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Friday, 20 March 2009

Hedge Funds Ate My Shorts

Poor Investors, Rich Managers

For someone with a sceptical, not to say cynical, view of the global securities industry the trials of the hedge funds over the past year has at least raised a hollow laugh. Managers of hedge funds have traded on their ability to make so-called absolute returns – profits – regardless of whether markets were rising or falling. In return for this they received extortionate fees and eye watering bonuses. So now that we’re facing difficult economic times and nasty falling markets how have they done?

Pretty damn well actually. Most of them have retired, leaving their investors nursing huge losses. Don’t worry, though, they’ll be back to rip us off some more just as soon as people forget.

Absolute Returns "Guaranteed"

At root the ability of hedge funds to generate absolute returns was dependent on their ability to invest across a wide range of, supposedly, uncorrelated asset classes and to go short as well as long. Going short essentially means selling shares or other stuff you haven’t got and then buying them back later, hopefully at a lower price, and pocketing the difference.

Given these advantages hedge funds were supposedly just as likely to make money in falling markets as rising ones. Hedge funds would, obviously, be able to outperform other sorts of funds that could only invest in restricted sets of asset classes and, often, were not allowed to short the market to any significant degree. Yet hedge fund valuations have collapsed over the last year along with the rest of the markets. In fact many hedge funds have done worse than the market, a remarkable effort under the circumstances. So what went wrong?

The Law of Large Numbers

There’s an iron rule in the markets. As soon as someone finds a model that makes money they’ll squeeze it until the pips start howling. And then they’ll squeeze some more. And they’ll keep on squeezing until the model stops working. Which it will, because the Law of Large Numbers makes it inevitable.

The Law of Large Numbers means that the more money there is in any given fund or sector the more difficult it becomes to make excess returns. If you have a few thousand to invest and you’re a good analyst it’s easy enough to find a home for the money by buying a few shares in a cheap company or shorting an expensive one.

However, if you have thousands of millions to put away there are far less places where you can put it. This became a problem for the hedge funds – as they became more and more successful and got larger and larger amounts of money to invest it became more and more difficult to find places to put it and, hence, to generate the kind of returns they marketed themselves upon.

Hedge Trimmers

At the same time, spotting a trend, other companies jumped on the bandwagon to the extent that you only had to slap the label “hedge” on anything and people threw money at it. Hell, they tried to give my gardener a couple of million when all he wanted was a loan for a hedge trimmer. He got a really nice one, mind you.

In the end it seemed that pretty much the whole industry was playing a single game – shorting financial stocks and going long on commodities with other people’s money. Ours mainly, it turns out. Which went really, really, really well until – suddenly – it didn’t. At which point all the things that had been pushing up hedge fund valuations went into reverse, with predictably nasty consequences.

Commodities, Banks and Gearing

Firstly commodity prices simply got out of line with the real-world needs. Oil hit nearly $150 a barrel despite the reality that there was so much of it sloshing around that there wasn’t enough room to store it. Although waves of hot money can sustain market prices at stupid levels for long periods of time they must eventually fall victim to basic economics.

So, no sooner were highly paid and brilliantly educated oil market analysts confidently predicting oil would be at $200 a barrel within weeks than – guess what? The price collapsed, of course. With it went one of the hedge funds’ props. Once the valuations started going in reverse and hedge funds started to sell out the collapse in commodity prices accelerated, making the problem worse.

Meanwhile, governments worldwide were struggling with the ongoing financial crisis and eventually, about a year after everyone else, noticed that the hedge funds were shorting the banks like crazy, destabilising their prices and exacerbating the problems. So a number of countries suddenly banned the shorting of bank stocks. Whereupon many of the hedge fund managers threw their toys out of their prams, started crying and complained that it “wasn’t fair”. This knocked away the second leg of the hedge funds’ strategy and was very amusing into the bargain.

As the underlying investments collapsed hedge funds were forced into waves of price insensitive selling. In essence this meant that they were forced to sell assets at any price in order to raise cash. Why?

Well, the third leg of the hedge funds’ strategy was gearing – borrowing lots of money to invest in buying commodities and shorting financials, secured on the underlying valuations of said investments. As these collapsed the need to find money to unwind their gearing meant that assets had to be sold at any price. As the hedge funds’ valuations dropped investors got cold feet and started to redeem their investments, which meant the funds had to sell more assets in order to pay them. And so, one by one, the dominoes toppled.

Cue stockmarket collapses.

Ponzi Revisited (Again)

Now many funds have either been forced to shut down, paying out a fraction of their previous worth, or to stop allowing redemptions, effectively locking in their investors while awaiting a resumption of normal service, whatever that means. Big fees, I imagine. All of which basically proves that any business model that achieves exceptional returns will attract competition and that competition will eventually ensure that the exceptional returns disappear. Done unwisely the exceptional returns may turn into exceptional losses.

So, what was originally a smart idea executed by smart people, eventually ended up as a giant Ponzi scheme in which the funds received extraordinary levels of remuneration for doing no more than copying each other. Typical fees were 5% of the fund value and 20% of the profits. Every single year. Based on these fees average hedge fund managers would have needed to provide returns nearly on a par those of the greatest investors of all time in order to allow their investors to achieve the same returns they could have got in an index tracker.

Go figure.

The Follies of the Robber Barons

Not all of the hedge fund industry has been a disaster for everyone, however. The really smart hedge fund managers have made a fortune by listing their funds on the stockmarket at the peak of their valuations.

Investors should always avoid Initial Public Offerings (IPO’s) or flotations – when companies first get listed on the stockmarket. This is because the people selling the companies know more about what’s going on than the new investors and they’re not likely to be selling something on the cheap. Especially when they’re as savvy as Hedge Fund managers. This was never going to end well for the buyers of these stocks.

So the leading Hedge Fund managers floated their companies at the top of the market in 2007, took out a fortune in cash and have left their investors holding massive losses. Many of these managers bought the giant folly homes that line the Connecticut Turnpike, originally built by the great robber barons of the early twentieth century. It’s all very apt.

As ever, of course, those who forget their history are doomed to repeat it.

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