The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

Watching A Dinosaur Die ?

07/22/2013

Years ago, I was asked by my employer to consider a transfer to a newly-created hedge fund department, and I’m so glad I did not do so.

After World War II, an Australian journalist in New York wanted to create an investment fund that was “hedged.”  In other words, the fund would retain its value regardless of whatever the stock market did.  This is sometimes called an “absolute return fund.”  (He did this by shorting each stock he owned.)

Over time, hedge funds developed eleven different strategies for making money.  By far, the two most profitable strategies were macro and arbitrage.  The macro strategy depended heavily on either inside information or advance information.  Changes in SEC regulation in 2000 made this much more difficult and penalties much more severe, reducing profitability for that strategy.  In addition, the arbitrage strategy depends on market inefficiencies, such as a temporary difference on a stock on the New York Stock Exchange and the Tokyo Stock Exchange.  When the market moved to decimalization, the differences per share were reduced from 12.5 cents per share to only one cent per share, and profits of this strategy also disappeared.

Only wealthy investors are allowed into hedge funds, because the SEC assumes they have enough money to hire intelligent advisors and can also afford to lose their money.  Currently, wealthy investors have poured $2.3 TRILLION into about 8,400 different hedge funds.  After all, it is obligatory for wealthy investors to mention they are hedge fund investors at cocktail parties, isn’t it?

But, are they still good investments?  Well, so far this year, hedge funds have been beaten by the plain, old-fashioned stock market by over 10%.  This is huge!  At the same time, their fees of 2% annually and 20% of the growth are horrendously high.  Their investment edge has steadily eroded over the years.  Today, Bloomberg describes them as glorified mutual funds for the rich — that under-perform the market.  Rich people get to pay extra for less performance.

Are hedge funds dinosaurs?  Of course not!  They will be around for a very long time, but we will know they are finally dinosaurs when we see people at cocktail parties brag that they avoid hedge funds.

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