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Other People's Money


I sure hope these "sophisticated" managers don't crash my party!

Just yesterday I was discussing with the other side of the office the level of systemic risk being assumed by institutions investing in various asset classes. The conversation began around a recent $800+/sq.ft. sale of a downtown building, which will yield south of 5.5% cash-on-cash, but ultimately drifted to what Prof. Succo was seeing yesterday morning: panic selling of options, risk be damned.

While the real estate guys understood what I was describing with regard to option selling, all of them were incredulous that these traders were taking these potentially toxic positions out of simple greed for premium. They are convinced that there are ulterior motives, or strategies at work, that make selling options under the market compelling and/or not risky. Put it differently, they have a hard time believing that sophisticated investors could possibly be taking on that type of risk, knowing full well that such risk exists.

I had a tough time rebutting their skepticism other than suggesting to them that the prices and trades are what they are.

What say you Professor Succo? Are these sellers as dumb as their trades? Is there more at work here than meets the price? How can it be possible that people would jeopardize billions of dollars of other people's money when the relative risk proposition is for all to see at the stroke of a Bloomberg button?

Prof. Succo: They are right and so are you. Although the sophisticated ones are doing the selling, they are selling for the unsophisticated. This is the great disconnect created by "funds".

Unsophisticated investors employ sophisticated managers to better manage their money, to use intelligence and experience to "beat" the market.

Over the last fifty years the average mutual fund has under-performed the S&P 500 by approximately the fees they charge. So the sophisticated are not beating the market after all (although you will see headlines of various managers beating the market from time to time, very few have done it consistently. And it only takes one or two years to waste all those returns. Julian Robertson has lost more money than he ever made for investors even though he beat the market for many years). So what is going on?

Sophisticated managers set up a fund to attract investors. Once they have the money, they "risk" returns in a way that makes little sense as a fiduciary who is responsible for balancing risk and reward because they are in fact betting with other people's money. In this way they have a free option. If they lose, they may or may not go out of business, but it is unlikely they will lose their investors right away, regardless. And if they win, they win big.

In fact the biggest risk these managers have is that they are honest and say to the investor, "Sorry, options are too cheap and we don't want to sell them here." So the investor says, "Then why am I paying a fee to have you manage the money?" So the investor takes the money away.

Of course if they acted like true fiduciaries they would do the right thing anyway. But I believe they instead act to maximize their own firm's profit.

So when funds sell options cheaply they do so because their investors expect them to (or allow them to) even though based on risk for reward they are doing the wrong thing. They can still win even though it is a bad risk.
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