Hedge funds - large piles of dumb money

[markrmau]

I think there is a misguided belief that hedge funds represent 'smart money' whose investments should be copied. I argue that the opposite is actually true.

These funds generally look to make money by studying previous price action either between different asset classes, different assets within an asset class, or even on a single asset itself. The problem is that through leverage, and competition amongst hedge funds, there is such a weight of money following the same return that they distort the market.

So the large market movers have actually become dumb money - not actually adding to the 'information' present in the market place.

This gives us an opportunity to front run the changes in trends and changes in market sentiment.

 

[theasxgorilla]

Interesting idea.

I'm not sure that I agree with the statement about how hedge funds generally look to make money. I think that they can have any number of techniques for picking what positions to take, from nitty gritty fundamentals or big theme investing through to pure technical analysis.

Irrespective of their reasons for putting on a trade, if they're large and/or leveraged enough, then indeed they'll shift the market and their activities will show up on the charts. Who's to say whether this is distortion or not? If it shows up as price action on the charts then it happened, it was real. Each of us observing the chart must make a decision about what we believe it means.

 

[markrmau]

I'm not sure that I agree with the statement about how hedge funds generally look to make money.

Yes, perhaps I should narrow this to the ones that look purely at statistical analysis of previous price action.

How large is this slice of the pie? How much leverage into the already leveraged hedge funds is there?

 

[theasxgorilla]

How large is this slice of the pie? How much leverage into the already leveraged hedge funds is there?

It's too big and complicated for anyone to comprehend or measure. While the good times continue to roll we probably won't know what proportion is due to leverage. When the day of reckoning arrives and the leveraged positions are unwound we can discover it by observing how much the "correction" becomes an over-reaction. Think oil right now.

 

[theasxgorilla]

Here is an excellent post-mortem case study on LTCM.

http://www.erisk.com/Learning/CaseStudies/Long-TermCapitalManagemen.asp

 

[Mofra]

Mark & Gorilla,

Hedge funds to me represent a massive risk for correction, largely due to their unregulated nature. The $1 trillion dollar mark was passed in June/July last year and given the number and variety of funds, it would not take much for another LTCM (the smaller funds at under US$25m don't even have to be registered I believe, taken from an article a few months back).

In the event of a serious downturn, how deep are the Fed's pockets and would they bail multiple failures out?

 

[Uncle Festivus]

Hedge funds insatiable thirst for money now gambling on the futures of retirees by the look of it. The scary statistic - "About 30% of hedge funds' assets now come from pension funds"

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SAN FRANCISCO (MarketWatch) -- One measure of hedge fund risk suggests parallels with the financial crisis sparked in 1998 by the collapse of industry giant Long-Term Capital Management, according to research released on Wednesday by the Federal Reserve Bank of New York.
Hedge fund returns have become much more correlated of late, meaning managers are generating similar gains and losses in similar market conditions, according to a study by Tobias Adrian, an economist at the bank. That also happened before LTCM collapsed in late 1998, he said.
However, Adrian also noted a big difference between then and now. Today, the increased correlation of hedge fund returns has been driven by an overall decline in the volatility of returns in financial markets, the economist added.
In 1998, the increase occurred independently of broader market behavior. And as LTCM collapsed, hedge fund return correlations declined sharply as some managers profited from the crisis and others didn't, Adrian concluded.
LTCM collapsed in late 1998, prompting the Federal Reserve to arrange a bank-funded bailout to avert a possible financial crisis. Since then, assets in the hedge fund industry have ballooned to almost $1.6 trillion. That's led some regulators to worry about another blow-up.
Indeed, International Monetary Fund Managing Director Rodrigo Rato on Wednesday said he's concerned about the growing amount of capital that hedge funds are raising from pension funds. About 30% of hedge funds' assets now come from pension funds, Rato noted.
"It may be that pension funds are using hedge fund investment to diversify their own risks, but a situation where almost one-third of the capital for institutions on the cutting edge of financial risks comes from institutions whose first priority is safe investments certainly bears watching," Rato added, according to the text of a speech to the Council of the Americas Washington conference.

 

[rich4495]

I don't think the large hedge funds are dumb money at all, in fact the small to medium sized hedge funds may be the dumbest. The largest hedge funds have the most transparent and instant access to over 40 markets to trade, they can trade through dark pools, build support in short selling a position without calling a single person and they have partnerships and connections with more traders, research groups and powerful quant models that they out-manage risk compared to their smaller peers. The large hedge funds are often the most successful because of these factors above and their diversity of strategy offerings.

 

[MRC & Co]

Who provides liquidity for large intstitutions (hedge funds), locals? Who is 'smarter'?

What smart money?