 |
|
| View previous topic :: View next topic |
| Author |
The End of Hedge Funds? |
rffrydr
Moderator
Joined: 30 Oct 2005
Posts: 13138
Location: Sunny California
|
 Posted: Sun Mar 23, 2008 4:30 am Post subject: The End of Hedge Funds? |
 |
|
Martin Wolf runs some numbers looking for what's real. --Maybe better not to look too deeply into the well....
| Quote: | Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.
Getting away with producing adulterated milk is hard; getting away with an investment strategy that adds no value is not. That was the point made by John Kay, in a superb column last week (this page, March 11). With the “right” fee structure mediocre investment managers may become rich as they ensure that their investors cease to remain so.
Two distinguished academics, Dean Foster at the Wharton School of the University of Pennsylvania and Peyton Young of Oxford university and the Brookings Institution, explain the point beautifully*. They start by asking us to consider a rare event – that the stock market will fall by 20 per cent over the next 12 months, for example. They assume, too, that the options market prices this risk correctly, say at one in 10. An option costs $0.1 and pays out $1.
Now imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.
There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.
The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.
The immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now.
We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.
Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit.
Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky. In their telling example, the chances are more than 10 per cent that the fund will run for 20 years without being exposed. In other words, even after 20 years the outside investor cannot be confident that the results were not being generated by luck or a scam.
It is also tricky to align the interests of managers with those of investors. Obvious possibilities include rewarding managers on the basis of final returns, forcing them to hold a sizeable equity stake or levying penalties for underperformance.
None of these solutions solves the problem of distinguishing luck from skill. The first also encourages managers to take sizeable risks when they are close to the return at which payouts begin. Managers can evade the effects of the second alternative by taking positions in derivatives, which may be hard to police. Finally, even under the apparently attractive final alternative it appears that any clawback contract harsh enough to keep unskilled managers away will also discourage skilled ones.
It is obviously best not to pay the manager, as a manager, at all, but rather to invest alongside him, as at Berkshire Hathaway, Warren Buffett’s investment company. But we still have the challenge of knowing whether the manager is any good. We know this today of Mr Buffett. Fifty years ago, that would have been very hard to know.
What we have then is a huge “lemons” problem: in this business it is really hard to distinguish talented managers from untalented ones. For this reason, the business is bound to attract the unscrupulous and unskilled, just as such people are attracted to dealing in used cars (which was the original example of a market in lemons). The lemons theorem states that such markets are likely to disappear. The same may happen to today’s hedge-fund industry.
Now consider the financial sector as a whole: it is, again, hard either to distinguish skill from luck or to align the interests of management, staff, shareholders and the public. It is in the interests of insiders to game the system by exploiting the returns from higher probability events. This means that businesses will suddenly blow up when the low probability disaster occurs, as happened spectacularly at Northern Rock and Bear Stearns.
Moreover, if these unfavourable events – stock market crashes, mortgage failures, liquidity freezes – come in stampeding herds (because so many managers copy one another), they will say: “Nobody could have expected this, but, now that it has happened to all of us the government must come to the rescue.”
The more one believes this is how an unregulated financial system operates, the more worried one has to become. Rescue from this crisis may be on the way, but what about next time and the time after next?
*Hedge Fund Wizards, and The Hedge Fund Game, January 2008 |
_________________
Today is the Tomorrow you worried about Yesterday! |
|
| Back to top |
|
 |
| Author |
The End of Hedge Funds? Replies |
nodoodahs
Moderator
Joined: 06 May 2005
Posts: 2229
|
| Posted: Mon Nov 16, 2009 8:31 pm Post subject: |
|
|
| nodoodahs wrote: |
Edit to add: the optionality implied in running the HF structure pretty much insures that low-standard deviation and high-kurtosis, strongly negatively skewed strategies will be the PREFERRED strategies. 99 times out of 100 they produce smooth non-correlated returns and the FOFs love them. The one time it blows up, well, close the fund and start another one. |
Speaking of which ...
http://www.ft.com/cms/s/0/331bae80-be93-11de-b4ab-00144feab49a.html?nclick_check=1
| Quote: | Meriwether setting up new hedge fund
By Sam Jones in New York
Published: October 22 2009 00:03 | Last updated: October 22 2009 00:03
John Meriwether, the hedge fund manager and arbitrageur behind Long-Term Capital Management, is in the process of setting up a new hedge fund – his third.
The move comes barely three months after Mr Meriwether decided to close his second fund manager, JWM Partners, which was wound down after clients saw the value of their investments fall by more than 44 per cent over the course of the financial crisis.
JWM Partners was set up soon after the collapse in 1998 of Mr Meriwether’s first – and most infamous – fund, LTCM, which triggered a wave of panic across the world’s markets and prompted the US Federal Reserve to take the then-unprecedented step of orchestrating a multi-billion dollar bail-out.
Mr Meriwether’s new venture, named JM Advisors Management, will, like both of his previous hedge fund management companies, be based in Greenwich, Connecticut.
People with knowledge of the situation say the fund has not yet started accepting outside investments, however. According to HFMWeek, an industry publication, the fund will open to investors in 2010.
The fund is expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.
The strategy, described by the Nobel Prize-winning economist Myron Scholes as being akin to a giant vacuum cleaner “sucking up nickels from all over the world”, can be highly successful in periods following market dislocations.
Relative value trades profit by betting on unusual pricing relationships between securities, anticipating a return to an historically modelled “normal” state between them.
