In a recent article in response to the massive success of last week's initial public offering of Fortress Investment Group a recent WSJ article noted that :--.
But some recent research reports point to trouble lurking for the $1 trillion hedge-fund industry.
Hedge funds generally charge their clients -- deep-pocketed individuals and institutions -- fees amounting to 2% of assets under management and 20% of profits. Add in trading costs, and these lightly regulated vehicles need to generate gross annual returns of 18% to 19% to deliver a 10% return to investors, according to a Dresdner Kleinwort paper. And those returns are pre tax. Most funds use mark to market accounting all gains are taxed as ordinary income, so you can knock that after tax return to 6.%, about the same as a 70/30 portfolio of a stock index/bond index portfolio.
One worry relates to hedge-fund trading strategies, which look low-risk but could be dangerous if the market turns quickly….
….Hedge funds can improve returns by adding to investments with borrowed money, getting more bang for their buck. Dresdner estimates hedge-fund borrowing ranges from $900 billion to $4.2 trillion. In other words, for every dollar they have received from their investors, Dresdner estimates hedge funds have added at least a dollar of borrowed money. Leverage makes for high returns, and big losses if things go sour.
Now that is scary, look back on virtually every “blowup” in financial or commodity markets and at the center of the debacle will be one common cause: too much leverage.
In an excellent analogy the wsj writer notes that some analysts:.
liken hedge funds to individuals selling "deep-out-of-the-money" put options. A put option gives an investor the right to sell an asset at a prearranged price should its value fall. For the buyer of a put, it is a hedge against a down market. For the seller, it is a way to turn a profit as long as prices don't fall. Deep-out-of-the-money options look especially safe because prices have to fall a long way to trigger them. When prices do tumble, the losses are steep.
The analogy is quite, apt because if you ask anyone familiar with the options markets what was the cause of major disasters experienced by options traders the answer will be the same: too much selling of out of the money options that wound up “in the money”.
Nassem Taleeb in his brilliant book Fooled by Randomness describes such events as “black swans” unexpected events (the tails in the bell curve) which occur randomly and create disasters.
Thre are many unforseen risks in financial markets that are masked by historical data. In point of fact the only true way to reduce risk in a portfolio is to add short term fixed income and reduce the exposure to equities or to reduce the potential for losses by spending money to purchase put options
“Hedge” funds which make use of esoteric strategies have nothing to do with the true meaning of hedging. Add in leverage and one is doing the exact opposite of hedging. To use the option analogy: a put option buyer has purchased a hedge on his portfolio, he has paid to transfer that risk to the put option seller. The option seller (hedge fund investor) on the other hand has unlimited downside risk.
And here is the ultimate irony: the hedge fund manager has a free call option (actually he is paid for his call option). If the fund scores big he scores big. If the fund blows up, he walks away with the annual fees collected up until the time the fund has blown up. And after that he probably gets a job at another fund. The investors are left licking their wounds and staring at their diminished finances.
No comments:
Post a Comment