The Hedge Fund Hustle

What would you think if you discovered your mutual fund manager had turned over his portfolio almost 3 times? No, not in a year, in a day. Every trading day for a month. At any long only institution I know, men in white coats would within days have bundled the clearly demented portfolio manager away for some much needed downtime. But hedge fund managers are made of sterner stuff, and their wealthy investors don't ask too many questions but just pay their 2 + 20 (at least until it all blows up).

Greg Coffey, the soon to depart star fund manager at GLG, one of the world's most prominent hedge funds managing $24bn, runs an Emerging Markets fund with $4.6bn in assets. He returned 5.1% in May as he turned over the portfolio 56 times in the month, or on average 2.8 times a day. In total this one fund manager traded $255bn of emerging markets instruments in a month to make 5%. Ask yourself: is that a strategy of genius or lunacy? Is this healthy or sustainable for those investors, the individual concerned or markets in general?

Remember this is not some black box quantitative trading fund like those run by Renaissance Technologies, just a plain vanilla equity fund. No wonder emerging markets have been so volatile recently. As for his investors, perhaps they should reflect on the $500m-700m in broking commissions paid out in that single month. Bet the guy's in line for a few great broker lunches, if he ever gets away from his trading screens. And despite this frenzied activity, the fund has lost 13.4% YTD, worse than the MSCI emerging market index through the end of June.

Both in the initial bear market sell-off last year, and in the recent commodity/financials reversal it has become clear from the correlation of hedge fund performance statistics that most are shamelessly momentum trading, and dangerously exacerbating market volatility in doing so. As hedge funds have proliferated in recent years, investors paying for Alpha are often getting turbocharged Beta; there are only so many smart, gutsy traders to go around. Every year there will inevitably be traders that make a big bet on some idea which proves to be inspired, but long term median risk adjusted returns have been strikingly mediocre in absolute terms and certainly don't justify the extortionate fees.

At the same time details are emerging of the $270m option profit garnered on an extreme option bet in March that Bear Stearns would more than halve within a couple of weeks, an utterly irrational bet on the basis of time decay and implied volatility unless the buyer could destabilize the bank and make success self-fulfilling. If the SEC can't prosecute activity so destructive to the stability and integrity of the US financial system, then anything is fair game for these hustlers.

I stated back in March in Bear Stearns: Hubris begets Humiliation... that 'hedge funds abandoning BS as too risky a prime broker were the death knell; rumors that many of the self same funds were short Bear stock are all too credible and as with the wild speculation in commodities indicate the destructive influence funds are now having on broader market stability.' The increasingly desperate and reckless tactics undertaken by a small but dangerous minority of hedge funds to earn their 20% plus performance fees are one of the biggest systemic risks as we head into the Autumn. The shadow financial system of which they are a key component remains largely opaque and unregulated.

I believe the risks of an LTCM style disaster in the hedge fund industry, with spiraling collateral damage via prime brokerage activities at investment banks and liquidation upheaval, are now better than evens, and may trigger a renewed slump in the market. I compared the activities of some hedge funds previously to Crackheads in a Casino, but actually, with the benefit of hindsight, that's a little harsh. On both drug addicts and Las Vegas, that is.

Comments

[notsosmart:]

its all become a game to the advantage of the insiders.(even some of them lose). wallst has become vegas but as you lose nobody brings you a drink.you cant believe anybody about anything.think for yourself. all have an agenda (mainly their hand in your pocket).sad.

2008 Aug 16 11:32 AM

[viewfromnyc:]

This is one of the dumbest posts ever. Lets' see a hedge fund manager (of course it has to be a hedge fund manager, not a prop. trader from an investment bank) manages to make 5% in one month net of fees and commissions and this is a bad thing? How often does prop. capital turnover at investment banks, specialist firms, commodities trading groups? Is it so evil when those who don't charge 2% and 20% do it? And what are the imputed fees paid by shareholders of investment banks and other trading firms to the internal prop. desk traders who get bonuses, car service, expense accounts. Maybe the hedge fund shouldn't have paid any commissions by doing zero trades and made no incremental return for the month.

