Tuesday, February 28, 2006

Hedge Funds - High Risk

There are many types of Hedge Funds.

Originally hedge funds started as a way to control market risk. Most folks agree it is almost impossible to guess where the markets will go tomorrow. At least honest folks agree.

There are a million ways to make money in the markets - and all of them are short lived and hard to find.

Some money managers decided to hedge their risks - buy companies they liked - fade (sell short) companies they didn't. This theoretically would allow them to make a profit and avoid loss regardless of market direction.

Hedge funds
were touted as wealth defense.

Very few true hedge funds were created and then survived. Investment managers soon discovered they could structure a hedge fund around regulation - huge profits for investment management then assured success of the name hedge fund.

There are now thousands of hedge funds. Statistics on their success have a decided survivability bias, even stronger than the regulated mutual funds..

Bill and Martha go to Vegas, Bill lose money all week, and Martha beats the odds and has a big win one day. If you remove the losses - as many people psychologically do - they were big winners. If you have enough
Bill and Martha teams - a few will be big winners for many years in a row.

Say you start the year with 3000 hedge funds taking huge leveraged risks. Five hundred hedge funds win big and start attracting hot money. One thousand hedge funds do horribly and close or merge. The 1500 hedge funds in the middle languish and wait for next year. Of course when money managers look at the cash made by the top 500 hedge fund managers - you will have more than 1000 new hedge funds for the new year.

survivability bias looks at the above information and says we have more hedge funds than last year - and the older funds have done fantastic. Avoiding the math, the huge overall gain is largely due to the losing hedge funds disappearing totally or merging themselves into a "successful" hedge fund.

Lets look at the top 500 hedge funds in the above example. Next year assume 100 have a great year, 100 are so bad they close or merge, the other 300 can still brag on their "results since inception." The top 100 managers paychecks and egos are now huge. Continue and after 5 years you will have a few wealthy "superstars of finance."

You could do the same. Maybe that's how Hillary made a hundred thousand in the commodities market and only "invested" once. The broker could have two opposite future accounts opened and leveraged them to the hilt. One account went up $100, 000.00 while the other account went down a similar amount. Surprise - Hillary had the one that "earned" 100k.

The next view of hedge funds is less charitable. The first notice of this type of scam I am aware of is in a book recommended by almost every top investor, advisory, or speculator - Confessions of a Stock Operator.

The latest version of the scam will be in tomorrow's email.

The way con artists can do the same thing is to send out 200,000 emails telling about their "new" program. 100k emails will recommend going long in Soybeans and 100k emails will recommend going short. Half of the recommendations will have big gains and receive a new email - half recommending going long in pork bellies, half of the emails recommending short. After two wins money will start to come in for "investment" in the program. Repeat to the "winners" and the cons are an expert with a great track record according to the "lucky recipients of the offer." Rinse and repeat.

It's a bit like being an economist: if you can't guess right - guess often.

Today almost all hedge funds share one characteristic - high unhedged leverage. Those that blow up will not be around to taint next years graphs of hedge fund returns.

My opinion is derivatives will probably cease to exist in their present form after they are blamed for the next depression. In the interim they are frequently tools of excess leverage that are hidden behind the doors of many huge banks. These banks are counter-parties to largely unregulated hedge funds and overly creative corporate and government finance departments.

This derivative balloon will not end well.

Those that claim nothing has gone wrong since LTCM are like the fellow that jumped off a fifty story building. As the jumper passed each floor folks could hear him saying; "so far so good - so far so good."

Consider the above before you invest in a hedge fund.

The graph a hedge fund shows you is of them as a small percentage survivor, the past is definitely no assurance of next years results. An "unforeseen catalyst" may cause devastating losses.

Heck if it was foreseen the hedge funds would have prepared for it. Bad things will continue to surprise in the future.

Here is a repeat of an important speculation rule that greatly applies to investing in hedge funds:

Life is not linear.



Blogger Think Extraordinary said...

There are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk.Investment Risk

2:33 AM  
Anonymous Anonymous said...


Thank you for the comment. There are other risks, counter party risk comes to mind. This risk like some others is hidden by lack of disclosure, how do you defend yourself against the unknown?

The risk most apparent now is "the madness of crowds," that believes thousands of hedge funds can be able to beat massive fees and still consistently yield an above average return.

4:48 AM  

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