Contents
Foreword
Introduction
Chapter One: What is a Hedge Fund?
Comparing Apples to Oranges
Regulation . . . or Lack Thereof
Size: The Achilles’ Heel
Manager Fee: The Infamous Two-and-Twenty
Investment Strategies: The Long and the Short of it
Liquidity: Swimming in Pools of Money
So, Do they Actually Hedge?
The Proof is in the Pudding
Chapter Two: The Parlor Cars of the Gravy Train
Inside the Olive Pit
The Secret is in the Sauce
And the Beat Moves On . . .
The Revenge of the Nerds
And Now for the Not-Quite-as-Successful
Emerging from the Ashes
Where Are We Now?
Chapter Three: Accessing the Inaccessible
It’s All in the Name
The Institutional Invasion
Take Out Your Measuring Stick
What It Boils Down To . . .
Chapter Four: Heads We Win; Tails you Lose
Keeping Up with the Joneses
The Ends Justify the Means
Even Cowboys Have the Blues
Chapter Five: The Alpha Game
The Alpha-Beta Song
Another Theory, Another Definition
Driving with One Foot on the Brake
Putting Theory into Practice
A Word of Caution
Sometimes Diversification Just Ain’t Enough
The Bottom Line
Chapter Six: Ironing Out Inefficiencies
A Kid in a Candy Store
Times, They Are a Changing
Living on the Edge
Putting Theory into Practice
The Efficiency of Inefficiency
The Fact of the Matter . . .
Chapter Seven: A Balancing Act
Long/Short Equity—Borrowing from Peter to Pay Paul
Relative Value—Two of a Kind . . . but Different
Event Driven—One Man’s Loss is Another Man’s Gain
Directional
Chapter Eight: If you Can’t Beat ’Em, Join ’Em
Stop Right There!
Manager Selection
The Screening Process
The Never-Ending Process
Filling in the Data
Portfolio Construction
Stay Alert . . . It’s Your Money
Chapter Nine: The Men Behind the Curtains
A Quick History Lesson
More than Just a Middleman
The Specifics
Your Dream Team
The Pluses . . .
. . . and the Minuses
Chapter Ten: From Wall Street to Park Avenue
Wall Street’s Mass Migration
Only the Strongest Survive
Inside the Mind of a Super Capitalist
A Quick Pop Quiz
Scoring a Job at a Hedge Fund
A Final Few Words: 15 Things I Would Do If I Were you
Conclusion
Appendix
Acknowledgments
Little Book Big Profits Series 
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The Little Book of Hedge Funds by Anthony Scaramucci
Copyright © 2012 by Anthony Scaramucci. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Scaramucci, Anthony.
The little book of hedge funds: what you need to know about hedge funds but the managers won’t tell you / Anthony Scaramucci. — 1
pages cm.—(Little book big profits series)
ISBN 978-1-118-09967-4 (hardback); ISBN 978-1-118-23707-6 (ebk); ISBN 978-1-118-22373-4 (ebk); ISBN 978-1-118-26204-7 (ebk)
1. Hedge funds. I. Title.
HG4530.S363 2012
332.64’524—dc23
2012005564
To my great kids, Alexander, Amelia, and Anthony.
I am so grateful that we are a part of each other’s journey, and I love the three of you with all of my heart.
Foreword
In 1972 Woody Allen filmed the funny movie Everything You Always Wanted to Know about Sex But Were Afraid to Ask. It has taken 40 years, but now finally Anthony Scaramucci has written the perfect and comprehensive manual on Everything You Always Wanted to Know about Hedge Funds But Were Afraid to Ask.
Using the layman’s language and a wit that at times parallels that of Woody Allen’s comic genius as Anthony is a man who is as funny as he is smart. He provides the perfect primer on the esoteric world of hedge funds and their investment strategies. And being an insider who knows about hedge funds as much as anyone can—by running a leading fund of hedge funds—Anthony can reveal in simple but clear and still profound terms the explanation of exotic terms such as alpha, absolute returns, shorting, hedging, leverage, and two-and-twenty. It is a true insider’s guide to hedge funds.
