daily volatility, non-correlation …and beta (ii)

This post is about hedge funds.

hedge funds:  a purist’s view

To a purist, a hedge fund is about hedging.  That is, it’s about running a portfolio with offsetting long and short positions.

Conceptually, this can be done either by assembling pair trades (one long, one short, often both in the same industry) or by creating opposing portfolios of good ideas and clunkers.  By using the money obtained from borrowing, and then selling, the hoped-for clunker stocks to fund the hopefully strong-performing good ones, the hedge fund manager ends up with no net exposure to the securities market he’s working in.  His return consists in the spread, if any, between the performance of the aggregate long portfolio and the shorts.  In a perfect world, he never loses money, although the amount he makes in a given year is up in the air.  It depends on the relative valuations of the “good” and “bad” securities that his market gives him.

(By the way, I worked on, and briefly ran, a very successful short-only portfolio for an innovative institutional client in the early 1980s. We pruned “bad” stocks from an S&P 500  index fund and reinvested the money in the rest of the index.)

today’s version

In today’s world, hedge funds are a motley group of mostly strongly net long, mostly highly concentrated portfolio strategies.  They do have common characteristics, though.  They charge very high fees, and as a group they’ve underperformed the S&P 500 pretty continually for more than a decade.  Also, many times it’s hard to get your money back if you no longer want to participate.

why institutional support, despite weak returns?

Why do pension funds continue to support hedge funds with a tolerance for weak performance they would never exhibit with long-only managers?

Two reasons:

–the claim of non-correlation with stocks and/or bonds.  This is basically a rerun of the fallacy of gold as a zero-beta asset, and

–the low expected return from stocks and bonds.  To pluck numbers out of the air, let’s say that over the next five years we can expect returns of 2% annually from bonds and 6% from stocks.  A portfolio made up of equal portions of both asset classes would have an expected return of 4% per year.  Suppose the actuarial assumption of a plan sponsor is that the plan is fully- or mostly-funded if the plan can achieve of 5% annual returns–or maybe 6%.  The plan managers, who hire outside portfolio help, have no way of get to either goal using conventional long-only investments.  That’s even going all in on stocks, which sponsors find too risky.  So the managers can either tell the sponsoring organization to add more money to the pension plan   …or they can hire hedge fund managers with pie-in-the-sky stories of high potential returns.  Until very recently, my observation is that they’ve by and large chosen the latter.





3 responses

  1. hi

    thank you very much for the interesting blog.

    i have a question on the second hedging strategy you have mentioned in the second paragraph.

    can you please explain how it works that you dont have any risk? and what is the role of borrowing money, is it from the bank?


  2. Thanks for your comment. Two things:
    –today’s hedge funds seem to me to generally be highly concentrated long portfolios. That is, they mostly own a small number of huge-sized long positions. Those may be stocks, or bonds, or commodities futures, or options. But they are by and large betting that the somethings they own will go up in price.
    In contrast, the traditional hedge fund figures out things it doesn’t like, borrows them from the owners in return for an IOU (there are issues of collateral and fees for the use of the assets, but let’s ignore them) and then sells them. That gives the hedge fund a pile of money that it uses to invest in things that it does like. In other words, the money for the long positions comes from selling the shorts. Again traditionally, the size of the long position is exactly the same as the size of the short position. So one offsets the other. If there are long bonds against short bonds, long stocks against short stocks…there’s no net long or short position.
    –this doesn’t mean there’s no risk. There’s no market risk if, the bet against the stock market (the shorts) is the same size as the bet on the market (the longs)…. The two cancel one another out. There are other risks, though. If the supposed clunkers do better in aggregate than the supposed winners, the hedge fund will make a loss. Worse than that, if the owners of the borrowed assets ask for them back while the hedge fund is in this situation (they’re allowed to do so with a few days’ notice, although the reality is a little more complicated than that), there won’t be enough cash from selling the longs to repurchase the shorts and return them. So there’s what one might call execution risk.

    I know this all sounds a little weird. What makes it a little more counterintuitive, the shorts don’t have to go down for the hedge fund to make money. They just have to do worse (up or down) than the longs.

    I hope this helps.

    • thank you for the fast and clear replay.

      i didnt quite understand though what is the different between the traditinoal and the new generation hedge funds. they are both betting, only the the old one can win in two scenrioes out of 4 – good stock go up better than bad or bad stock goes down deeper than the good one; and in the long only position only one secenario out of the 2.

      does the old hedge fund has another source of making high yeild like leverage or somthing else? would i was suppose to do extra return on my equity beacuse i used my own equity and the money from the short position? but than i am not covering my long short position in the same amount…


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