Are Hedge Funds a Risk to the System? The Proof is in the Provenge

Echo To All submits: Before you read this, know that I am a fan of hedge funds and think they should police themselves. Nevertheless, I acknowledge the arrogance of some. So with that…

A CNNMoney article reports that the Feds are now saying Hedgies may pose a market risk. The reason I say some hedgies are arrogant is because of Dendreon (DNDN). Hedgies shorting that stock at 5 are down about a half billion. (I am sure they hedged some of their trade, but not all.)

Arrogance like this is what is the problem, not hedge funds. HF investors have to remind their HF managers to remember the first rule of investing: do not lose money. Instead managers are focused on overcoming a hurdle rate or just being greedy.

Some investors are also to blame. When a hedge fund manager blows up a fund, and then 8 months later is able to raise millions upon millions of dollars, the question then becomes, why is the manager going to care about your money? This will lead to arrogance, which will lead to a stupid trade - such as being short DNDN. Or long Natural Gas when the fundamentals at the time did not merit such a trade.

Comments

[jdiercks:]

Investors are very much at fault. As a hedge fund of fund manager I see it first hand. Investors are chasing return, leveraging up risk in what they believe is a low risk environment. This environment however is anything but low risk and at some point they (the private investors) will pay the price in lost principal.

Jeff D.

2007 May 04 09:32 AM

[karpodiem:]

When you have a sizable amount of equity in the hands of fewer and fewer institutions, the chance occurrence of a position going bad and bringing down the house, increases. Whether or not this manifests and brings down a few more firms in the coming years remains to be seen, but typically after a couple of well documented cases in which this has occured, I would think there are a few more safeguards in place that such a event does not transpire.

2007 May 04 10:38 AM

[Amit Chokshi:]

Hedge funds are arrogant because they shorted DNDN? What kind of prime broker will let a fund manager ride out a $4 short up to $20+ or wherever it hit during that phase? Most funds that were short would have gotten out or forced to buy back much earlier. DNDN is hard to locate as well so it's even that much harder to maintain the overall short without addiitonal margin. Also, are there any indications of hedge funds that bet the house on shorting DNDN? I don't think there are so if you run a long/short and are short DNDN with maybe 1%-2% of your portfolio, sure it's painful but you're not first of all riding a short from $4 to $20+ and secondly, other positions should have mitigated the loss.

As for arrogance, whether you're long or short any stock I'd imagine most funds conduct some due diligence before initiating a position. Also, some of the best value investors (Buffett, Pabrai, Greenblatt, etc) have had over 30% of their portfolios represented by just one position at times. The determination of whether these types are arrogant or made a smart bet is all based on the outcome. If the investment works well, ex ante it might look arrogant but ex post it makes them look like geniuses that stood by their convictions and had the right analysis to back those positions. I can bet a guy like Jim Chanos probably gets lashed the most in terms of arrogance due to the duration of his ideas mismatched with short-term expectations. His short on LeapFrog might have been arrogant cause it went up quite a bit and he kept shorting and then, now, on an ex post basis he's once again vindicated.

2007 May 05 10:55 AM

[Everyday Fi...:]

Of interest to some readers of more meager means (don't meet the 2MM net worth, 200M/yr income), there are mutual funds out there that employ hedging strategies that are available to regular investors. They both beat the long run averages of the major indices and they have reasonable fees similar to other actively managed funds; not 20% on profits like some hedge funds (which admittedly, have even higher returns in some cases). For reviews, research and comments, feel free to check out at:

www.everydayfinance.bl...

2007 May 05 04:07 PM

[biomund:]

When you say that the arrogance of the hedge funds is the problem but then recommend that these same entities should not be subject to regulation and review is inconsistent. If corporations and mutual funds have reporting and disclosure requirements why shouldn't hedge funds be similarly be monitored.

A hedge fund investor has a right to know what the degree of concentration and corresponding risk is before making an informed decision. Mutual funds have to abide by rules and it is not seen as an unnecessary intrusion on their investment strategies. Hedge funds have the financial ability to cause serious damage to our financial system if permitted to operate under a wild west scenario.

2007 May 06 03:09 PM

[Echo To All:]

Amit,

"What kind of prime broker will let a fund manager ride out a $4 short up to $20+ or wherever it hit during that phase?"

there really was no choice, the stock moved up to 15 as soon as it started trading from being halted during the AC meeting.

Buffett, i am sure would not, at least to what I know of his trades, put 30% concentration of a portfolio in a seasonal trade hoping for a hurricane to occur. But he would in an entity with a clear durable competitive advantage. Then again, that is the difference between a 30% concentrated speculative play verse a 30% concentrated investment.


biomund,

"A hedge fund investor has a right to know what the degree of concentration and corresponding risk is before making an informed decision"

forgive my ignorance (but i'm not in the biz), but can't investors ask, and if they are not satisfied with the answer, simply walk away and go to a fund that does provide such info?

I do not think it is wrong to have standards as an investor before investing in a management. does not mean you need regulation.


all,

thanks for the comments.

2007 May 07 12:47 AM

[Amit Chokshi:]

Right, I realize that and many funds were forced to cover but again, how does that speak to arrogance. Tom Brown and David Einhorn had good portions of their portfolios in companies like New Century and are likely underperforming due to these positions (Einhorn I believe was on the board of New Century so it made his predicament even more difficult). These two guys are phenomenal investors that run hedge funds and stocks like New Cent immediately traded down on days when bad news was released. Would you call them arrogant or reserve those comments soley for funds that short rather than go long?

Also, while I'm not familiar with the short interest build up in DNDN, do you believe the majority of funds shorted at the low and not in the $5-$8 range and a good portion of the short float was just funds rolling over their exposure in advance of the news? DNDN was a binary play and I think any fund manager on the long or short side recognized that, it was either a 0 or a 5x return event, so if you lose on either side you'd be in trouble. But you're also talking about a microcap biotech, even at its current valuation, so to expound on this being some sort of catastrophic event for fund managers is extreme in my view.

2007 May 07 09:42 AM