Asymmetrical Information

So, if people are underpricing risk what do we put our money in? Cash?

(the anwer may very well be yes)

How about in my hedge fund that I'm starting? I call it the Opportunities Opportunity Fund. I work on the same island as Goldman Sachs. That should mean I can get at least a billion dollars to start with, right?

'Disaster generally follows' - isn't that awfully strong? I might agree that disaster sometimes follows, but generally?

There needs to be some money going to actively managed funds (the so-called 'hedge' funds or others), or else the market can't possibly be relatively efficient. Too few active investors will lead to higher returns to active trading, which will draw in more active traders, only some of whom will, ex post, manage to beat the others. The equilibrium isn't perfect at all times - mistakes will be made - but there's no stable long term equilibrium without active investors that are making, on average, sufficient returns on their activities.

Do we have too many active investors right now? I don't see how we can measure that. Are people expecting too high a return? Possibly, but this doesn't automatically spell disaster, only future disappointment.

Perhaps there's something more serious that I'm missing. But we certainly shouldn't get too worried just because more money is going to hedge funds, unless those funds are reasonably likely to somehow cause systemic problems (as opposed to simply getting low returns).

How much capital is flowing into Latin American bonds dues to the moral hazard that has resulted from previous bail-outs?

I doubt that much, given that Argentina just gave the finger to western investors, with one of hte biggest sovereign write-downs in history.

Yeah, you're probably right, but I still have memories of the taxpayer coming to the rescue of previous bondholders. Let us hope that the taxpayers aren't left holding the bag when the next bubble bursts.

Regarding people who "have come to expect ridiculously high levels of return": When my company talked about its 401K, they said "historically we have gotten 1%", but then turned around and told us to compute our retirement based on expecting an 8% return. I've seen lots of retirement brochures touting this 8% figure. So investors have not come to have these expectations out of thin air - they are being sold a bill of goods by people who should know better.

Let us hope that the taxpayers aren't left holding the bag when the next bubble bursts.

<cynicism>Well, that's one reason to hop on the bandwagon. If it's a big enough bandwagon, when it falls over, it'll take *everyone* with it. So you're choice is taking a risk, and doing well until the party is over, of playing it conservatively, living on meagre returns, and then losing it all anyway when the fallout sideswipes everyone with hyperinflation or massive taxation of those who have anything left to help bail the country out.

Not only that, but the people responsible for the crash will still be employed because "everyone else did it", so one can't blame them. The people who advocated being conservative will be fired long before.</cynicism>

There is some debate about the odds of a liquidity-destroying hedge fund meltdown (like that of LTCM). One side holds that, as opportunities grow smaller, hedge funds will take increasingly leveraged positions until contagious stopping-out becomes inevitable. The other holds that, because investors have supplied hedge funds with so much money, they have underutilized money enough to step into distressed markets if they see opportunity there.

History does repeat itself, but with variations.

if you are using the right private banker, you can get into closed funds.

a number of good firms are creating many funds so that they can get into a number of things and be able to move the needle by having more smaller funds, rather than one big fund. there's also a lot more private equity and alternative funds that are getting involved in interesting overseas investments. Being in the process of dealing with private bankers and hedge fund managers, there is lots of opportunity out there if you have sufficient capital.

Hopefully the clamor to get into hedgies by mass-affluent investors will not be heeded. They are the people most likely to be fleeced and not be able to afford it. This is about the only time that I agree with regulations, as there are just so many sharks out there when presented with enough of a target, especially since so many of the people that will end up acting like sharks will never have any intention of acting like sharks or any knowledge that they are screwing their investors.

Incompetent traders chasing losses and trying to fix mistakes is what causes most problems (the other being Nobel Prize winners making bad assumptions).

I definitely agree with you in terms of Latin debt. Shorting and putting Lacro debt is the never lose long term bet. The problem is can you afford to be right? I'm looking to go short everything venezuelan as falling oil prices are likely to put chavez in an uncomfortable position. We'll see who goes bankrupt first, Chavez or me.

hedge - a securities transaction that reduces the risk on an existing investment position.

Anybody who invests in a hedge fund for any reason other than the above has no clue what the heck they're doing. It should be only a small piece of your asset allocation (if at all).

