Can it ever make sense to invest in a hedge fund?

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Can it ever make sense to invest in a hedge fund?

Postby boggler » Sat Aug 31, 2013 2:47 am

On this forum we usually assume markets are reasonably efficient. Often times, hedge funds are one of the major players keeping these markets efficient. For example, when Bernanke announces that he's raising interest rates, these institutions sell stocks, causing the market to drop. In doing so, they are making a profit if they can react before everyone else.

My question is: If you know you'll always be one of the first to react to a market-moving event, does this not make active management worthwhile? Often times with actively-managed mutual funds, there is a significant "luck" component, and the top funds one year may be in the bottom another year. But in a situation like this, it seems like the "first mover advantage" is hard to deny. By being passive investors, aren't we missing out on this? Assume you have enough assets that you could invest with a company like Citadel, for example.
Last edited by boggler on Sat Aug 31, 2013 7:35 pm, edited 1 time in total.
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Re: Hedge funds

Postby edge » Sat Aug 31, 2013 2:50 am

How do you know which way it will move? And who is on the other side of your trades?
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Re: Hedge funds

Postby boggler » Sat Aug 31, 2013 2:59 am

edge wrote:How do you know which way it will move? And who is on the other side of your trades?


You're reacting to an event that will almost certainly move the stock market in one direction. On the other side is the trader who hasn't yet reacted to the new information.
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Re: Hedge funds

Postby JoMoney » Sat Aug 31, 2013 4:06 am

Yes, there are opportunities to arbitrage markets and to be the first to react. Some of these groups pay massive fees to news companies to get the data before the general public ( http://www.cnbc.com/id/100809395 ). Sometimes they pay massive fees to get their trading computers even closer to the market ( http://www.nytimes.com/2009/07/24/busin ... ading&_r=0 )
These are good reasons why you don't want to be an individual trader trying to go up against them.
But all of these information advantages cost money to implement. The hedge funds pass along all these fees and then some to their clients.
http://www.forbes.com/sites/investopedi ... -expenses/
On top of it, you may never know if you've managed to pick one of the funds with a winning strategy, or that their strategy will continue to be profitable. Most of the market-moving trades are coming from investors like this (it's not from buy-and-hold investors). It's a constant struggle for them to maintain their advantage. If someone learns their method they have increased competition, or possibly an opponent that will use the information against them.
And all of this trading is of very little benefit to society. When you own a business (or stock representing ownership of a business) you're earning profits by providing some sort of goods and services. Some of the earnings are paid out as dividends, some of the earnings potential (eventually) gets worked into the price of the company. Trying to make profits by trading and out guessing which direction someone else is going to go is a zero-sum game. Some will guess right, some wrong, either way - lots of expenses.

Although ten years is hardly conclusive, it will be interesting to see how Warren Buffett's long-bet works out.
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Re: Hedge funds

Postby umfundi » Sat Aug 31, 2013 6:57 am

boggler wrote:
edge wrote:How do you know which way it will move? And who is on the other side of your trades?


You're reacting to an event that will almost certainly move the stock market in one direction. On the other side is the trader who hasn't yet reacted to the new information.

How could you possibly know?

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Re: Hedge funds

Postby YttriumNitrate » Sat Aug 31, 2013 9:34 am

umfundi wrote:How could you possibly know?


Obviously you can't know for certain what will happen, but you can make predictions based on what has happened in the past. Something along the lines of "90.2% of the times the ADP jobs number indicates a 1.0% growth or higher, the SP500 is up 5 minutes after the number is announced"...

I guess this brings up the questions of how fast are most actively managed funds?, can we consider all non-quant funds to be slow?, and a whole bunch of others questions that don't keep passive investors up at night...
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Re: Hedge funds

Postby Spirit Rider » Sat Aug 31, 2013 10:50 am

YttriumNitrate wrote:
umfundi wrote:How could you possibly know?


