How to invest like a hedge fund manager

Fund managers may be feared and famous, but they still occasionally make mistakes in their betting. The key is that their financial power lets their successes more than make up for their errors.

George Soros, one of the world’s most feared investors, is betting $2 billion that the US stock markets will go through a correction. Brendan Smialowski / AFP

Hedge fund managers retain an almost mythic status in the investment world. They can move markets, break central banks and make billions of dollars in the process.

Who wouldn’t want to invest like a hedge fund manager? Like every myth, however, this is only partly based in reality.

Even stars such as George Soros and John Paulson do not always get it right. We tend to remember their successes and ignore their failures.

And for every stellar success, there are plenty of failures. In 2008, during the global crisis, many funds banned withdrawals as panicky investors headed for the exits.

Wealthy investors have forgiven them. Money continues to pour in – about US$38 billion in the first quarter of this year alone. Global hedge funds now boast more than $2 trillion of assets under management.

Hedge funds still have a slightly sinister reputation, says Tom Elliott, the international investment strategist at deVere Group in Dubai. “They stand accused of triggering the credit crunch of 2008, through excessive use of derivatives linked to the US mortgage market. Recent performance has disappointed, as they have failed to repeat the stellar returns of the late 1990s and early 2000s.”

This doesn’t seem to have dented the myth. Hedge funds are often accused of lacking transparency, because they have relatively few disclosure requirements. But their world is no longer entirely secretive, because funds with more than $100 million in qualifying assets are obliged to file a Form 13F with the Securities and Exchange Commission every quarter that lists their recent investment holdings.

If you want to know what globally-renowned managers such as Mr Soros, Mr Paulson and David Einhorn are buying, holding, selling or shorting, this is where you find out.

Mr Soros has an intriguing trade right now, according to his Form 13F, filed on June 30. He is taking a massive $2bn gamble that US stock markets will fall.

His fund, Soros Fund Management, has taken out 11.3 million put options on the SPDR S&P 500 Trust exchange-traded fund. This short position is now the fund’s single largest trade, at 16.65 per cent of the portfolio.

This suggests the man who famously broke the Bank of England in 1992 by short-selling sterling, making £1bn (Dh5.92bn) in the process, believes a crash could be on the cards.

Soros has not explained his trade, but with the S&P 500 recently breaching its all-time high of 2000, he is not the only one who thinks the market is vulnerable to a correction.

If you agree, you might also want to short the market, says Laith Khalaf, the head of research at Hargreaves Lansdown, the United Kingdom’s largest financial advising firm. “Private investors can short stocks and markets through instruments such as contracts for difference (CFDs), spread betting and exchange-traded funds (ETFs). But these are complex and risky vehicles, and you could lose far more than your initial investment.”

A safer way to hedge against the threat of falling markets is to invest in a conservatively-managed fund with a focus on capital preservation, such as Newton Real Return or Troy Trojan, Mr Khalaf says.

It is far easier for private investors to replicate Mr Soros’s long-only trades. He has doubled his stake in the Market Vectors Gold Miners ETF, which invests in US gold mining companies.

The gold price has fallen from a high of $1,900 to about $1,270, but given today’s geopolitical risks that could swiftly reverse. If it does, Mr Soros will cash in.

He has also loaded up on Apple and Facebook. “These are both strong global brands, but they sit in a capricious sector, where keeping at the forefront of technological developments and consumer trends is key,” Mr Khalaf says. “Any fall from grace could be swift. Remember IBM?”

The hedge fund hero, Mr Einhorn at the New York-based hedge fund Greenlight Capital, actually sold 4.5 million shares in Apple in the second quarter, presumably to bank profits, as the shares rose 20 per cent in the first quarter and 22 per cent in the second.

Mr Einhorn introduced three new US-listed stocks to his portfolio – AerCap Holdings, Northstar Realty Finance Corp and Chemtura Corp

It is very difficult to unpick manager strategies and replicate them yourself, says Charlotte Thorne, a co-founder and partner at Capital Generation Partners. “No private investor could do that – this is just far too complex. The big hedge fund managers are incredibly smart people, making incredibly smart bets. They can make huge sums of money and afford to lose them.”

When a hedge fund manager gets it right, they go down in investment history, says Dan Dowding, the chief executive for the Middle East and Asia at Killik & Co. “The hedge-fund manager John Paulson’s strategy of using credit-default swaps to bet against the US subprime mortgage in the run-up to the financial crisis netted him $5bn and was described as the ‘greatest trade ever’.”

Yet subsequent performance has been disappointing, Mr Dowding says. “Mr Paulson has a chequered record since 2008, having made a big losing bet against the survival of the euro in 2011, and incurring losses on gold by taking a long position as the price started falling.”

Mr Paulson has since shifted back to his area of expertise – corporate takeovers. “Two of his biggest positions are on the takeover of the US pharmaceutical Allergan and the cable operator T-Mobile,” Mr Dowding says.

The most renowned investor of all, Warren Buffett, is not a hedge fund manager. The Sage of Omaha has been critical of the sector, warning that the “field has gotten swamped”. He also described short-selling as “too difficult”.

Despite that, Mr Buffett’s long-only trades are far easier for private investors to replicate, and he has millions of disciples around the world.

Buffett says he only invests in companies he can understand, with strong brands, loyal customers and robust underlying economics. Coca-Cola, McDonalds and Gillette figure prominently in his fund, Berkshire Hathaway, the fifth-biggest public company in the world.

He is a “value” investor, which means he targets companies that have fallen in price but remain fundamentally strong, which he buys and patiently waits to recover. This straightforward strategy has made him the world’s third-richest man.

Right now, Mr Buffett is sitting on a $55 billion pot of cash as he awaits a “fat pitch” worthy of his attention. But with the S&P 500 tripling in value since the financial crisis, finding undervalued shares is not easy.

Hedge funds are far too complex for the average investor to understand. But sometimes the simplest strategies are the most rewarding.

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