Alex Trias

Hedge Funds: Back to Basics

The issue may go beyond hedge funds, per se. I'm going with the theory that statistical arbitrage is what's getting pinned down at the moment. Statistical arbitrage works only when trades don't get too crowded. Once the trade gets crowded, the only way to garner returns is through leverage. Take away the leverage, and we all know what happens.

Why is statistical arbitrage really going into the soup? The simple reason is that it adds nothing to the market or to the economy. In the good old days, investors would give some money to a company in exchange for stock, and the company woudl take that money, build factories, hire people, and produce and sell products. It makes sense that the investor would get paid for helping the economy get things done. What does a statistical arb trade do for anyone? Add liquidity to the markets? So what! Add price efficiency? The opposite! Statistical arbitrage has nothing to do with whether a company is valuable, or makes good products, or anything - so trades based on statistical arbitrage really obfuscate information efficiency. So it makes sense the market would deliver negative returns to these folks over time - what's odd is how long it took this time around.

So, here's a new model hedge funds might want to explore: invest in companies with good earnings, get in at a good price, and maybe hedge some of the risk with options if you can get a decent price on those.

No, this will not generate 40% returns a year. Not even close. It's old school value investing with a little less risk. But if the pitch is "invest with less market risk", here's a reasonable way to go.