Obviously you can't know for certain what will happen, but you can make predictions based on what has happened in the past. Something along the lines of "90.2% of the times the ADP jobs number indicates a 1.0% growth or higher, the SP500 is up 5 minutes after the number is announced"...

I guess this brings up the questions of how fast are most actively managed funds?, can we consider all non-quant funds to be slow?, and a whole bunch of others questions that don't keep passive investors up at night...

Hedge funds who are "supposedly in the know" have average returns below actively managed mutual funds. Those actively managed mutual funds have average returns below market indexes.

In fact, "those in the know" who consider themselves smarter than everyone else, are far more likely to cause short term mispricing than to take advantage of it.
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Re: Hedge funds

Postby Ranger » Sat Aug 31, 2013 11:11 am

JoMoney wrote:Sometimes they pay massive fees to get their trading computers even closer to the market ( http://www.nytimes.com/2009/07/24/busin ... ading&_r=0 )


You are confusing Hedge funds with HFT. HFT is mostly used by trading firms, rather than most of Hedge funds. Hedge funds is catch all term used by main stream media and others, there are many strategies with in Hedge funds. Here are some strategies used by Hedge funds

Image

JoMoney wrote: Sometimes they pay massive fees to get their trading computers even closer to the market /


Again, you are mistaken. You can lease server space in exchanges starting from $100. Technology is actually least expensive for these strategies. It is knowledge about market structure and writing codes, which is most expensive. There are many small firms in HFT space. These firms have the same advantages of GS and Citadel's of the world.

JoMoney wrote:These are good reasons why you don't want to be an individual trader trying to go up against them.


Some of the individual traders has some advantages over these hedge funds too. Hedge funds have scaling problem and heavy market impact cost. Also, Hedge funds have to over come 2/20 cost structure which individual traders does not have.
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Re: Hedge funds

Postby JoMoney » Sat Aug 31, 2013 4:43 pm

Thank you Ranger. I do appreciate the opportunities to learn from my often mistaken ideas.
There's a lot about this I don't know. Admittedly, my understanding of it is only through main stream media.
I do understand there are different types of hedge funds, and different strategies. Maybe this type of trading isn't truly "hedging" anything and shouldn't be labeled a "Hedge Fund".

Regarding the OP and the trading he is discussing, the media does seem to imply the costs are expensive (and as you indicated the costs don't stop with the computers themselves)

http://content.time.com/time/business/a ... 24,00.html
"co-location space has gotten pretty scarce,"
"Firms pay for the server space they use: as little as $50,000 a year, but as much as $500,000 a month to co-locate at the NYSE and other exchanges, says Murray White, senior vice president of global technologies at the exchange."


http://spectrum.ieee.org/computing/netw ... ond-market
"$300 million project will reduce the travel time for signals between New York and London to something less than 30 ms, which is a couple of milliseconds faster than any fiber-optic connection now in place. Saunders says that Hibernia has customers already signed up for the new link—all high-frequency traders. “There’s nobody else who will pay the same price,”

These articles are old, I'm sure there is more competition, lower prices, smaller scale operations. It may all be over-hyped media sensationalism. There probably are small opportunities for individual traders. I still think buy and hold makes more sense then engaging in the zero-sum minus expenses trading game.
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Re: Hedge funds

Postby Ged » Sat Aug 31, 2013 6:23 pm

HFT volume and profitability is on the decline. Basically the software has wrung it dry and the profit has been arbitraged out.

So the markets are doing their usual thing.

http://www.businessweek.com/articles/20 ... nd-fall#p1
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Re: Hedge funds

Postby boggler » Sat Aug 31, 2013 7:38 pm

YttriumNitrate wrote:
umfundi wrote:How could you possibly know?


Obviously you can't know for certain what will happen, but you can make predictions based on what has happened in the past. Something along the lines of "90.2% of the times the ADP jobs number indicates a 1.0% growth or higher, the SP500 is up 5 minutes after the number is announced"...


