Hedge funds should learn past lessons
FREE email from MoneyWeek
Discover the latest profit opportunities and understand what’s really going on in the investment world with our punchy daily email. CLICK HERE
This genius investor does dizzying levels of research to uncover...Half Price Shares!
“While the hedge fund community will almost certainly survive, the landscape has certainly changed...
1. Many more funds will probably close. The rumour going around that there are more spectacular failures and bailouts waiting in the wings seems unlikely. Many supposedly market-neutral funds have been exposed as being anything but neutral. Their investors will be redeeming their shares and many funds will simply shut down as a result.
2. The funds that survive are going to reduce their leverage. There will be a backlash from bank credit departments against the surviving funds. Hedge funds will need to post more collateral and the banks will be more conservative in their pricing of the collateral. This will result in lower returns posted by the hedge fund community but also commensurately lower risk. Investors used to 15% annual returns from hedge funds will probably have to get used to 10% for at least the next few years.
3. Investors will diversify their holdings across many hedge funds. One of the most surprising things about investors in hedge funds is that most currently hold relatively few funds. Even funds of hedge funds often invest in only a handful of funds. Investors will look at the impact of a 100% loss in one of their funds and realize that the best way to invest in hedge funds is to take small stakes in a large number of funds."
The more astute reader will appreciate that the commentary above does not relate to the current hedge fund panic, but to the aftermath of the failure of Long Term Capital Management, back in 1998.
There is truly nothing new under the sun. In the article, the author addresses a number of misconceptions about hedge fund investing in the light of Long Term Capital's now well-known collapse. Given the heightened anxiety of the current rumour-driven market (The Sunday Times namechecks GLG, Cheyne, Ferox, Bailey Coates, Polygon, Rubicon, Vega, Moore Capital and Brevan Howard under the hardly nuanced title 'City hedge funds head for domino collapse'), his article is unusually topical:
"There are many lessons to be learned from LTCM.
1. Diversify
(Article continues below)Advertisement
2. High return investments are also potential low return investments
3. Trading in illiquid secondary markets is potentially disastrous in extreme market conditions
4. An asset that returns in excess of 30% per year, as LTCM did, is a very risky investment.
These are, of course, lessons that are true for all investments, and have nothing to do with the fact that LTCM was a hedge fund."
One can also suggest that, as with LTCM, ostensibly sensible-looking trades can turn toxic if allied to imprudent leverage and accompanied by a market climate of panic which causes many asset classes and trading strategies to become highly correlated.
In the washout of the current debacle, anything that slows the creation rate of new hedge funds, encourages a greater emphasis on disciplined risk management and drives out some of the weaker players has to be seen as a positive development for the industry.
Tim Price is Director of Investment at PFP Wealth Management. He also edits The Price Report investment newsletter.
FREE! For all our latest advice on making profitable investments, claim your 3-week FREE trial of the MoneyWeek website and magazine now.
Money Morning is the FREE daily email from MoneyWeek
– a punchy round-up of the latest investment news and profit opportunities.
DON’T MISS IT!
