The Global Guru: Why Hedge Fund Managers Aren’t As Dumb as You Think

With the average hedge fund failing to beat the U.S. stock market for four years in a row, the reputation of Wall Street’s Masters of the Universe is taking a beating of late.

According to London’s Financial Times, a simple portfolio of 60% U.S. equities and 40% bonds generated the same 7.3% return that an average hedge fund did over the past decade.

Adding fuel to the fire was last week’s report that the top recommendations of the hedge fund world’s leading lights at the annual Ira Sohn hedge fund conference in New York failed to beat the gains in the S&P 500 over the past 12 months.

Sure, there were some winners among last year’s picks. Glenview’s Larry Robbins pick Tenet Healthcare Corp. (THC) ended the year up 140%. Nevertheless, the average return on the top recommendations added up to less than the S&P’s average return of 22%.

That, of course, didn’t keep this year’s Masters of the Universe from making big predictions for the coming year. Stan Druckenmiller is betting on Google (GOOG) and against the Australian dollar (AUD). China Bear Jim Chanos recommends shorting Seagate Technology Public Limited Company (STX). Greenlight’s David Einhorn is betting bet on Oil States International Inc. (OIS). Jeff Grundlach is shorting Chipotle Mexican Grill, Inc. (CMG), dismissing “a gourmet burrito” as an oxymoron.

So, have the giants of the hedge fund world lost their touch?

Certainly, the hedge fund world has become more competitive.

I have more investment information at my finger tips on my new HTC One (sorry, Apple, I couldn’t wait any longer…) than George Soros ever did in his prime.

So, it’s no surprise that it is harder to eke out market beating returns, consistently.

That said, compiling a virtual track record of hedge fund managers based on last year’s recommendations as if they were “buy-and-hold” investments completely makes for little more than an entertaining news story.

And here’s why…

The Elephant in the Room

As sexy as specific recommendations are, they are the least important part of successful trading.

Although you will never learn this in any finance class, any street smart trader will tell you that it’s how you manage a trade once you put it on that matters.

Some of the leading hedge fund managers in the world will readily admit that they are wrong more than half of the time.

Among them is London-based hedge fund manager Colm O’Shea, who had no problem admitting as much in his interview with Jack Schwager in his most recent book, “Hedge Fund Market Wizards: How Winning Traders Win.”

The implications of this are profound.

If leading hedge fund managers admit that their picks are “worse than random,” what good are they?

Here’s the counterintuitive reality:

The good trader is not a good trader because he is “right.”

A good trader is a good trader because he is willing to admit when he is “wrong.”

All of us know a “newbie” trader who gets on a hot streak, begins to think he is the next George Soros, and then — almost like clockwork — blows up his trading account and suddenly finds himself sending out resumes.

A good trader has a fundamentally different approach to the market.

Here’s an iconic quote I unearthed from George Soros that I found buried in an interview with Soros in John Train’s “The New Money Masters.”

“My approach works not by making valid predictions but by allowing me to correct false ones,” Soros said.

It’s this fundamental understanding that separates the “one-hit wonders” of the hedge fund world (think John Paulson and Peter Theil) from those hedge fund managers who stick around for decades (Stan Druckenmiller and Bruce Kovner).

It also means that you should take this year’s predictions by the great and the good at the Ira Sohn conference as just entertainment.

Any hedge fund manager worth his salt knows that whatever he says today may not be relevant next week, let alone next year.

The Lessons of Poker

Although I am not a poker player, I’ve always been fascinated how many of the world’s best traders also are good poker players.

Thinking like poker players gives hedge fund managers an edge over their pure financial analyst counterparts.

Here’s why…

Say you are dealt a hand in poker. You play that hand the best that you can. If it’s a good hand, you bet big. If it’s a poor hand, you bet little. If you get an unusually bad hand, you may just throw in your cards.

Perhaps your hand will improve, when you draw the next card. If it does, you adjust the size of your bet accordingly. You can play a “good hand” poorly. Or you can play a “bad hand” well. Sometimes you win. Other times you lose.

Let me land the plane here…

It’s the same way in trading. Your trade is the “hand” you are dealt. Sure, it would be great if your trade goes and stays in your favor.

But the real skill of trading lies in how you manage a trade once you’ve entered it.

• How much do you bet initially?
• How do changing circumstances change your bet size?
• Do you decide to increase your bet… or just throw in the cards?

Hedge Fund Recommendations: Do They Matter?

Here’s the bottom line…

Examining the returns of hedge fund managers based on recommendations made a year ago as if these were “buy-and-hold” recommendations is completely wrongheaded.

It would be like assessing the skill of a poker player by looking only at the initial hand he’s been dealt.

It ignores 90% of the skill of what good hedge fund manager brings to the table.

As Alan Raphael, a former chief investment officer for George Soros, noted, “This is a tough business. If it were easy, meter maids would be doing it.”

To read my e-letter from last week, please click here. I also invite you to comment about my column in the space provided below.