As the top five hedge fund managers went before Congress last week, many Americans asked whether these men are worth the $1 billion they each made last year. The answer is obvious: of course not. Citadel’s Kenneth Griffin was married at the Palace of Versailles. Need we say more?
But let’s look a little more closely at the question. Investors willingly pay hedge funds these vast sums—20% of profits and a 2% asset fee—for increased odds of making money themselves. Specifically and theoretically, they are paying for “absolute” performance, which means they will never see a down year regardless of what the overall markets do. So if billionaires like George Soros and John Paulson can deliver 20% year-after-year even after those huge fees, then people are willing to pay for that expertise.
The whole question is irrelevant at this point, however, as half of all hedge funds are projected to go out of business. The bad ones will be gone. Hedge fund managers were still being called the masters of the universe as recently as a year ago, but now they are more likely to be called the bane of the markets.
Griffin’s main fund is supposedly down 40% this year. T. Boone Pickens, who made $1 billion in 2006 and 2007, has lost $1 billion in his fund, and Myron Scholes’ Platinum Grove Asset Management lost 29% in the first half of October.
As investors withdraw and banks tighten credit, these funds must sell assets to create cash. This cyclical liquidation has created much of the recent pressure on the markets. Scholes’ fund, which managed close to $5 billion, may see withdrawals as high as 25%, according to Bloomberg. That may force a lot of selling to come up with $1 billion in cash to meet those redemptions. And that’s just one fund.
Their loss of personal wealth of the hedge fund managers and their wealthy clients means little to the average investor. But there are still lessons to be learned from their downfall.
The wonderful thing about trading options is that once you have a good grasp of the strategies, you don’t need hedge funds. You can outperform the markets, protect your portfolios, and hedge in a variety of ways. And in watching the spectacular blow-ups of the year, you may well be able to do a better job than most of those hedge fund managers—you just won’t make $1 billion.
The real issue is that these funds, despite their nomenclature, were clearly not very well hedged: They were leveraged, and that is the reason for their outperformance in the good years, as well as their current problems.
Their risk management is clearly flawed. Scholes won the Nobel Prize for his work on the options pricing model (really a risk management model), yet adding his current losses to the fact that he was a risk manager for Long Term Capital Management when it blew up, one has to question just how good a risk manager he is.
Finally, there is an important point for the rest of us. Many of these problems have come from investors—including endowments and pension funds—that have flocked to the “hot” investment, which, of course, have been hedge funds in years past.
It is essentially a hedge fund bubble, similar to the tech bubble of the ‘90s. The number of funds swelled, as did their assets, and now that bubble is popping.
While most of the stories out there are about the big losers, some hedge funds have done well. But even they are seeing redemptions, which speaks to the herd mentality of investing. Investors are fleeing hedge funds just as they blindly rushed into them over the past five years.
For self-directed “retail” traders and investors, there are at least two important things to take away from all this. The first is that in prediction markets like stocks, “professionals” do not necessarily know any more than the rest of us. That is part of the reason that 80% of actively managed mutual funds underperform the markets.
The second lesson is not giving up on something that works because of an emotional response. I have seen many traders give up on systems and strategies because they have produced losses that are well within what should be expected.
If you find a system with a 70% win rate and get three losses in a row, it should not just be accepted, but expected. All strategies and systems have bad times. If those bad times are still outperforming the overall markets and the indexes, then dropping them is one of those emotional decisions that has no place in the investment world.
Pete and Jon Najarian are the co-founders of optionMONSTER.com, a publisher of news, perspective, and market intelligence on options and equity trading. Their research and analysis is widely cited by financial media. Jon Najarian has developed patented trading applications used to identify unusual activity in stock, options, and
futures markets. Pete Najarian co-founded the Hedgehog trading platform and is a cast member of CNBC’s ‘Fast Money’ program.
post a comment
email to a friend
digg this
del.icio.us
