Seeking Alpha

Chris DeMuth Jr.'s  Instablog

Chris DeMuth Jr.
Send Message
"It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it - who look and sift the world for a misplaced bet - that they can occasionally find one." - Charlie Munger I look... More
My blog:
Rangeley Capital on Harvest
My book:
Rangeley Capital Best Investment Ideas
  • What Do Hedge Funds Do? 17 comments
    Feb 12, 2013 9:09 PM

    Why are "Unregulated" Hedge Funds "Secretive" and Why Are Their Managers "Reclusive"?

    Regulations

    Legislation called the American Jobs Act was recently signed into law that broadens what the hedge fund community can disclose to the outside world. While a lot of people in our area work for them or invest their money with them, they have historically operated under severe restrictions about what they can say about their work. This has led to the habitual descriptions of "secretive" or "reclusive". Such villanous-sounding folks were typically also "unregulated", despite the detailed regulations preventing their activities' disclosure. So, now that they can spill the beans, what do they do?

    Research

    Hedge funds are primarily research operations. The research that hedge funds produce is primarily based on original sources. In this regard, it is a bit of investigative journalism or detective work. It involves an enormous amount of reading.

    Researching What?

    Prices, and more specifically, mispricing. In other words, they are in the business of finding flaws in markets and fixing them for a profit. Here is where hedge funds really are completely different than traditional money managers, even though the basic description sounds similar. Conventional money managers pay a given price for stocks or bonds in order to expose their investors to that risk. Hedge funds are doing something that looks similar but is completely different. They are researching all types of markets in order to wait for a flaw in the price system. Markets can operate smoothly, rationally, and efficiently most of the time. But sometimes they don't. Why might prices fail? Essentially price has to do too many things at once. It has to sort out differences between views on what something is worth - value - but also sort out differences in terms of how much someone wants their money back - liquidity. Occasionally the job that a single price has to do leaves it out of whack. That is when hedge funds swoop in.

    Partnerships

    Finally, hedge funds are partnerships, but in structure and in substance in ways that few other industries still are. Fund managers usually have much of their wealth in the funds that they offer to investors. For better or for worse, they are on the same team. In the 1800s, private partnerships dominated the financial services industry, but they died out throughout the 20th century. And in this century, when we went through the greatest financial crisis since the Great Depression, the epicenter of the crisis was our government and public corporations. With so much of their own money at stake, most private partnerships behaved much as they have for centuries. There were few hedge fund failures and none that threatened the stability of our economy or required a bailout. They were researching, waiting, watching, and finding price failures.

    Hedge Funds Regulate Markets

    Unregulated? The short answer is that it is simply untrue. Hedge funds have regulators. However, the longer answer is that hedge funds are market regulators. Average investors have little by way of resources to bear on any one investment, that they cannot be faulted for research that tends to be light by hedge fund standards. It is normal for hedge funds to spend hundreds if not thousands of man hours on a given investment, with research into every conceivable aspect of a potential investment. Due to the intense pressure for fund managers to operate on a timely basis, this work is typically done months or sometimes years before a government regulator has looked into a market. What do fund managers find? Many of the accounting frauds of the past few decades where discovered by hedge fund research well before the government or auditors. Hedge fund research first drew attention to structural flaws within housing finance, bond insurance, and sovereign debt. Hedge funds have the motive, alignment, and resources to uncover and begin to fix market flaws in a way that is swifter and surer than any government. Unregulated? Hedge funds are the regulators.

    Further Reading

    For further reading on what hedge fund managers do, you might consider Hedge Fund Market Wizards: How Winning Traders Win.