In the process he discusses many important open and controversial issues. Is there true alpha? My answer is a partial yes, as there are a number of hedge fund managers who can provide superior uncorrelated absolute returns even if many others are just mimicking beta or do not have superior investment skills. So it does take a lot of work to pick the right managers, and that is the challenging role that funds of hedge fund can and should play.
Why has the industry become so big? Because in a world of low returns on traditional investments as zero policy rates are now the norm, there is a huge demand for higher absolute returns. And, until 2008, those returns were higher than those on traditional passive or even active long-only strategies. Given the massive losses that the industry faced in 2008 and 2009, an open question is whether those higher returns were based on superior skills or rather leveraged beta. The jury is still out, but there are certainly some managers who are consistently providing alpha (if at a steep set of fees).
Why are hedge funds interesting to institutional investors? Because in a world where returns on traditional investments are low and pension funds have large unfunded liabilities, the search for the holy grail of alpha can diversify risk and provide superior returns. However, we also know that when risk is off rather than on—when tail risk implies high risk aversion—all risky assets become perfectly correlated and there is nowhere to hide, even among hedge funds. So, again, finding better managers becomes key.
Finally, what is the future of the hedge fund industry? Most likely a shake-up: thousands of smaller and under-performing funds have disappeared in the past few years while the more successful players are consolidating and becoming bigger. But then the issue remains of whether successful funds can maintain alpha returns when they become so large that they can move markets or they run out of successful trading ideas.
There are thus still many questions on the present and the future of the hedge fund industry. But no one else is as good as Anthony in providing a clear and yet rigorous introduction to this industry still wrapped in a veil of mystery and misconceptions.
Nouriel Roubini
Professor of Economics at the Stern School of Business, New York University, and Chairman of Roubini Global Economics
Introduction
Anatomy of a Hedge Fund
The Password Is . . .
Hedge funds are the ultimate in today’s stock market—the logical extension of the current gun-slinging, go-go cult of success.
—Peter Landau, “Hedge Funds: Wall Street’s New Way to Make Money” (New York Magazine, 1968)
FOR MUCH OF THEIR history, hedge funds have been viewed as exclusive, intentionally vague, high-risk investments that were only accessible to the überelite. Often referred to as “Wall Street’s last bastions of secrecy, mystery, exclusivity, and privilege,” they have generally been resented, misunderstood, and vilified for causing market turbulence and creating legions of wealthy people who seemingly have “more money than God.” And yet, most do exactly what they say: They provide superior returns with less volatility. As such, investors continue to pour money into these alternative investments, with assets increasing from $38.9 billion in 1990 to $1.77 trillion in 2007 to $2.04 trillion in the third quarter of 2011.1 With posted gains of 19.98 percent and 10.4 percent in 2009 and 2010, respectively, an increasing number of individuals and institutions are eager to gain insight and access into this secret society. However, many mysterious hedge fund managers often shy away from unveiling their profitable secrets.
Isn’t it time that someone unravel the secret world of hedge funds? Isn’t it time to provide intellectually curious people with a comprehensive overview of the industry without clouding it with jargon, negativity, and dry numbers? Isn’t it time to help eager and cautious investors reap impressive gains while reducing overall market risk? Isn’t it time to explain to the masses how hedge funds impact their pocketbooks even if they don’t directly invest in this alternative investment vehicle?
