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Since October 2017, about half of my wealth has been invested in a hedge fund. Coincidentally, this first blog update about the fund’s performance comes at an interesting time: Q4 2018 and Q1 2019 can be seen as a micro-model of a recession and recovery period, highlighting the differences between different stock-investment strategies.
I’ll use this chance to make the report more interesting, by reviewing the history of my stock investments and comparing different approaches to investing in stocks. Here we go.
Timing the Market
Company stocks prices react to a variety of events: product releases, financial statement, merges, scandals etc. Audacious investors follow the basic adage of “buy low, sell high”: They try to anticipate price fluctuations, and grab a stocks just when its value is about to rise (or, more radically, bet against a stock whose value is about to drop, which is called “shorting”).
This is not as simple as it sounds, as stocks are highly unpredictable. Like most people who’ve tried, I personally had some successes, but ultimately lost a lot of money on bad bets.
Growth Investment / Value Investment
Some investors try a seemingly safer approach: Rather than specific price fluctuations, they try to anticipate long-term trends. They look for companies that exhibit signs of growth, and buy their stocks with the intention of selling them some years later when the company is big and successful.
To be honest, I never understood this approach. Trying to anticipate reactions to specific events is one thing; trying to foresee the distant future is quite another. Who actually knows which company would succeed 5 or 10 years from now?
Still, I took advice from a friend and made some growth investments. Guess what? I lost just as much. Long-term trends are as hard to predict as short-term fluctuations.
Buy & Hold
The polar opposite of the previous methods. “Buy & Hold” consists of two principles. First: Don’t pick individual stocks, just diversify across as many stocks as possible. Second: Don’t try to predict their performance, just count on their combined value to grow over time. Naturally, ETFs are the perfect assets for this type of investment.
An Exchange-Traded Fund, or ETF, is an assortment of stocks contained in a single product. ETFs are typically focused on a specific sector (e.g. pharmaceutical stocks) or an entire market (e.g. US stocks).
Stock Market Index
An index is a measurement of the combined performance of a group of stocks. For example, the “S&P 500” index shows the combined performance of the top 500 companies traded in US stock markets. Hence, an S&P 500 ETF would replicate the composition of the original S&P 500 index, allowing investors to hold a share of the leading 500 US companies all at once.
The “Buy & Hold” approach is based on the notion that, when viewing a long enough time frame, stock markets always exhibit an upwards trend:
In light of this historic data, buying and holding index funds makes sense. Why bother with specific stocks and timing if the overall market always rises? This approach is favoured by large investment firms, like the one I hired to manage my investments after I gave up hand-picking stocks. But it’s far from perfect.
Sometimes you’re down…
Even if you diversify across hundreds of stock, the markets themselves still fluctuate, especially during economic recessions. Let’s zoom in on the 2008 financial crisis, when the S&P lost about half of its value:
Strong-willed investors lived to see their investment regain its value… 5.5 years later. Many broke along the way and sold at heavy losses – but we can’t blame the “buy & hold” strategy if people just fail to hold, right? Well, try telling that to Japanese investors who have been waiting for the NIKKEI to recover its value since January 1990:
This nightmare scenario may occur in any other market. But even if it doesn’t, and even if you feel strong enough to resist the urge to sell at a loss, there is still the issue of timing.
If you invested 100$ in an S&P ETF in 2007, by now you would have 180$. If you invested the same amount in 2009 (when the price was lower and you could get more shares for the same price), by now you would have 393$. The difference is that fucking huge. So buying and holding ETFs is the perfect strategy, as long as you time your investment perfectly. Weren’t we trying to avoid just that?
Thankfully, no financial crisis occurred while my own money was invested in ETFs. But for 8 whole months it gained almost nothing due to minor fluctuations… Which brings us to the last type of stock investments (at least in my personal repertoire)
Actively-Managed Funds: The Best of Both Worlds?
Just as I became impatient with my ETF portfolio, close friends of my parents told us about a hedge fund where they have been making consistent returns for the past few years.
A hedge fund is a type of managed fund. As opposed to simple ETFs, where the composition of stocks is a static representation of some part of the market (like the S&P index), managed funds buy and sell stocks dynamically in response to market trends, trying to out-perform the market.
These funds come in two varieties: public or private. The former can be purchased just like simple ETFs. The latter is a private partnership which can only be joined via personal invitation, and is also called a hedge fund.*
The fund recommended by our friends operates from Europe, but focuses on the American stock market. They combine market analysis with day-trading (buying and selling stocks at very short intervals based on minute changes in value, eliminating the impact of long-term trends and cutting losses short).
Apart from quarterly reports, I don’t have any access to the exact details of their deals. Such funds offer no transparency; first, to avoid other funds copying their moves, and second, because any public activity might force them to become a publicly traded company, which they prefer to avoid. That’s why I don’t even share their name on the blog.
Needless to say, these funds are not without risk. The lack of transparency creates all sorts of concerns, the managing partners may run into trouble, or they might simply make bad investments and under-preform the market. In fact, this is the case with most managed funds.
But I trust the people managing this specific fund, who claim to have been beating the benchmarks for about 15-20 years now, and pride themselves on making profit even throughout the 2008 crisis. So I’ve decided to take a leap of faith, sold my ETFs and joined the fund.
OK, let’s get to the point. The fund’s performance, while not mind-blowing, has been good so far. This quarter’s result are the best I’ve seen yet:
The 5.03% quarterly return seems amazing when viewed independently… But wait a minute, the S&P went up a whopping 13.07% this quarter! Where’s the advantage of the hedge fund?
Ah-ha. Like we’ve established, markets fluctuate. In Q4 2018, the US stock market dropped hard, like a mini recession. The sharp rise in Q1 2019 was simply a “correction” of that drop:
Which brings us to the million dollar question: Did the hedge fund also drop during the previous quarter?
I’m happy to say that it didn’t. While the fund didn’t generate any profit in Q4 2018, it barely lost any value either. Here is a more complete picture:
This table sums up the advantage of a hedge fund over buying and holding an index ETF. Let’s just hope the advantage is maintained throughout the next financial crisis.
That’s it! I hope that this has been educational, inspirational, or at least not too boring. In my next post I’ll share some Mintos techniques – stay tuned.
*My explanations are based on my limited understanding of these confusing topics, and may include some inaccuracies, especially in different countries and markets. Please forgive any inaccuracies, and feel free to correct them in the comments.
**This post is not meant as investment counselling! I’m just a fellow investor sharing his thoughts and experiences.