Right. I imagine there are a large number of Bogleheads, even, that would be willing to take such bets. E.g. If Apple reports way larger than expected earnings, the stock price is almost certainly going up. The problem is, most investors can't place their bet fast enough, so we simply buy and hold. But if you could place these bets, wouldn't you be way better off?
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Re: Hedge funds

Postby umfundi » Sat Aug 31, 2013 7:59 pm

boggler wrote:
YttriumNitrate wrote:
umfundi wrote:How could you possibly know?


Obviously you can't know for certain what will happen, but you can make predictions based on what has happened in the past. Something along the lines of "90.2% of the times the ADP jobs number indicates a 1.0% growth or higher, the SP500 is up 5 minutes after the number is announced"...


Right. I imagine there are a large number of Bogleheads, even, that would be willing to take such bets. E.g. If Apple reports way larger than expected earnings, the stock price is almost certainly going up. The problem is, most investors can't place their bet fast enough, so we simply buy and hold. But if you could place these bets, wouldn't you be way better off?

Really? Come on.

How do you possibly think you can act on public information faster than anyone else? How would you even know the information before anyone else?

Apple has larger earnings than who expected? You? Or, are you waiting to learn what other people think?

I would hope there are no Bogleheads who are willing to take such bets.

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Re: Can it ever make sense to invest in a hedge fund?

Postby tadamsmar » Sat Aug 31, 2013 8:20 pm

boggler wrote:On this forum we usually assume markets are reasonably efficient. Often times, hedge funds are one of the major players keeping these markets efficient.


How do you know that? What if it's not true?

For example, when Bernanke announces that he's raising interest rates, these institutions sell stocks, causing the market to drop. In doing so, they are making a profit if they can react before everyone else.


The mere act of announcing does not magically cause the price to move.

My question is: If you know you'll always be one of the first to react to a market-moving event, does this not make active management worthwhile? Often times with actively-managed mutual funds, there is a significant "luck" component, and the top funds one year may be in the bottom another year. But in a situation like this, it seems like the "first mover advantage" is hard to deny. By being passive investors, aren't we missing out on this? Assume you have enough assets that you could invest with a company like Citadel, for example.


Nobody knows they will always be the first to move.
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Re: Can it ever make sense to invest in a hedge fund?

Postby nisiprius » Sat Aug 31, 2013 8:49 pm

I don't own a personal copy so I forget exactly what Larry Swedroe wrote in The Quest for Alpha: The Holy Grail of Investing, Chapter 3: Hedge Funds, The Evidence, but I'm pretty sure I'd remember if he'd concluded that unlike everything else he examines in that book, hedge funds do create alpha. In this forum, he quotes Eugene Fama as saying "If you want to invest in something (hedge funds) where they steal your money and don’t tell you what they’re doing, be my guest." He also says that "hedge funds overall have had a hard time keeping up with the risk adjusted returns of TREASURY BILLS once all the biases in the data have been removed."

But forget all that. I think there are people who win consistently at rock-scissors-paper, there are definitely people who win at poker, and there are people who win quick-draw contents. And I would not be at all surprised if there are people who have what amounts to inside information that is technically legal, or even illegal but don't get caught.

Let's assume that you have identified a hedge fund that will be a consistent winner because it can outpsych the market, it does better information than others and we don't mean a Bloomberg terminal nudge nudge wink wink, and does moves faster than others. A very very aggressive, competitive player whose skill set involves beating other aggressive, competitive players.

Why, exactly, do you think they would share their winnings with you? Being the sort of aggressive, competitive players they are, isn't it more likely that they would calibrate their fees to extract the precise maximum amount from the patsies who invest with them, while giving the patsies just enough now and then to keep them hooked? They are the sort of people who are capable of getting the lion's share in a deal with other investors, why wouldn't they get the lion's share in the deal with their clients?