Enter The Little Book of Hedge Funds. I’m your host. Anthony Scaramucci. Well, not actually your host—more like your trusted resident advisor. In 2005, I cofounded SkyBridge Capital Management, an alternative asset management firm that is now running approximately $5.7 billion in total assets under management by investing in over 35 different hedge fund managers. As an alternative asset manager and founder of the SkyBridge Alternatives (SALT) Conference, which is one the premiere conferences in the industry, I have been privy to cloaked conversations among some of the world’s most successful hedge fund managers. I have listened carefully to their views on the industry, observed how they have ironed out market inefficiencies through their dynamic use of alternative investment strategies, and studied the ancillary literature written on the subject. And, as a managing partner of SkyBridge Capital, I witnessed my experienced staff thoroughly and thematically evaluate the quantitative and qualitative factors that go into allocating capital and selecting a hedge fund manager across all industry segments. And now, in this Little Book of Hedge Funds, I will pass this amassed knowledge onto you.
Consider this Little Book to be your personal guide to the hedge fund industry. We’re going to provide you with a comprehensive overview of this secretive world, while exploring its impact on the overall market and global economy. We’re going to explain the history and evolution of hedge funds and how they operate. Along the way, we’re going to hear valuable insight from hedge fund luminaries and investing titans who have transformed the financial industry. And, we’re going to do it all by using plain English—no jargon here.
After reading this Little Book, you will no longer have to shy away from conversations about accredited investors who allocate capital to hedge fund managers who take two-and-twenty by exploiting market inefficiencies through investment strategies (short, hedge, leverage—oh my!) that minimize risk while generating absolute returns . . . all in the quest for alpha. (Don’t worry, you’ll learn what all of this means in this book—just keep reading.)
Seeing the Forest from the Trees
Before we can delve into the money-making secrets of hedge funds, we must first define the term. And yet, in keeping with the mysterious nature of hedge funds, there doesn’t seem to be a universally accepted definition. Perhaps the reason why many experts differ on the exact definition stems back to the origins. Although we will have a detailed history lesson in Chapter 2, hedge funds earned their name because they literally hedged. Once upon a time in a faraway land, a journalist named Alfred Winslow (better known as A.W.) Jones began managing his portfolio by selecting securities to be both long and short through leverage, thus, providing a hedge.
Although some managers still hedge, many hedge funds do not. So, what do they do? What do they all have in common?
As there is no magic formula for defining the term, but since this is the hedge fund industry, I want you to imagine that you are back in biology or anatomy class, peering over a pig—the capitalist kind. That’s right. It’s time to travel back to high school. Picture it. Freshman year. Biology lab. Pig dissection day.
You are sitting on some uncomfortable wooden stool, trying to look all macho and act all cool in front of your hot lab partner, who is deathly afraid of dissecting the small, fetal pig that lies before you. You strap on your boxy goggles, pick up the scalpel, and open up the pig (of course all the while smiling at your attractive lab partner). As you make careful incision after incision, you begin to extrapolate vital components of the pig’s anatomy. With every piece you discover, you are learning the sum of the pig’s parts, which will ultimately provide you with a better understanding of the overall makeup of the animal.
The same technique is needed to provide a definition of hedge funds. But instead of dissecting an animal, we are going to dissect the colloquial and controversial definitions presented over time by the experts.
Let’s start with a technical definition provided by Jack Gain, president of the Managed Fund Association:
Hmm . . . that definition doesn’t say much, now does it? Besides, I’ve never been one for pragmatism. Let’s keep moving.
According to the Alternative Investment Management Association’s Roadmap to Hedge Funds:
Sounds like a good definition to me . . . but let’s take it further. Let’s push the scalpel around a bit more. In All About Hedge Funds, Robert A. Jaeger defines a hedge fund as:
Now we’re getting somewhere, but this extrapolation is still missing something—firsthand knowledge from a legend in the industry. As such, we need to move our scalpel over the supercapitalist’s heart so that we can see the following definition from legendary hedge fund manager Cliff Asness of AQR Capital. According to him, hedge funds are:
Although I may be biased toward my talented friend Cliff—who if he weren’t running AQR might be writing comedy sketches for Jimmy Fallon or, better yet, could replace Seth Meyers on Saturday Night Live’s “Weekend Update”—his humorous definition is chock-full of vital information about hedge funds that completes the discovery process and enables us to fully learn the sum of a hedge fund’s parts.
