Hedge Funds the Next Bubble?

March 25, 2008 | Leave a Comment

As the flight to liquidity continues it’s hard not to notice that macro and managed futures strategies, particularly those focused on natural resources, have been the beneficiaries of the asset flows (check out the hedge fund index numbers: macro has been on fire while all other strategies have been taking lumps).  There is massive momentum here, but do the fundamentals justify the valuations?  Although most of the securities underlying these strategies are liquid, they are still subject to significant declines if everyone heads for the exit at the same time.  We’ve seen it before and we’ll see it again: money can leave a strategy just as fast as it entered the strategy.  Furthermore, as we have seen in the past, many traders and fund managers are geniuses on the upside (see the tech bubble), but are susceptible to getting carried out in the midst of a sustained downturn in their asset class (see the bursting of the tech bubble).  Are your macro managers the inheritors of market beta now (i.e., luck), or can they effectively manage exposures and minimize risk during periods of downside volatility?  In any event, this still does not relieve you of your responsibility to diversify across sub strategies, asset classes, operational risks, and multiple market risk factors. 

We say: Diversification, Diversification, Diversification!

Hedge Fund Returns on the Cheap, Really?

July 6, 2007 | Leave a Comment

We have been acquainted with Dr. Harry Kat (professor of risk management at Sir John Cass Business School, which is part of City University in London) for a number of years. In fact, we use some of his research to justify why investors are well served to take a look at emerging hedge fund managers over their well established colleagues. Recently, Harry Kat was interviewed by The New Yorker about his latest endeavor, a software product designed to generate hedge fund returns mechanically and cheaply. In particular, Kat chose to try and replicate the returns of the Quantum Fund run by George Soros. To quote the article:

“It is possible to design mechanical futures-trading strategies which generate returns with the same, and often better, risk-return properties as hedge funds,” he said. “This means investors can have hedge-fund returns but without the massive fees and all the other drawbacks that come with the real thing.”

One of Kat’s main complaints about hedge funds, or maybe not necessarily a complaint but an observation, is that the 2 and 20 compensation model used by hedge fund managers negates the returns for the investors. Now Kat does not claim his FundCreator product will match Quantum before fees, but it will match or at least come close after fees. To be fair, Kat understands this and makes it clear in the article by stating …

“People say, ‘Look, you don’t generate any alpha.’ After fees, I generate a lot of alpha. I just generate it differently. Instead of trying to beat the market, I get the fees down.” He conceded that there will always be hedge funds whose returns FundCreator can’t hope to match, but he argued that even some of the most prestigious funds owe much of their success to luck. “You can be fortunate,” he said. “You can live off market trends for quite a while. As in credit spreads”—the difference in yields between different types of bonds. “Credit spreads start to come down, and you make lots of money in credit. A couple of guys from an investment bank’s credit desk jump out and start a fund. If they are lucky, the trend continues for another couple of years, and they will look like masters of the universe. But when the trend reverses, or when there is no trend left, they are in trouble. If a guy has done well for two years, what does that mean? He could be really smart, or he could be really lucky. If I had bought stocks at the end of 1997 and you had looked at me at the end of 1999, I would have looked brilliant.”

And of course it is nearly impossible to distinguish between genuine investment skill and random variation. Yet, some firms manage to generate high returns with low volatility.

But the point is whether or not hedge fund managers will be sidelined as computer programs like Fund Creator continue to be tested, developed and marketed? This may threaten some of the more “traditional” hedge fund strategies such as long/short rather than global macro. Or maybe not. In the mean time, we would not worry much about it. We are thinking of contacting Harry Kat to get more perspective on his research and FundCreator product. Stay tuned.

Can Hedge Fund Talent and Skill be Mass Produced?

April 17, 2007 | Leave a Comment

One of the aspects of the hedge fund industry that has always intrigued me is how true talent and skill can rise to the top. When I saw this story appear on The Red Herring recently, I had to ask myself — can a parallel be drawn that might help illustrate the complexity in achieving this?

Goldman Sachs, Merrill Lynch, and J.P. Morgan have rolled out tools to replicate, or clone, hedge-fund-style performance without the standard fees, which typically amount to 2 percent of assets and 20 percent of any gains. Industry players say mainstream mutual funds or exchange-traded funds based on exotic hedge fund strategies could be launched within a year.

IndexIQ, based in Rye Brook, New York, which opened its doors in June and raised $5 million in an A round from angels and financial-industry backers, is joining the effort to create synthetic hedge funds by building and licensing indexes that track hedge fund strategies. One such strategy could be betting on global “macro” trends.

My first reaction is to wonder if this is similar to George-Pierre Seurat’s attempt to quantify human emotion through a new language of art and a scientific method to painting. This announcement by Merrill, Goldman, etc sounds similar to me. However, maybe I’m reaching? This weekend I went to see the current exhibit at the Museum of Fine Arts, Houston, The Masterpieces of French Painting from the Metropolitan Museum of Art: 1800 - 1920 so I had painting on my mind.

Can talent/skill be bottled and marketed?

Comments