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Hedge Funds: Rhyme and Reason


Proceed with caution!

If you plan on investing in hedge funds, please consider the following about hedge funds in general and their place within market rhythms.

First, a hedge fund in general should above all control risk because they use leverage. A fund that uses leverage without controlling risk will eventually lose a large amount of capital. It is simply a matter of probabilities: at some point one of those big bets will go wrong and since more and more money is being bet over time, this will cause all the previous gains to be lost.

Bureaucratic "creep" is a good cause of this (by the way, we see "BC" in every institution from governments to companies). What once made the fund successful (like risk control) gives way to self-interest and hubris. The recent failure of a major hedge fund is a good example. They bet a huge percent (probably over 100% of their capital) on the price of one thing going up. Why? Their head trader, because of his success in the past, was able to carve out a deal where he participated directly in a large percent of the fund's returns. This created a "call" option for the trader. He took a huge risk with other people's money because he would benefit disproportionately with success and suffer minimally from failure. Controlling risk allows a fund to make many bets over a long period of time…bets that should have a statistical advantage.

So secondly, a hedge fund should have some kind of expertise, a concentration, where they are able to efficiently extract "spreads" that naturally exist in their market place. This is their advantage. It is like a poker player who counts cards and plays the odds playing others that do not. At the same time, it should eliminate most ancillary risks where they have no advantage (e.g. interest rates).

Hedge funds can employ fairly sophisticated strategies to achieve this, although those strategies should be able to be explained in a straightforward way. One very clear advantage of hedge funds is that they should be able to extract these returns regardless of market "rhythms".
For example, most stock pickers, mutual fund managers, credit investors, premium sellers, and wealthy retail investors rely on one thing: nominal asset prices (like for stocks) to rise over long periods of time. This is due to the fact that central banks use credit expansion (inflationary) as a means of keeping economies "expanding" (at the expense of ever rising debt and less and less productivity); inflation (expansion of money supply) as it erodes the value of currency over time, by definition drives nominal asset prices higher (lower currency valuation equals higher nominal asset price). So these "experts" can be bad stock pickers, bad economists, bad risk managers, but that is hidden by this one fact.

The one very important thing I said above is reduced productivity. This sounds incorrect because the media echoing the Fed constantly talks about increased productivity. I certainly agree that technological advances make an economy more productive, but that is my point. A central bank should only expand the money supply at the very most commensurate with economic growth (in reality, they should not even do this as it distorts real market dissemination of credit); by expanding it more they make credit conditions too easy allowing unproductive companies to survive and compete for resources like energy. This drives up costs which hurt the productive companies. Technological advances actually occur less frequently because of this. A recession is actually a healthy and natural process of destroying unproductive capital. What is unnatural is central bank policy that grows the money supply faster than economic growth (10% vs. 5%). This masks the unproductive forces growing along with too high debt growth. The only productivity we then talk about is what becomes necessary: productive companies like Intel having to cut costs through lay-offs and reductions in benefits. This is why income is now lagging in the U.S. economy.

If this rhythm of ever expanding credit and inflation is ever interrupted where credit actually begins to contract due to excessive debt, inflation will turn into deflation (credit contraction) and all the warts of mainstream Wall Street will suddenly be exposed. No wonder central banks complicit with Wall Street are desperate to keep that from happening. However, all their efforts to avoid this are cumulative and create more pressure for such to happen in the future. Bureaucratic solutions and manipulation of market forces will only delay and increase subsequent market forces. A normal correction and recession which would be a healthy thing becomes something much worse and unhealthy (although necessary). Attempts to "hyper-inflate" will work for a time, but inevitably lead to the same conclusion.

Make sure your hedge fund strategy can weather such a storm. Remember, there are many funds that call themselves hedge funds, but are in reality levered funds playing the same market rhythm that everyone else is playing.
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