Now, although we may never agree on a universal definition of hedge fund, you will notice that all four of these definitions have a few terms in common. So, let’s put down that scalpel and start examining the extrapolated components so that we can form our own definition.
- Alternative Asset Classification: Hedge funds live in the unique world of alternative assets, which—as the name implies—are investment vehicles other than the traditional investments of stocks, bonds, cash, or real estate. Alternative assets include other kinds of assets such as commodities, options, currencies, collectibles, convertible bonds, emerging market debt, and so on. Just as hedge funds lack a clear definition, so do their alternative asset parents. So when you hear the words alternative investments just think of anything in the investment world that is an alternative to stocks, bonds, and real estate and that utilize alternative trading strategies like hedging and shorting (don’t worry . . . we’ll get to those terms a bit later).
- Absolute Returns: As an alternative investment that uses alternatives to stocks and bonds, the returns that hedge funds seek are different. Unlike mutual funds that strive to outperform a relative index or benchmark such as the S&P 500 or Dow Jones, hedge funds utilize a bevy of alternative investment strategies in order to produce positive returns regardless of market conditions and fluctuations.2 In other words, the goal of hedge funds is to deliver long-term growth of capital and achieve positive returns. Hedge funds produce these “absolute returns” by investing in alternative assets (referenced in previous section) with alternative investment strategies (referenced below).
- Alternative Investment Strategies: In order to produce these absolute returns that are disconnected from the stock and bond markets, hedge funds rely on a wide range of diverse alternative investment strategies that seek to mitigate risk while protecting capital and maximizing returns. Although we will discuss these strategies in detail in Chapter 7, they are classified into the following categories:
- Long/Short Equity
- Relative Value
- Event Driven
- Directional
- Managers/Partners: Just who are these magicians who employ these alternative investment strategies in the quest for absolute returns and how do they structure their funds? Primarily, hedge funds are legally organized as limited partnerships, trusts, or limited liability companies (LLCs). Under this arrangement, there is one general partner who is equipped by the private placement memorandum to have discretion over the assets of the fund. The limited partners are the investors in the fund who are not fully liable—they are only liable for any losses that relate to their investment amounts. As such, many hedge fund managers “operate as general partners through another company as a way to avoid the unlimited personal liability, thus only exposing themselves to limited liability given the company serving as the general partner.”3
Oftentimes, the general partner has his own money invested in the fund. In theory, this arrangement incentivizes and motivates the manager, while comforting the weary investor, because any investment decisions and/or results will impact the manager’s personal pocketbook.
A word of caution—don’t invest in a manager who doesn’t have skin in the game and doesn’t put his money alongside that of his clients or limited partners. There is nothing that concentrates the mind better than the fear of capital losses.
- Fees: How do these managers make money? Hedge fund managers typically charge two types of fees: a performance fee and a management fee. Infamously known as “two and twenty,” the fees that a general partner typically makes are between 1.0 to 2.0 percent of the fund’s assets under management plus 20 percent of the profits. Translation: if you put a million dollars into the fund, the annual management fee will be $15,000. The manager is then entitled to a percentage of the profits. So, let’s say that the group has a gross return after the management fee of 20 percent. In this example, the manager gets $40,000 and the investor gets to keep $160,000. (We’ll discuss this structure in more detail in Chapters 1 and 4.)
- Accredited Investors: Unlike mutual funds in which any Tom, Dick, or Harry can invest, hedge funds have historically only been available to “accredited” investors. In order to meet this criteria, individuals must have a minimum of $1 million net worth (excluding the value of the primary residence) and/or make more than $200,000 a year, while entities must have a minimum of $5 million in total assets (or entities the owners of which are all accredited investors).
