart shows the S&P 500, but we see a similar pattern in the Nasdaq 100 Index and other indexes. Large-funds investors are slowly accumulating new positions.
This indicates there is room for gains in the current market. To benefit from that, investors should look at the stocks hedge funds are buying.
In the most recent quarter, hedge funds
For now, hedge funds are saying aggressive stocks should do well in the coming months.
Regards,
Michael Carr, CMT, CFTe
Editor, Peak Velocity Trader