HF vs. LO: Vantage from a Junior Research Analyst - Part I: Path Dependency

HF vs. LO: Vantage from a Junior Research Analyst - Part I: Path Dependency

In this article series, I will dive deeper into the difference between single-manager hedge funds and mutual funds / long only ("LO") from the vantage point of a junior research analyst (“junior RA”). I am not discussing multi-manager because it is a super unique way of generating return.

This week I discuss how path dependency plays a huge role in hedge fund land.

Say you bought a stock at $20 and believe the underlying business is worth $100 in 5 years. That’s a 38% compounded annual return if you are right in year 5. Of course, if investing were this easy, pay wouldn't be so great in this profession.

A mutual fund and hedge fund can have the same long-term thesis on a stock, but very different approach to managing the stock position day-to-day. 

Mutual Fund 

In the pie-in-the-sky world that the mutual fund’s investors are truly long-term oriented (in the real world, investors love to pile money into a fund at peak and withdraw money at trough): If the $20 stock drops to $10 at the 2 year mark and the junior RA convinces the Portfolio Manager (“PM”) that the long-term thesis is intact, the PM might not change sizing or exit the stock. The firm can just hold until the rest of market revalues the stock to $100 at the 5 year mark, if they are right of course.

Hedge Fund

The junior RA needs to diligently channel check before quarterly earnings results and calls investor relations or management of the company to challenge the validity of their financial guidance to ensure no “blowups” - ie. the company significantly misses market expectations and the stock tanks. Exhibit A below that happened to Crowdstrike (CRWD):

If the junior RA concludes the company might miss quarterly earnings, the PM could buy puts or sell the stock outright: 

  • If the stock indeed drops, the junior RA is a hero. PM is happy. 
  • If the stock surges 40% for exceeding expectation and the junior RA recommends a sell, PM is not happy. 

If the RA recommends doing nothing:

  • If the stock tanks, PM is not happy.
  • If the stock surges 40% for exceeding expectation, the PM is happy and could sell some stock and reallocate to other stocks with higher upsides.

Even when you are right about a stock over a 5-year period, you could be forced to sell at the 2 year mark because of the above dynamic - that's where the path dependency adds an element of challenge for hedge fund investing. Therefore, an ideal stock for hedge fund on the long side is the one that is straight line up for as long as possible - very hard to find of course. 

As you can see, hedge fund life is more tedious and that explains why average tenure of a hedge fund analyst is only two years. That said, no one likes drawdowns (I have no doubt mutual fund PM is unhappy about drawdowns after company missing a quarterly earnings), but whether you want to develop the skills to position your portfolio for quarterly results is a philosophical decision that I am not getting into (as belief in investment style can get intense as religion.)

You might wonder why hedge fund is more acutely paying attention to every data point even when they believe in the same long-term thesis. Charlie Munger once said incentives drive behavior and that’s precisely the driver here.

Mutual fund is not as motivated to generate crazy returns every year because they only make a fee on the assets managed. So they are incented to only be asset gatherers. Of course, a mutual fund needs to generate returns to gain assets. So in a way, mutual fund is implicitly incented to perform but not explicitly compensated for it.

In comparison, hedge fund is explicitly compensated to perform because they charge a 20% fee on the annual return (hence the “2 and 20” model, 2% on client assets managed, and 20% on annual returns, though fee has come down for the industry over the year).

You see: It’s a hedge fund’s job to care more than a mutual fund, because hedge funds are paid more to add value on a shorter-term basis. Hedge funds also need to be paranoid about any drawdown and manage “risk” (vs. in Buffett’s world drawdown / volatility is not risk unless long-term thesis is wrong) because hedge funds are on a “tighter leash." - For paying a higher fee structure, clients expect hedge funds to perform. Well, preferably always. 

Now for a junior RA, when you are covering a company, you should follow every news that is related to the company and have views with the respect to the stock. The only difference is you can afford to disregard more information as noise if you work a mutual fund than at a hedge fund.

Like I said, I don't want to debate what's the right way to invest. My goal is to help you understand what you are signing up when you decide to pursue certain style of investing professionally. 

I hope this helps. Please email me your comments and feedback. I will to continue to dive deep on this subject next week. Peace. 

If you are interested in learning more about professional equity investing (the "buy-side"), I have two other great articles for you:

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