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Hedge Funds Bushwhacked By Volatility

November 3, 2012

Every so often we see an advertisement for a new hedge fund that holds out the possibility (but not the guarantee) of taming market volatility by taking long and short positions simultaneously in baskets of stocks. The schema (not to use a more familiar term) is that the long position can be financed by the investor cash and the cash that is realized on the short positions and the hedge fund manager charges “only” two or three percent on the capital, optional front- or back-end loads (one or the other or both) and twenty percent of the portfolio gains, should there be any. The manager can even go over the top by leveraging the long position with debt or the margin account and, guess what, who pays for all of that? After all, the “sophisticated” and well-heeled investor with $1 million or more to “invest” did give them their money, didn’t they.

These funds can’t work (and the sources of failure are built-in) except by accident which is always a possibility. But most investors will be better off if struck by lightening (twice) on the way to the sales presentation UNLESS the contract or prospectus has the word GUARANTEE in it, as in “we legally and actuarially guarantee the capital” AND  “we hope to provide an investment return that exceeds the rate of inflation”. Anything else is just a gamble.

Interestingly, it is neither hard nor expensive to guarantee the capital  (please see, for example, our Post, The Wall Street Put, August 2012). If the guarantee costs at most 4% of the capital (and the guarantee could, in fact, be a profit centre) and the management fees (MERS) and loads could only be deducted from the earnings of the fund, then the management would have to produce a return in excess of 6% per year just to get paid. Surely, that is not too much to ask, is it.

Postscript

Hedge fund managers are warning their clients not to expect double-digit returns this year – should they know or care, having already clocked their 2% commission and, possibly, locked in our funds.

The recent volatility in the stock market, they say, is the wrong kind of volatility – it’s just up and down and up and down and all the stocks are rising and falling, rising and falling, like boats adrift.

What hedge fund managers really need is the other kind of volatility – basically, up and down and up and down, but confined more to individual stocks in markets that might or might not go up and down and up and down. Sounds profound, absent rocks and shoals.

Reuters – June 22, 2010 – J. Gaunt & L. Fletcher “You have higher volatility – which is good – but higher correlation.  So natural hedges are hard to put in place.”

One might think that the problem is further compounded by billions of pension fund monies now committed to glamorous and sophisticated hedge funds with good performance several years ago (not including 2007 and 2008, of course).

New York Times – August 3, 2007 – Jenny Anderson “On Monday, Sowood Capital … announced it would shutter its funds seemingly overnight, leaving Harvard’s endowment with a $350 million loss.”

This year, then, expect a cash return, that is, no capital gains,  from a properly designed “hedge fund” in volatile markets although many hedge funds are also slanted to the long equity return – if there is one and if they’re around long enough to find out.

If it does something else, then we won’t know what it is “until the tide goes out” (Warren Buffett) and we can see what “shorts” they’re wearing because hedge funds are unregulated by the SEC and don’t even need to keep audited books. We also have the further illuminating and sales worthy statement of Mr. George Walker, head of Goldman Sachs alternative investment strategies group, and second cousin of former President George Bush:

Forbes – May 24, 2004 – N. Weinberg & B. Condon “Sophisticated institutional investors have torn apart the hedge fund business. They’ve read or written the studies and know exactly what they’re investing in.”

Alas, it sounds hopeful and well-meaning but it seems that our retirement monies are being run by dupes, and we have only ourselves to blame. The better economists of today have long since denigrated mean-variance methods and the size, scope, and opportunities of today’s global financial markets suggest that the cherished and simplistic (statistical) model is nothing more than a skiff in thirty-foot waves – RiskWerk, June 2012.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”.

Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability.

We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now.

The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”,  ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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