To be just a shade less cynical: what percentage of the alpha they generate do you think they share with their clients?
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Re: Hedge funds

Postby JoMoney » Sat Aug 31, 2013 9:58 pm

boggler wrote:...I imagine there are a large number of Bogleheads, even, that would be willing to take such bets. E.g. If Apple reports way larger than expected earnings, the stock price is almost certainly going up. The problem is, most investors can't place their bet fast enough, so we simply buy and hold. But if you could place these bets, wouldn't you be way better off?


It's not just about being "fast enough" (although if you're going to play the trading game, it is an advantage).
If you have two traders on your Apple stock, one buying and one selling, they would be better off as a group if they split ownership of the stock equally and just accepted the gains from the earnings of the company. Instead, they quote prices back and forth, trade back and forth, and no new value was created. The trading did absolutely nothing to change the earnings of the company. All it did was cause additional expenses for them.
http://www.investmentintelligencer.com/ ... g_is_.html

But, it isn't entirely without value. Without this market trading it would be more expensive to sell companies and harder to value them.
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Re: Can it ever make sense to invest in a hedge fund?

Postby technovelist » Sun Sep 01, 2013 12:50 am

nisiprius wrote:I don't own a personal copy so I forget exactly what Larry Swedroe wrote in The Quest for Alpha: The Holy Grail of Investing, Chapter 3: Hedge Funds, The Evidence, but I'm pretty sure I'd remember if he'd concluded that unlike everything else he examines in that book, hedge funds do create alpha. In this forum, he quotes Eugene Fama as saying "If you want to invest in something (hedge funds) where they steal your money and don’t tell you what they’re doing, be my guest." He also says that "hedge funds overall have had a hard time keeping up with the risk adjusted returns of TREASURY BILLS once all the biases in the data have been removed."

But forget all that. I think there are people who win consistently at rock-scissors-paper, there are definitely people who win at poker, and there are people who win quick-draw contents. And I would not be at all surprised if there are people who have what amounts to inside information that is technically legal, or even illegal but don't get caught.

Let's assume that you have identified a hedge fund that will be a consistent winner because it can outpsych the market, it does better information than others and we don't mean a Bloomberg terminal nudge nudge wink wink, and does moves faster than others. A very very aggressive, competitive player whose skill set involves beating other aggressive, competitive players.

Why, exactly, do you think they would share their winnings with you? Being the sort of aggressive, competitive players they are, isn't it more likely that they would calibrate their fees to extract the precise maximum amount from the patsies who invest with them, while giving the patsies just enough now and then to keep them hooked? They are the sort of people who are capable of getting the lion's share in a deal with other investors, why wouldn't they get the lion's share in the deal with their clients?

To be just a shade less cynical: what percentage of the alpha they generate do you think they share with their clients?


I believe this has actually been studied, and if I recall correctly, the answer is "zero".
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Re: Can it ever make sense to invest in a hedge fund?

Postby Valuethinker » Sun Sep 01, 2013 9:51 am

nisiprius wrote:
Why, exactly, do you think they would share their winnings with you? Being the sort of aggressive, competitive players they are, isn't it more likely that they would calibrate their fees to extract the precise maximum amount from the patsies who invest with them, while giving the patsies just enough now and then to keep them hooked? They are the sort of people who are capable of getting the lion's share in a deal with other investors, why wouldn't they get the lion's share in the deal with their clients?

To be just a shade less cynical: what percentage of the alpha they generate do you think they share with their clients?


I don't necessarily welcome the cynical tone. Hedge funds are in a competitive environment for clients as well as investment ideas. Overly venal funds will tend to die.

But your general point is correct. Renaissance Technologies core funds have outperformed for decades. We don't know how. We do know that Jim Simon has generally hired people who had published in the field of voice recognition technology (he was a mathematics professor).

However there is no public access to the fund, and the vast majority of the money in the fund now belongs to employees and some favoured clients of Ren Technologies.