Back To Chris DeMuth Jr.'s Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (17)
Track new comments
  • SA Editor Samir Patel
    , contributor
    Comments (163) | Send Message
     
    This is a great post, Chris - it's nice to have some visibility into what goes on in the hedge fund world. Thanks for sharing.
    12 Feb 2013, 09:30 PM Reply Like
  • Chris DeMuth Jr.
    , contributor
    Comments (4037) | Send Message
     
    Author’s reply » You're welcome! -C
    12 Feb 2013, 09:36 PM Reply Like
  • Hypnos7
    , contributor
    Comments (141) | Send Message
     
    There are of course many strategies employed by hedge funds -- this kind of fundamental research is one of them.
    12 Feb 2013, 10:01 PM Reply Like
  • Chris DeMuth Jr.
    , contributor
    Comments (4037) | Send Message
     
    Author’s reply » Yes, you are exactly right.

     

    Perhaps I should not have sounded as if this was speaking for all funds; instead, my thought was to express the view that the idea of hedge funds in popular culture is somehow nefarious, when the reality is far from that image. Actual activities of such funds can be, at least in some instances, pretty innocuous.
    12 Feb 2013, 10:06 PM Reply Like
  • SafisKusai
    , contributor
    Comments (233) | Send Message
     
    If only this wasn't just on a financial website and was something written in the actual media where hedge funds are seen as demons out to make money. I think if more people realized some of the great things hedge funds have done in the past like the regulation you speak of, (Einhorn on Allied Capital; Soros on the Brit Pound; Chanos on Enron) then people might like them much more as they are as you say giant research operations. Einhorns 100+ slide powerpoints are always fascinating with how much research there is.

     

    While short sellers probably will never be popular on Wall Street, they often are the ones wearing the white hats when it comes to looking for and identifying the bad guys! - Jim Chanos
    12 Feb 2013, 11:04 PM Reply Like
  • Chris DeMuth Jr.
    , contributor
    Comments (4037) | Send Message
     
    Author’s reply » Exactly! I like profit, but I love justice. In each of the cases that you mentioned, hedge funds positioned their interests between the price on one hand and the value on the other. They happened to be short positions only because the value was less than the price. Everything that they did and everything that they said was profit-seeking, but they were also revealing what the value was and in doing so, brought these companies to justice. For further reading, here is a bit more about the pace of investors versus the pace of regulators: http://seekingalpha.co...
    12 Feb 2013, 11:11 PM Reply Like
  • SafisKusai
    , contributor
    Comments (233) | Send Message
     
    The last bit you talk about in that article is the biggest thing. More has been done to regulate shorts than to regulate actual frauds.

     

    Every time disaster happens to a sector, the government all of the sudden blames the shorts (who will expand the coffers of the government through taxes on their profits as opposed to the losses on the fraud) and end up banning short sales and dragging out a slow, illiquid death of a companies value and creating long periods of turmoil... no one likes a slow death, rather get it done quick and start rebuilding right away.
    12 Feb 2013, 11:24 PM Reply Like
  • Sal Marvasti
    , contributor
    Comments (1364) | Send Message
     
    Chris, too much of regulation can be self fulfilling prophecy.
    Hedge funds also do algo and statistical arbitrage trading. I guess we are talking about two different types of hedge funds.

     

    Its like if you tell people the economy is bad, it really does go bad. If you short a stock enough, you can actually bring it to the brink of disaster. Its all to do with a debt run economy. I won't elaborate here on a single comment.
    Psychology is the economy, not the other way round. If you make people believe the economy is bad, it will go bad. Very simple.
    Think what happens when people stop spending.... Its a game of did the chicken come first or the egg.
    12 Feb 2013, 11:51 PM Reply Like
  • Blue & White Investment Club
    , contributor
    Comments (26) | Send Message
     
    Reflexivity at its finest
    13 Feb 2013, 09:35 AM Reply Like
  • mrholty
    , contributor
    Comments (816) | Send Message
     
    Chris-

     

    Few questions for you regarding the HF structure.

     

    1. Where does most of the investment in HF's come from? Individuals, corporations such as banks/Insurance investing part of the capital, WS firms (such as Goldman)?

     

    2. When you started your fund, what was your biggest challenge? How do you get funding from people who may know nothing about you other than their name?

