Wednesday, September 29, 2004

The Hedge Fund Paradox

Today's [$] WSJ article talks about JP Morgan's recent purchase of Highbridge Capital. Of particlular interest:

But in the last five years, investors have rediscovered a stock-market maxim, stocks can actually go down. A couple of years in a row of 20% or more losses is like getting hit in the head by a two-by-four -- once you come to your senses, you quickly figure out how to avoid getting hit again. The answer may be hedge funds. In 1949, a guy named Alfred Winslow Jones figured out he could improve his investment returns by borrowing money to buy stocks with one hand and simultaneously selling stocks he didn't actually own with the other. If he constructed the right transaction, he could make money in a raising or falling market. That's how he discovered a 'hedge.' A.W. Jones is still on a door over at One Rockefeller Center.

Of course part of the reason that the "hedge" strategy has worked so successfully in the past was because not everyone was doing it. When all the "smart" money flows into hedge funds, all the "dumb" money will eventually follow. When this happens look out. We've already begun to see the effects of this in the number of hedge funds that have started up in the last few years. It's a statistical impossibility for all people to be above average and so it is with hedge funds; they can't all be stars unless they don't have the majority of investment dollars to work with. As they become a bigger and bigger their stellar returns (in aggregate) will revert to the mean.

This will occur because of two primary reasons. First, the need to add personnel to the operation will cause funds to have to take on sub-par analysts, managers, etc. just to fill seats in the organizations. Second, as they take on more assets and become a larger part of the economic landscape their funds will begin to act like an anchor dragging down returns. This will continue as long as assets under management grow.

That little innocent looking statement at the end of the prospectus that past returns are no indication of future performance is not just lawyer-speak. It might more appropriately read, "Past returns are usually an inverse indicator of future performance."
The reckoning on this could be scary indeed.


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