Friday, April 11, 2008

Hedge funds: The nerds and the barbarians

(FT Alphaville) On the back of a dismal March for hedge funds, which has wounded several big names, something of a blogophere debate has broken out.

As so often, Felix Salmon started it: “Aren’t hedge funds precisely the asset class which is meant to benefit from volatility?”

Hedge fund managers, sick of being laughed at when their returns failed to match the equity indices during the bull run, were endlessly telling us that they’d come into their own once the market turned. Putting money into hedge funds was meant to position investors for exactly these kinds of troubled times, wasn’t it?

Baruch, at Ultimi Barbarorum, is here to help. Hedge funds hate volatility of the real up and down kind, where they get caught out by their own stops.

the strategists at my beloved employer told the punters, correctly, that this year would see a lot of volatility in equities. So, they said, increase allocation to equity long short, which struck me as precisely the wrong thing to do. Paradoxically in times like this it is the dumb, directional money, the long only crowd, who can ride out volatility better.

Equity long/short, he notes, fared particularly poorly in March.

So the hedge fund reality fails, in part, to live up to the marketing hype. Most hedge funds want enduring trends with clear cues to take a position. They want a bog-standard bear market, one which more or less consistently moves down, rather than one that flies around erratically.

David Merkel though thinks you can’t generalise.

Hedge funds are limited partnerships that do a wide variety of things in the markets. Some aim for easily modelled consistent gains through arbitrage. Others aim for maximum advantage, no matter what. I call the first group the “nerds” and the second group the “barbarians.”

Nerds, along with funds of funds, get hurt in volatility, as simple arbitrages rely on calm markets and ample liquidity. Barbarians, in contrast, see opportunities, in the ‘noise’ of the market.

Apt to take big bets that may be right or wrong, the latter sounds rather binary: outsize returns or outright implosion. And the volatility this year has already caught out ample nerds, in the manner of Peloton or Endeavour. Sounds like hedge funds as an asset class offer scant protection in volatile times.

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