I think there is ample evidence there *are* investing anomalies. However they are not large, and success in a hedge fund normally means growing AUM, and that inevitably means expansion outside of the niche opportunity (too much money to exploit it).

In other words the bond arbitrage team at Salomon, which was responsible for more than half Salomon's profits in the 1980s and early 90s *did* know what they were doing and *did* find exploitable anomalies.

However they went and formed Long Term Capital Management, grew to c. $10bn under management (levered to over $150bn via borrowings), made a major repayment of capital to investors (but they cherrypicked who they wanted to pay back to, ie favoured clients and employees were allowed to continue in the fund with no payback-- a major failure of governance in my view), and *still* reached a point where they had to diversify from their core expertise on arbitrage.

As a result when the Russian default hit they were widely exposed, encountered a liquidity freeze, and LTCM collapsed.

The lesson is the same, if you want to invest in hedge funds:

- invest early
- invest, paradoxically, in a team with a track record from another institutional setting
- make sure the team has a lot of their own money in the fund
- if you achieve outstanding performance, take money *off* the table, don't 'roll your winnings' or clamour to invest more

Hedge Funds are the classic 'fat tail' returns and as such can play a part in a portfolio, but beware that some of the fat tails will give you returns of -100% or near as.

The trick is to be buying Commercial RE in 2009. Emerging Markets in 1998-99 (but note, the bet in 1994 when Mexico crashed then took 10 years to come right). NOT to be buying the asset class when everyone else is buying.
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Re: Can it ever make sense to invest in a hedge fund?

Postby Ranger » Sun Sep 01, 2013 10:28 am

JoMoney wrote:"Firms pay for the server space they use: as little as $50,000 a year, but as much as $500,000 a month to co-locate at the NYSE and other exchanges, says Murray White, senior vice president of global technologies at the exchange."


http://www.eotpro.com/products-colocation.php

$499/month for dedicated server or $299/month if you want to share the server space. I have seen $100/month for shared server space in one of the trade publication ad's.

HFT's main strategy is to capture rebates by providing liquidity for stocks. so they will have dedicated server in New Jersey also. But these costs are nowhere near media claims to be.

I always take trading costs claims in this forum with loads of salt.
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Re: Can it ever make sense to invest in a hedge fund?

Postby nedsaid » Sun Sep 01, 2013 10:41 am

I remember another thread where a poster was on the search for the "secret sauce" of investing. Generating alpha.

The conclusion after a lot of discussion is that the early bird gets the worm. The early adopters of strategies get most of the returns. Once a strategy gets well known and popular, the performance premium disappears.

David Swenson is a good example of this with his well known success at Yale as manager of their endowment funds. Other college and university endowment funds that tried to copy his strategies did not get his results.

For example, if I was Mr. Swenson I would have swooped into Phoenix after the burst of the housing bubble and purchased a lot of single family real estate and formed a management company to rent them out and manage the properties. There were folks that in fact did that and profited handsomely. If things didn't turn around for a while, Mr. Swenson and Yale could just collect the rents until the markets recovered. They can wait and wait for a long time. The problem for retail investors is that by the time investment companies roll out the "Phoenix Residential Home Investment Fund", the story is largely over. I don't know if Swenson did this, but I am illustrating the "early bird gets the worm" principle.

Ditto for the "alternative" investments to bonds. Markets aren't stupid and by now after interest rates have been very low for a few years, the prices of these investments have been bid up. By the time retail investment firms start pitching these to their customers, the smart institutional players have swooped up these asset classes at low prices. Retail investors wind up picking over the leftovers or buying these at high prices.

Another thing to remember is that sometimes the big institutions are wrong. They get burned trying to outguess the markets like you and I do. Having a few billion dollars available to manage doesn't make an investment manager infallibe.

So there are really smart folks that generate alpha. There are incredible bright people out there working out the math and programming computers to churn through data 24/7 looking for market inefficiencies. But even they goof up too.
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