Thanks, Jane. Every once in a while I like a reminder of the cheery, upbeat analysis that first drew me here. ;-) (I kid because I love. And because I can't afford to invest anyway.)

And here I thought they called it a hedge fund because the person who sold it hung out under a wall of topiary...

My understanding was that they typically hang out by a shrubbery in close proximity to the Knights of Ni in order to take advantage of the inflated market value of shrubberies in that location -- but I can see the confusion.

winterspeak wrote: "So, if people are underpricing risk what do we put our money in? Cash? (the anwer may very well be yes)"

Cash is paying 4+%. There is too much money chasing too many deals. I don't see anything out there screaming invest in me. I have read that there are 8,000 hedge funds. I belive that number is higher than the number of mutual funds or the number of listed stocks. I donot think that there is enough talent or enough deals to allow all of them to make money after they take out their 2% fee and 20% carry.

Cash. Bank CDs look good also.

Now is not the time for the intelligent investor to be getting into hedge funds, now is the time to be getting out. Same can be said for real estate in certain markets.

Investing is like a crooked poker game, if you can't tell who the mark is, you're the mark.

There will be a lot of bloodletting until investors realize that they will not be able to earn the 1990's level of return they've grown to expect.

Robert Schwartz: Cash is king, but if your pile is big enough, medium duration investment corporate bonds can do a little better (6-7%). But it's gotta be individual bonds held to maturity - bond fund investors are going to get slaughtered in the rising interest rate environment we face now and in the future.

There was also a window for commodities, but it's closed now.

And one can still make money in equities, but it's very rough sledding. We're basically trading in a range right now, and as long as you aren't greedy, you can be profitable. I've traded out and into a position twice this year, using RSI as a trigger. But I expect to be sitting on the sidelines next year, as I'm figuring the range will be broken to the downside. And most investors don't have the stomach for that kind of trading. October was a stressfull month. I'm out and happy in cash now.

well no, you don't have to be hedging a position to invest in a hedge fund. the managers, ideally, should be using a market neutral stategy, and should be hedging any long position with an opposing position that tends to be inversely correlated to a given investment position.

are hedges actually hedging? most of them aren't, most of them are actually levering up and replicating LTCM... not a good thing. unregulated funds are good in their ability to take on innovative strategies and positions, but are bad now that people are just doing idiotic imitative trades and positions.

Did Peter Lynch really beat the market? Unfortunately I've lost the reference, but a book I read some years ago noted that he bought mainly mid-cap stocks, and when compared to a mid-cap index he fell behind.

KevinM wrote:

"Investing is like a crooked poker game, if you can't tell who the mark is, you're the mark."

That is so good, I am going to steal it.

"if your pile is big enough, medium duration investment corporate bonds can do a little better (6-7%)."

Big enough is a loaded term. The extra yield is the spread over Treasuries. To be able to avoid/diversify around credit risk means lots of issuers and lots of bonds. Given trading and research costs, I would think that you would need to be investing at least 8 digits worth in fixed income securities. Nice work if you can get it.

rmark: Peter Lynch showed how smart he is by quitting while he was ahead. Few of us ever do.

One important point undermines a number of arguments here. Hedge funds are not an asset class, they are heterogeneous. There are those that run so-called market neutral strategies, there are 'long-only' strategies, macro/currency-oriented, 'activist investor' funds, etc. So to me, the argument that they are doomed (or blessed) as a class is flawed. So is the equation of the term "hedging" with Hedge Funds. Hedge Funds are more capable of 'hedging' than mutual funds, but often don't.

There are also valid arguments that the hedge fund structure is more conducive to capitalizing on manager skill - degrees of freedom, 'double alpha', size limitations in favor of performance-based fees etc.. Lock-ups are a small part of the advantages Hedge Funds bring to managers. Potential pay is, of course, much better.

There are indeed too many competitors in the space, and I expect a shake up. Some funds will blow up spectacularly (indeed, some already are). So I forecast a high degree of specific risk, but not necessarily a huge negative return in hedge funds. Jane is right to suggest their returns will become more market-like.

The active and long/short trading generated by this growing pool of investors does seem to promote specific volatility in the markets. This is consistent with a much more general trend of micro-volatility and macro-stability outlined here

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