- SEC Regulation: As of the writing of this book in January 2012, not all hedge funds are currently regulated by the U.S. Securities and Exchange Commission (SEC), a financial industry oversight entity. However, it certainly seems that regulators are anxious to crack down on these alternative investment vehicles. As a result of this lack of regulation, hedge funds are able to invest in a wider range of traditional and untraditional securities using an array of investing techniques. Many funds in the industry—including SkyBridge—have embraced the regulation and are allowing regulators the opportunity to review their businesses for best practices.
Now let’s bring the pieces all together to form a definition—a hedge fund is an alternative investment vehicle that seeks to produce absolute returns by utilizing a wide range of traditional and untraditional investment strategies that exploit market opportunities while protecting principal, preserving capital, and maximizing returns. These private investment pools are actively run by managers who typically invest their own money in the fund and receive a 20 percent performance fee, which consequently serves to align their interests with investors in the fund.4 They are only available to accredited investors and are currently not all regulated by the SEC. (Boy! That was a mouthful!)
. . . what’s that you say? You want to keep dissecting further? You want an in-depth overview of all of those components just referenced so that you can impress your friends at your next dinner party with your vast wealth of knowledge as it relates to this mysterious industry? You want a piece of the hedge fund universe? We’ll get to all of that—and more—in the next 10 chapters.
Lifting the Veil
Have you ever tasted condensed milk? You get all of the creamy, rich, authentic, sugary taste of whole milk, without any of the fat, calories, or guilt. Consider The Little Book of Hedge Funds to be the same. It will be chock-full of synthesized information that will make you wiser and potentially more profitable, yet has none of the unnecessary, extraneous, high-brow content that will make you want to run for the hills. And, just as condensed milk is no substitute for the real thing, I’m not going to ask you to stop pouring whole milk in your cereal. I’m just going to expose you to an alternative. A hedge fund alternative.
Ready to take your first sip?
First, we’ll explore the inner realms of the hedge fund world by defining and dissecting its core features and comparing this alternative asset to its more popular twin sibling—mutual funds. This crash course will be like an Italian Sunday dinner. We will load you up with information and fatten you up with a comprehensive knowledge base.
Then, we will move to a more technical space where we will learn about the various ways in which hedge funds actually make money. At this juncture, you will receive Jedi training on more complex subjects such as alpha, beta, and volatility. You will learn the various ways in which hedge fund managers exploit market anomalies and iron out inefficiencies through a series of “exotic” hedge fund strategies.
After that, I’ll show you how you can invest in a hedge fund directly or through a more feasible alternative—a fund of hedge funds. My objective since starting SkyBridge Capital has been to open the window of access and transparency into the industry so that every dentist in America can have access to the world’s finest money managers and feel comfortable when making their investment decisions. (You don’t have to be a dentist, by the way . . . but you get the point.) In these middle chapters, I will show you how we do that in SkyBridge’s day-to-day operations.
Finally, I’ll suggest how you—or your son or daughter, nephew or niece, friend or foe—can get a job at a hedge fund so that you, too, can reap the benefits of a highly incentivized fee structure.
And, all along the way, you’ll meet legendary, powerful, and wealthy hedge fund moguls who will candidly describe the hedge fund industry and its impact on global markets in their own words. In addition to reading their commentary throughout each chapter, you will also get inside the minds of the hedge fund gurus. At the end of each chapter, you’ll read their responses to a series of four questions that allows them to talk about the industry in their own words.
So, are you ready to enter “Wall Street’s last bastions of secrecy, mystery, exclusivity and privilege?”
Access granted. No password required.
Notes
1. Everett M. Ehrlich, “The Changing Role of Hedge Funds in the Global Economy,” September 13, 2011, www.top1000funds.com/wp-content/uploads/2011/09/The-changing-role-of-hedge-funds-in-the-global-economy.pdf.
2. Robert A. Jaeger, All About Hedge Funds (New York: McGraw-Hill, 2003), 3–4.
3. Scott Frush, Understanding Hedge Funds (New York: McGraw-Hill, 2006).
4. Mark J. P. Anson, The Handbook of Alternative Assets (Hoboken, NJ: John Wiley & Sons, 2006), 123.