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HEDGE FUNDS
Published: 1/1/05

More and more individual investors and money mangers are allocating assets to hedge funds. The attraction is understandable: showy absolute returns, low correlation with conventional asset classes, and pedigreed mangers. So what is the problem? Plenty.

Initially, some of the best traders on Wall Street, unhappy with their recompense and lack of autonomy, started their own shops. Some of the great minds believed they deserved a more dependable and greater percentage of the profits for their unique trading talents. Wall Street bonuses, although lucrative on a relative basis, can be very subjective and even the highest paying firms rarely give traders 20% of profits (the going rate for hedge funds). The firms believe the organization adds considerable value so no individual is indispensable.

Many funds managers started this way such as the principals of Long Term Capital (that was decidedly not long term at all). Many of these mavericks did quite well for their clients and deserved their out-priced fees. Some of these early hedge funds still maintain their superstar status and matching returns.

The problem with this proliferation is that the number of hedge funds outstripped the number of superstar traders. (Think of major league baseball and the travails of finding quality pitchers) Every quant geek or 26 year old trader with one good year behind him or her started a hedge fund to capitalize on the soaring demand. So too many dollars chasing too few traders caused the inevitable macroeconomic phenomenon: inflation. Only this manifestation of inflation was too many hedge funds. And just as major league ERAs are higher, hedge returns are correspondingly lower.

The next problem is essentially the same: too many traders chasing too few ideas. Currency arb? Buy convertibles and sell the calls? Borrow money in Japan, covert and buy Treasuries? Long/short strategies? Great minds will always find market anomalies, but is your hedge fund trader one of the great minds? This isn’t Lake Woebegone, they can’t all be ahead of their time; some have to be average or even worse, below average.

Absolute return and low correlation (to the stock market) are laudable; however it cannot be produced by just anyone and sometimes even the greatest minds such as the aforementioned Long Term Capital will mess up. So I believe the majority of the current class of hedge funds is incapable of producing the returns their clients are hoping to realize.

In a nutshell, a surfeit of mangers chasing a dearth of ideas equals poor return. Unless you have access to hedge fund mangers or a CTA (commodity trading mangers) that have consistently beaten the market, keep you money in known entities.

Written by: Marty Gallagher

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