The hedge fund community talks about the concept of “edge” all the time. In order to earn their exorbitant 2 percent/20 percent fees, such hedge fund managers need some type of edge over the average investor or else why would anybody bother to invest with them and pay such fees?
Yet for all the hoopla over how great and prestigious the hedge fund industry is, the reality is that their returns have been pathetic over the past several years. For instance, the average hedge fund was up just 5 percent in 2013 vs. the S&P 500's 30 percent! Hedging is not a great strategy in a bull market. Neither is being too smart for your own good. You can actually track or buy a hedge fund index through the ETF, HDG.
I'm a firm believer that all of us who are not professional money managers should simply buy low-cost index funds or ETFs. The most important thing we can do is manage our investment portfolio exposure to correspond with our tolerance for risk. It's extremely difficult to consistently outperform the markets, and it's much better to spend our time working on our careers, our businesses, or other areas of expertise to build wealth.
If you want to chase unicorns
Despite my recommendation for developing a consistent savings and index investing system to build wealth over time, e.g. invest 70 percent of savings in the S&P 500 and the other 30 percent in municipal bonds, I do think it's worth it for people to take more risk, especially when young. If you blow yourself up as a 26-year-old, at least you've learned a lesson and have more time to recover your losses. It's also very hard to take risks once we have a family that depends on us.
One of my biggest regrets now is not investing more money during the Internet bubble of 1999. I hit one huge home run in 2000 at the age of 23 and basically stopped looking for unicorns for the next five years because I was afraid of losing money after the bubble burst. But money-making opportunities present themselves every single day, long or short. We just have to spend time looking!
If you want to chase unicorns, then I propose you set aside no more than 10 percent of your net worth to actively manage. For example, I designated my rollover IRA when I left my job in 2012 as my Unicorn Fund. For those who feel they have investing super powers and find no need to limit their net-worth exposure in active investing, then the following advice on developing an edge should be considered even more important.
Developing your edge
“Edge” is just a code word for investing in what you know very, very well. My edge is investing in Asian equities because I grew up in various Asian countries, worked in Asian equities for 13 years, and speak a couple Asian languages. There are subtle cultural nuances that are exploitable if you have the experience in reading the tea leaves. For example, I wrote a 2,000-word article in May, 2012 explaining why I think Chinese equities, especially Chinese Internet stocks were poised to begin outperforming. As someone who runs an online business based in San Francisco and actively participates in social media as well, I thought this combination gave me a knowledge advantage. Names such as Baidu and Sina are up 100 percent and 55 percent since, respectively.
If you were to ask me about investing in apparel companies such as Lululemon or Under Armour, I would have no clue because I don't have any industry experience. All I can tell about Lululemon is what everybody else knows: estimated earnings growth for this year, operating margins, their CEO debacle, and basic balance sheet information. I have no edge, which means I have no way to exploit the stock.
The fact of the matter is, everybody has some sort of edge they can harness when investing. If you go to the casinos to play blackjack, even a 1 percent edge over the house can result in massive profits if you have a large enough bank roll to sustain the ups and downs. No wonder card-counting is frowned upon.
Discover your edge
- Industry experience. Everybody works in some industry. The longer you work at an industry, the more you will understand the industry given you've been through the cycles and understand the various competitive practices. Many money management firms hire industry veterans to become industry specialists. One common example is hedge funds hiring medical doctors to co-run health care funds. When you've spent 15 to 20 years after college specializing in oncology, you are the expert in cancer treatment, drugs, and equipment.
- Cultural background. You don't have to invest money only in your country of residence or origin anymore. There are ETFs that allow you to invest in emerging markets such as Europe, Africa, and the Far East. Let's say you lived in Greece for 15 years before coming to the States for the last 15 years. You understand Greek culture more than some Emerging European analyst who only goes to visit companies in Athens once a year. During the Greek debt crisis, maybe you would have found an edge in the political rhetoric which would have given you the courage to buy Greek bonds at 10 cents on the dollar enabling you to make a killing just a couple years later.
- Areas of interest. Perhaps you're really not interested in your industry or you've never immersed yourself in another culture other than your own. The next logical place to look for your edge is in intense areas of interest. Perhaps in 2005 you were a college football and NFL fanatic. You went to every single game within a four-hour driving radius and you noticed Under Armour uniforms popping up everywhere. You thought to ask the players what they liked about Under Armour products early on, and they raved about the material, style, and fit. (Under Armour stock is up 800 percent since going public in 2006, and went up 60 percent in 2013.) You get the picture.
What's your competitive advantage?
Gaining a 2 percent edge puts casinos out of business over the long run. Most people don't consider active investing gambling because research can be done to improve one's chances of making money. Where people mess things up all the time and lose or underperform is when emotions and misinformation gets in the way.
Active investing is a losing proposition over the long run, as study after study has shown. That doesn't mean there aren't active investors out there who are crushing it. Investors such as Warren Buffett, Ray Dalio, Peter Lynch, George Soros, Carl Icahn and many more are making outsized returns because they've developed some type of edge in their investment process. They don't invest in everything under the sun because their edge doesn't scale without hiring good people with their own edge.
If you are going to spend time actively investing a portion of your net worth, then it's important to go in with the understanding that you can and will lose money. Hopefully you've focused your investments on areas where you think you have an edge to outperform. Otherwise, it's much better to spend time on your expertise, investing index funds, or let a professional money manager try and make money for you.
Readers, where is your edge when it comes to active investing? Do you actively invest your money? If so, how have you done over time? What percentage of your net worth or investment portfolio do you carve out to actively invest?
Author: Financial Samurai
Sam spent 13 years working on Wall Street in the equities department at a couple bulge bracket firms before deciding to focus full time on Financial Samurai, a personal finance site that helps you slice through money's mysteries. Sam received his MBA from UC Berkeley's Haas School of Business and his Bachelor of Arts in economics from The College of William & Mary. He is a registered representative (Series 7 and Series 63).
Sam is based in San Francisco, California, and enjoys playing league tennis, poker, and anything that deals with the great outdoors. Sam's goal is to live a location-independent lifestyle by generating enough passive income to take care of a family of four.