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Saturday, December 04, 2004

Hedge funds attracting hot money 
Be afraid. Be very afraid.

A few observations here:

First of all, hedge funds have done fairly well lately. But the asset classes they go after to differentiate themselves from and lower their correlations with US stocks and US bonds (they wouldn't be very effective "hedges" if they tracked the S&P 500 very closely) have all been surging over the last couple of years.

Commodities have been zooming. Real estate. Emerging markets. Foreign debt. Foreign currencies and assets denominated in them. Even structured, securitized US debt has outpaced the high yield markets over the last few years.

So what do you think has been fueling their outperformance? Manager skill? Are you SUUUUURRE? How old are these hedge fund managers? What were they doing in the 1970s? (Answer: going to grade school. Their reputations were built during the stock market bubble [when the worst managers received the greatest accolades] and then ditched to start hedge funds at the top of the market, exactly when it was easiest for mediocre hedgers to shine, because EVERYTHING looked good relative to stocks, by the summer of 2002.

Meanwhile, hedge fund marketers have been going increasingly "downmarket," to less and less sophisticated investors, while simultaneously adding layers of expenses pushing "funds of hedge funds."

Let me pull back the covers just a bit, here:

While the hot money from weaker investors has been pouring into hedge funds, the E & O insurance underwriters: the guys who provide professional liability insurance to cover stock brokers and investment advisors against unsuitability, fraud, and failure-to-disclose risk lawsuits, have been denying coverage to advisors who deal in alternative investments, most ESPECIALLY hedge funds. (Many of them won't insure brokers who sell options, either, except for covered calls)

The reason is this: Bull runs don't last forever. Commodities cannot outpace stocks indefinitely. And short strategies are counter to market direction, long term.

Once the bull market in commodities, real estate, emerging markets, and the other alternatives peak, there is simply no way that, after adjusting for the tremendous fees in the hedge fund world, hedge fund managers as a group can add any value. The ones that do will cease to become hedge funds and become long stock funds. And no long stock manager can make good on 2% of assets plus 20% of any returns over zero.

The others will fail as well. As an aggregate, they cannot outperform the underlying asset classes in their investment universe and expertise, given the tire boot they tie to themselves in the form of expenses.

The E & O guys know this, and they know that at some point: maybe this year, maybe in three years, who knows- the hedge fund mystique will be popped, investors will get burned, and then they'll be dragging the hedge fund managers, their RIAs, and the brokers who put them in hedge funds into court.

The forward thinking lawyers are quietly sharpening their knives, too. They're already boning up on their arguments to use against bond funds in the widely anticipated bear market in long bonds. "You put granny in a supposedly "safe" bond fund, and the fund lost 15%" the argument would go.

They're already attending seminars on how to construct these arguments.

Now that hedge funds are pulling in hotter money from less sophisticated investors, hedge funds won't be far behind.

Be careful out there.

Splash, out

Jason





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