March 14, 2019

The Guru and The Investor: A Hedge Fund Story

Act One

The Setting

Guru appears on CNBC to explain what will happen with interest rates, Brexit, and the economy over the next two years.  Investor sees Guru on TV and assumes that CNBC would only have people on their shows who knew what they were talking about.  Needing a place to invest money for a prior employer 401(k) plan rollover, the Investor thinks the Guru may be the way to go.  The investor calls the Guru….

Investor:  Guru, I saw you on CNBC and was impressed with how much you knew about the future.  I have some money to invest, but first I’d like to ask you some questions.

Guru: Thank you. Predicting the future is one of my specialties.  Ask away…

Investor:  What is your basic investment philosophy?

Guru: I know things that nobody else does and I use that information to invest in things no one else would think of investing in.

Investor: That sounds great.  What is so special about you that enables you to have these unique insights?

Guru:  My team and I are really, really smart and we use AI, that’s artificial intelligence, too.

Investor: I see.  And how can I be sure that you know something that no one else knows?

Guru: Because my hedge fund has returned 20% per year for the last 20 years.

Investor:  Ok, that makes sense. There’s no way you could have achieved returns like that by taking excess risks or just by being lucky.  But tell me something else: If you have unique insights that enable you to beat the market, why not just invest your own money and keep your special abilities to yourself?

Guru: Because then I wouldn’t be able to spread the joy of making tons of money.  I only charge exorbitant fees for access so my competitors don’t get mad at me for wrecking the hedge fund compensation model.

Investor: You are a very gracious Guru.  Just one more question. There are numerous studies that indicate that most managers underperform their benchmarks, and for the few that do, their outperformance does not persist into future periods.  Understanding that you are different than everyone else, what happens in the unlikely event that, going forward, you underperform the market?

Guru:  That’s a silly question.  Those other managers aren’t as smart or as driven as we are to beat the market.  But to answer your question.  It’s simple.  We keep the management fees, close the fund, return whatever money is left to investors, and in a year or so, launch a new fund.  Pretty sweet stuff…

Investor: You’ve got quite the arrangement going.  Let me give this some thought.  I’ve also heard of an approach called evidence-based investing that sounds kind of interesting.  I’m going to look into that and compare the two and see which one makes more sense… Thanks for your time…