Chapter One
What Is a Hedge Fund?: The Traditional Long-Only Portfolio Versus the Alternative Hedge Fund Portfolio

Hedge funds are generally perceived to be the investment of choice of the rich and the informed, and they are more interesting and fun to discuss than your Vanguard index fund.

-Cliff Asness, AQR Capital Management

THE YEAR WAS 1989. I had just started working at Goldman Sachs in the world of investment banking-the industry adored by many Ivy League students and business school graduates. A few floors up, legendary research director Lee Cooperman was asked by Goldman Sachs to create a mutual fund and lead the Asset Management Division. This long-only equity mutual fund was called GS Capital Growth.

Although Cooperman was extremely successful at picking stocks and examining company income statements and balance sheets, he was intrigued by the opportunity of starting a hedge fund, as he saw its potential to profit from smart stock picking even if the market seemed overvalued at times. And so, he approached the head honchos at Goldman, trying to convince them to start a fund. At the time, they passed as they were concerned over the consequences of shorting the stock of one of their investment clients. After all, no investment bank would want to put a sell recommendation in writing for fear of losing its relationship with the companies it covered . especially when there were advisory fees on the line. The thought of shorting a client company's stock back then was unthinkable. For Lee Cooperman, however, his passion was managing the money, not managing the business.

Shortly thereafter, he started Omega Advisors. While his fund has experienced some ups and downs, he has had a spectacular career replete with great performance for his clients. The fund's ability to hedge risks through shorting, options, and derivatives has allowed his portfolio to have lower volatility and higher returns than he could have achieved in a classic mutual fund.

So, why am I telling you this story? Well, on a simplistic level, a Little Book of Hedge Funds just wouldn't be complete without a few big stories from big personalities who have become hedge fund legends. In fact, that is exactly what the hedge fund industry has become-big! Its managers' personalities. Its successes. Its failures. Its mystique. Its impact on the global market. Granted, it is a small, young industry that is still undergoing a maturation process, but this is an evergreen industry that has a big impact on the market and investors.

Right now we are witnessing an explosion in the hedge fund industry similar to the one the mutual fund business experienced more than 60 years ago. We are witnessing a transition of assets-and while there is competition from mutual funds, hedge funds will be a continued source of power in the world of money management.

So, back to my original question-why am I telling you all of this? In order for you to understand the hedge fund industry-its impact on the market and your investments-you need to first understand this alternative investing tool and how it differs from traditional asset classes such as mutual funds.

Although mutual funds are similar to hedge funds in that they are both pooled investment vehicles that invest in publicly traded securities in order to generate a positive return, there are a number of differences between these two fraternal twins. In this chapter, we will explore these differences. In doing so, we will gain a better understanding of the true meaning of a hedge fund so that you can better ascertain whether it is an appropriate investment vehicle for your portfolio while also helping you get a better sense of its impact on the overall market.

Comparing Apples to Oranges

Just ask any identical-or even fraternal-twin and they will tell you that their life has been full of constant comparisons and trade-offs. Which twin is better looking? Smarter? More outgoing? More athletic? Better with numbers? Makes more money? Has the better education? You get the gist. Similarly, the financial world is riddled with unbalanced comparisons of financial products that render investors bewildered and uncertain. A frequent source of such comparison often involves mutual funds vs. hedge funds.

Mutual funds are the propeller plane, while hedge funds are the fighter jets. Mutual funds are the general practitioners in medicine, while hedge funds are the surgeons-generally the neuro kind. Mutual funds are the Breyer's Vanilla Bean, while hedge funds are Ben & Jerry's Cherry Garcia. Mutual funds are Guy Lombardo on New Year's Eve, while hedge funds are Mayor Mike Bloomberg dancing with (and kissing) Lady Gaga. Mutual funds are Rodney Dangerfield, while hedge funds are Jon Stewart. Mutual funds are Berlin with the Wall, while hedge funds are Berlin with all the swank art galleries.

Have I satisfactorily crushed the mutual fund industry? I wasn't trying to. As your hedge fund muse, I was just trying to help you see that the mutual fund industry has matured and become prosaic, while the hedge fund industry has become cutting-edge. But, let's base this comparison on facts, not playful analogies. Let's start by comparing some definitions and performance, shall we?

According to the Securities and Exchange Commission, a mutual fund is a professionally managed investment company that invests clients' money in stocks, bonds, money market instruments, and cash. Although many brokerage houses would have an investor believe that this portfolio is composed of a wide set of subcategories including large-cap growth stocks, large-cap value stocks, municipal bonds, treasury bonds, and so on, most plain-old-vanilla portfolios are simply made up of stocks and bonds. And, as the old investment cliché goes, to figure out the exact allocation between these two birds, an investor should simply subtract his age from 100 to figure out what percentage he should allocate to stocks and then put the rest in bonds.

Now, anyone who wasn't living under a rock during the fall of 2008 can certainly tell you how the long-only allocation can play out under adverse market conditions. While this blend of traditional assets may be a winning strategy during periods of steady and stable growth, it has faced significant challenges over the past decade, particularly during market disruptions such as the one that occurred in the first months of 2020, when a pathogen known as COVID-19 reached our shores.

As I'm sure you remember, the pandemic was a major stress test for financial markets. Every morning, as we all woke up and wondered how to get masks and how much bleach to put on our groceries, we also watched unprecedented volatility in the markets. People with traditional long-only portfolios opened their Vanguard accounts every morning to find a number that was shockingly lower than it had been the day before, wondering in horror how long the carnage would last. I'm sure that some of them also wondered whether there might be a way to retain value (or even make money) in such a volatile environment.

That's where hedge funds-I mean the hedge fund comparison-come in. As we learned in the Introduction, 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% performance fee. Although many hedge fund managers hold a diverse portfolio of stocks, bonds, and alternative investments, the typical allocation varies by manager and their investment strategy. In other words, hedge fund managers are less interested in a pie chart that divvies up a portfolio by offsetting slices; rather, they are interested in exploiting market anomalies and gaining an informational edge through a dizzying array of investment and trading strategies.

While I am not naive enough to suggest that hedge funds always perform well during times of economic uncertainty, they do tend to be less destructive to personal worth than a traditional stocks-and-bonds portfolio. In 2008, at the worst of the financial crisis, the hedge fund industry was down an average of 22%, which is much better than the market, which was down approximately 55%. Furthermore, according to Hedge Fund Research, an investor who put $1,000 in hedge funds at the beginning of 2001 would have $1,418.89 at the end of 2010 (inclusive of all fees and taxes). One who put $1,000 in the Standard & Poor's 500 in 2001 would have just $920.67 at the end of 2010.

During the COVID-19 pandemic and its aftermath, hedge funds demonstrated similar resilience, albeit on a slightly smaller scale. From January 2020 to December 2022, the average hedge fund returned 4.2% annually, while the S&P 500 had an average annual return of 3%. An investor who put $1,000 in hedge funds at the beginning of 2020 would have approximately $1,127.20 by the end of 2022, compared to $1,092.70 if invested in the S&P 500. And if you were lucky enough to have picked out an excellent manager, you'd have done significantly better than that.

As Ronald Reagan once said, "Facts are troubling things, they...