     

    3. If you were in charge of the SEC or any other government body that regulates the HFs or securities fields what would you do? Close the HF exemption for the 15% tax rate on gains, HFT limitations, splitting up investment side of banks and IB.

     

    Best regards.
    13 Feb 2013, 06:27 PM Reply Like
  • Chris DeMuth Jr.
    , contributor
    Comments (4037) | Send Message
     
    Author’s reply » Thanks for these questions. Let me try to answer each of them.

     

    1. In my case, most of the investment comes from me (and my family). We have a few additional families and individuals who have joined us through the years.
    2. Finding situations where price massively diverged from value. Slowly, and then more over time following performance.
    3. None of the above. I would focus on a single regulation: rigid capital requirements. As long as financial institutions are dealing with their own equity, the rest of us are much safer.
    13 Feb 2013, 07:26 PM Reply Like
  • mrholty
    , contributor
    Comments (816) | Send Message
     
    Thanks Chris.
    14 Feb 2013, 06:36 AM Reply Like
  • Wall Street Teacher
    , contributor
    Comments (399) | Send Message
     
    I. I would love to see quarterly institutional reporting for both long and short positions. Some of the honest hedges who make a short bet are crucified by the media who likely does not appreciate that this skeptical segment of the investment community often performs a critical oversight function. I think quarterly filings will help to spread light on folks' views and maybe the honest hedge funds can be encouraged to explain their rationale for a given bet be it long or short.

     

    II. In the biotech area(where many unscrupulous hedgies operate), I think those involved in trials should e criminally prosecuted if they leak data. It is an abomination that results are often known prior to public relase since these binary events often seal the fate of a small issuer.

     

    III. Dark pools and their ability to transact away from normal (linked) markets bothers me. Regular investors are exposed to risk when sitting on the NBBO and often are not rewarded for their exposure. Reg NMS forced the first generation alternative execution systems to link to traditional venues. Why are dark pools exempt? I fully understand the mutual funds desire to stay out of the HFT fray, but that is life in a modern market.
    16 Feb 2013, 04:15 PM Reply Like
  • Chris DeMuth Jr.
    , contributor
    Comments (4037) | Send Message
     
    Author’s reply » Those all sound as if they are sensible ideas to me.
    16 Feb 2013, 07:43 PM Reply Like
  • kingry
    , contributor
    Comments (43) | Send Message
     
    Great post, I am starting the process of learning where HF's fit in the financial system and have some questions...How do you feel about a firm like Muddy Waters? Granted, they have exposed some large frauds, but do you see any risk in going too far down the spectrum? To the extent that the government can catch up on regulation, do you see a better balance between government regulation and regulation through HF activity?

     

    Regards,
    5 Mar 2013, 09:07 AM Reply Like
  • Chris DeMuth Jr.
    , contributor
    Comments (4037) | Send Message
     
    Author’s reply » I think that Muddy Waters is a terrific firm run by highly rational, analytical people. Do I see any risk in going too far down the spectrum? No. The better balance would be for the government to set capital requirements, then get out of the way and let the market act.

     

    “There is not a truth existing which I fear or would wish unknown to the whole world.” – Thomas Jefferson to Henry Lee, 1826. ME 16:179

     

    Chris DeMuth, Jr.

     

    Rangeley Capital
    3 Forest Street
    New Canaan, CT 06840
    203.801.9969
    ccdemuth@rangeleycapit...
    5 Mar 2013, 10:58 AM Reply Like
  • kingry
    , contributor
    Comments (43) | Send Message
     
    Thank you for the response!

     

    Regards
    6 Mar 2013, 05:31 AM Reply Like
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Most Commented
  1. GCVRZ Forum Archive (1,000 Comments)
  2. Event Driven Q&A Forum (224 Comments)
  3. GCVRZ Forum (149 Comments)
  4. GPT Forum (127 Comments)
  5. Shorts Forum (120 Comments)
Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.