If trading is so bad, why do we have markets that are open all day and night. Why not just have one price for all trades done on a given day? High frequency traders provide liquidity, to the venerable (sarcasm intended) long only managers, long term investors and all the other constituencies that claim to suffer from excessive trading and volatility. Buy and Hold Long only is a completely mediocore strategy. When you benchmark against annual returns of an index long only is fine. If you were to benchmark against some other measure of maximum potential return in the market, hypothetically say the absolute value of the whole years daily market changes, long only looks pathetic. Theorectically a trader could go long or short the S&P 500 (a popular benchmark) at the end of every day, analogous to betting red or black on roulette. The maximum return if you are right every day dwarfs anything produced by a long only manager. Oh and you can make money in an up market, a down market, and a flat market. The stock market isn't an odds based game like roulette where you can caluculate your expected return. There is information available which allows investors who gather and correctly analyze the information the opportunity to gain an advantage. Market participants who either don't gather the information or don't correctly analyze it and trade/invest accordingly get "fleeced" by those who do. You wouldn't gamble in a casino without knowing the rules of the game, it is no different in trading markets, just that the game is more complex.

No systematic risk comes from trading firms, whether they are hedge funds, prop desks, entering the public markets and providing liquidity. Systematic risk is introduced when someone decides to lend the traders and investors too much money, i.e. LTCM, the mortgage brokers, FNM, FRE etc. The biggest systematic risk in the market right now is derivatives trading. Which is why Bear was bailed out. The large banks seem to think that they should provide nearly limitless capital to investment funds to make bets in the CDS market. The banks and insurance companies also seem to think the counterparties in the CDS market have the creditworthiness to back all the CDS written. This is the same fallacy that lend to the problems with MBIA and Ambac et. al. That is the real potential problem.

2008 Aug 16 12:14 PM

[Aaron Krowne:]

Dumb or not, gearing + hedge and hedge-like funds (including at IBs) seems to have really destabilized things. Far from being an event likely "sometime in the near future", look at what is happening in gold and silver right now: paper market (but only paper market) price collapse; widespread shortages virtually everywhere else.

Luckily, no one has to eat gold or silver.

2008 Aug 16 01:33 PM

[Gina reader...:]

a interesting reading project for you all go read up on the start of the great depression I know it isn't the same but their re many clear parallels between the late 20's - early 30's in what I an watching happen now if the ppt wasn't playing games it would be even starker but they cant stop what is going down only delay it and making the inevitable far worse than it need be

2008 Aug 17 07:44 AM

[irondoor91:]

Re: Instability

The longer a market is stable, the greater the risk (opportunity?) for that market to become destabilzed. Many instituional investors, being human and looking to avoid employment risk, seek out stable markets and stable markets and stable returns because they know it is an easy sell to their constituents and clients. But, in order to distinguish themselves in the marketplace they use ever-greater degress of leverage. Great strategy when there is virtually unlimited liquidity available from the IB's and no real limits on ratios. Additionally, the creation of more exotic levered illiquid instruments introduces additional profit opportunity, which can only be enhanced with more leverage.

Eventually, the market becomes just a little bit unstable because it is actually resting its stability on the back of the least capable managers. Then, it becomes a bit more unstable as those few of the other managers who are holding the same instruments obtain the shaky information coming from the bottom-dwellers. Ultimately, there is nothing to stabilize the market when everyone is heading for the same illiquid exit.

That's where we are today, and it would be much worse if the Fed had not recognized the enormous risk to the entire world financial system inherent in the leverage. Their problem is that they cannot gather all the players into the same room to identify the sacrificial lambs. All those mortgages have been sliced and diced into too much "diversification".

2008 Aug 17 09:57 AM

[johnhaskell:]

Aaron Krowne- you say that there are widespread shortages in the gold and silver markets.

Can you please identify any gold or silver smelters, or jewelry manufacturers/ distributors/ retailers that have ceased operations because of their inability to purchase gold and/ or silver for dollars? Thank you.

As for the crybabies who keep saying that 40-to-1 levered companies long US mortgages and dope-smoking CEO's could only go bankrupt because of a conspiracy, please just stop talking. The adults here are getting tired of hearing the same thing over and over again.

2008 Aug 18 01:40 PM