Traders say the strategy has the potential to deliver huge returns in the current market, with many banks’ proprietary trading desks having scaled back their operations and far fewer hedge funds in existence.
Their absence is leading to “inefficiencies” according to many market participants.
The swap spread on 30-year Treasury bonds – the difference between the cost of a 30-year bond and the cost of an interest-rate hedge against it – is still negative.
However, as Mr Meriwether’s experience shows, relative value strategies are not without their pitfalls.
The strategy typically has a high “blow-up” risk because of the large amounts of leverage it uses to profit from often tiny pricing anomalies.
At its peak, LTCM borrowed 25 times more than it had in investor’s capital in order to ratchet-up its returns.
JWM boasted a more conservative 10 times leverage ratio.
The hedge fund industry average is estimated at between two and three times.
Copyright The Financial Times Limited 2009. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web. |
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose. |
|
| Back to top |
|
|
nodoodahs
Moderator
Joined: 06 May 2005
Posts: 2229
|
| Posted: Mon Nov 16, 2009 10:06 am Post subject: |
|
|
In mean-variance analysis, we speak of a “risk premium” whereby the larger volatility is compensated for by a larger mean return.
What Henry is fond of pointing out is that HF returns can be higher than simulated using “beta factors” because many of them make their money by providing liquidity.
Liquidity-providing strategies are very similar to option-selling strategies in their statistical properties. Compared to equity indexing, the standard deviation of these strategies is low compared to the mean, but the skewness is very very negative, and the excess kurtosis is extremely high.
Some points to think about:
(1) is “liquidity” simply another beta-factor?
(2) should the “risk premium” category include “kurtosis premium” in addition to “volatility premium?”
(3) are our typical evaluations of risk-adjusted return all wrong, with HF returns being significantly worse on a risk-adjusted basis than their Sharpe ratios would have us believe?
Edit to add: the optionality implied in running the HF structure pretty much insures that low-standard deviation and high-kurtosis, strongly negatively skewed strategies will be the PREFERRED strategies. 99 times out of 100 they produce smooth non-correlated returns and the FOFs love them. The one time it blows up, well, close the fund and start another one.
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose. |
|
| Back to top |
|
|
rffrydr
Moderator
Joined: 30 Oct 2005
Posts: 13138
Location: Sunny California
|
| Posted: Tue Nov 10, 2009 7:21 am Post subject: |
|
|
Maybe never a greater desire to go "both ways." They've proven while not so good at "hedging" very adept at selling. This seems incredible. And now they'll be regulated. We'll see how they fare against Private Equity in this brave new world.
And, yes that will be a emerging theme, "risk assets." We've already seen it with the average investor. This market is shedding the "Greed born of Fear" decade beginning to take risks again.
Venture capital however will probably fare less well than expected here however. Nothing is obvious. 
_________________
Today is the Tomorrow you worried about Yesterday! |
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
| Posted: Mon Aug 03, 2009 10:03 pm Post subject: |
|
|
If a fund is willing to reduce their fee structure from "2 and 20" or higher, it is not worth investing in. How could they hire the talent? Better go with a HF replication strategy or a mutual fund that adopts an absolute return strategy.
An industry with $1.5 trillion in AUM cannot all charge "2 and 20." And given the law of the financial markets, only a slight minority should be able to charge that over a market cycle. |
|
| Back to top |
|
|
rffrydr
Moderator
Joined: 30 Oct 2005
Posts: 13138
Location: Sunny California
|
| Posted: Mon Aug 03, 2009 9:26 pm Post subject: |
|
|
2 and 20 out the window with CalPers and other big pension money coming in after route and bringing reductions with them. At least one still getting 50! And, my kinda of revamp, one only collecting after principle's first doubling.
http://tinyurl.com/m3o6z4
_________________
Today is the Tomorrow you worried about Yesterday! |
|
| Back to top |
|
|
rffrydr
Moderator
Joined: 30 Oct 2005
Posts: 13138
Location: Sunny California
|
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
| Posted: Thu Jun 18, 2009 11:15 am Post subject: |
|
|
Felix Chee, special advisor to China's CIC (head of its hedge fund and prop trading efforts, and former head of the University of Toronto's endowment hedge fund unit) asserts that the CIC will aim to make investments in hedge funds:
http://www.bloomberg.com/apps/news?pid=20601087&sid=ai5PLqcRXWyc |
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
|
| Back to top |
|
|
rffrydr
Moderator
Joined: 30 Oct 2005
Posts: 13138
Location: Sunny California
|
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
|
| Back to top |
|
|
HenryTo
Site Admin
Joined: 06 Aug 2004
Posts: 9723
Location: Houston, Texas & Los Angeles, California
|
| Posted: Tue May 19, 2009 10:12 am Post subject: |
|
|
Hedge funds still underweight equities:
http://www.bloomberg.com/apps/news?pid=20601087&sid=azCMr9GHOI0U&refer=home
| Quote: | | About 30 percent of stock hedge funds were sitting on cash at the end of April, compared with 45 percent as of Dec. 31, according to a report published this month by New York-based Morgan Stanley. Net exposure -- the difference between the amount funds wager on rising and falling stocks -- rose to 32 percent in April from 27 percent the previous month. |
|
|
| Back to top |
|
|
Please log in to view without the ad banners |
|
|
|
You cannot post new topics in this forum
You cannot reply to topics in this forum
You cannot edit your posts in this forum
You cannot delete your posts in this forum
You cannot vote in polls in this forum
|
|
FAQ
Search
Memberlist
Usergroups
Statistics
Register
Profile
Log in to check your private messages
Log in
