3 Lessons from Top Hedge Fund Failures – Introduction
In the United States, the hedge fund industry is currently being focused on a lot by investors and regulators. In the past decade, the industry has done extremely well, producing several billionaires. However, the industry is currently under spotlight after a period of low returns and high fees. For starters, hedge funds charge investors a 2% fee of the money invested and a 20% incentive fee of profits. For example, a hedge fund with $1 billion in assets under management makes about $20 million from fee alone. It then makes money from the incentive fee. Therefore, if it returns 5% in one year, the fund pockets $10 million. However, in the past, several hedge funds have failed. The iconic Perry Capital that had $15 billion in AUM in 2007 recently shut down after the assets declined to $4 billion. William Ackman’s investment into Valeant Pharmaceuticals cost him $4 billion.
- Even the brightest fail
The first lesson from these failures is that even the brightest stars fail. One of the reasons why hedge funds charge so much is that they hire the best people. They hire traders in leading firms like Goldman Sachs. These are usually people from institutions like Harvard and Wharton School of Finance. These people don’t come cheap. They are paid a six-figure salary plus bonuses. The hedge fund managers themselves are often from leading organizations. For example, Long Term Capital Management (LTCM) was once a leading hedge fund managed by several Nobel Prize Winners. It failed.
- Learn to Cut losses
Many times, you will conduct a research about a stock or currency pair. Then, you will initiate a trade. For a few minutes or days, the thesis will work out. Then, the trade will start going against you. You will start making losses. Inside you, you will believe that the trade will reverse and work on your favor again. Unfortunately, in most cases, this might not work out. This is what happened to Bill Ackman’s Valeant Pharmaceuticals trade. At the beginning, it worked out fine. However, after a while, the stock started to fall. The stock he had bought at $150 reached $250. Instead of exiting, he believed that an upside potential existed. When the fall started, it was painful. He later on exited his trade at $11. As a trader, you should learn to accept losses.
One way of doing this is to have a stop loss. The stop loss should be in such a way that it does not expose your account to more than 2% of losses. Therefore, if you have a $1,000 account, it should not lose more than $20 per trade.
- The buck stops with you
If you have a trading floor, you need to realize that the buck stops with you. It does not stop with the traders. When the floor fails, no one will blame the traders. In the case of Perry Capital, it had more than 50 employees. When it failed, no one blamed the employees. Richard Perry took the blame. The same is true for Pershing Square Capital. No one blamed the employees. Therefore, you need to learn how to compensate the traders. When you compensate traders with a base salary, chances are that they will not be very attached to the fund. If on the other hand you compensate them based on their performance, they will have the morale of getting to perfection. Therefore, learn how to compensate them.