The Independent Market Observer

7/19/13 – Why Not to Invest in “Hedge Funds”

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 19, 2013 7:23:17 AM

and tagged Economics Lessons

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Per yesterday’s post, I want to start off by defining my terms. “Hedge fund,” for purposes of this discussion, means “currently fashionable investment that everyone wants because they think they will make a lot of money.” In this sense, “hedge fund” could mean housing in the mid-2000s, tech stocks in the late 1990s, commodities or the Nifty Fifty stocks in the 1970s, or—well, you get the idea.

At any given time, there will be a hot investment idea that is valid. (That’s probably how it got hot in the first place.) There will be well-established managers executing successfully in that space. They will understand the market, know what they’re doing and why, and will be very unhappy to see the rest of the world showing up in their niche.

As the idea gets more press and more interest, there will also be increasing numbers of managers moving into that idea from adjacent areas, claiming that their existing expertise will surely translate into this fashionable space. Over time, managers whose primary expertise is in marketing will also hop on board. Meanwhile, the original managers are forced to take more chances to maintain their returns as new players move in. This stage is where things get dicey.

To avoid the problems that arise from this scenario, it’s necessary to focus less on why to invest and more on why not to invest. There is a strong institutional imperative to deliver reasons for investing. Developing reasons not to invest is up to you. A big part of what I try to do in my own analyses is come up with the why not. To that end, here are some questions to ask when you’re considering a “hedge fund.”

  1. Do I understand how this works? Not necessarily all the details, but conceptually? Personally, if the manager can’t explain in words of one syllable why something works, I get very suspicious.
  2. Once I understand how it works, does it make sense? Any investment strategy should make sense both theoretically and empirically. If I question either, I need to do more digging.
  3. What are the current valuation levels of the asset class in question? This is a bit more technical, but not complicated. Basically, buying something cheap and expecting it to return to normal may make more sense than buying something expensive and expecting it to get more expensive. It may happen, but . . .
  4. Does success in this investment depend on things being different this time? This point arises from the end of the previous question. If history teaches us anything, it is that people—and markets are people—don’t change that much, if at all.
  5. How does this blow up? I am (in)famous here at Commonwealth for asking this question, but, for me, it adds a great deal of valuable perspective. If you’ve thought carefully about something going bad, you have analyzed the weaknesses, the underlying assumptions, the market vulnerabilities, and a number of other factors that you should really understand. This question distills many of the other ones into an easily understood analysis.

Now, let’s apply these questions to some past situations. First, we’ll look at the dotcom era.

Conceptually, question 1 was easy to answer; the problem was that the answer was wrong from an investor’s point of view. The Internet enabled everyone to shop for everything in a price-transparent way. This should—and did—push margins down for businesses, as price became the dominant decision point. Ask the owners of Borders or Barnes & Noble what they think of Amazon, for example. Amazon may be seen as a counterexample, but for every Amazon, there was Pets.com, Kozmo.com, and too many others to name.

Questions 2 and 3 were also easy to answer. Any business where you essentially have to give away money to attract eyeballs has questionable underpinnings. Any business where you can’t value the earnings, because there are no earnings—and ditto for revenues—has valuations that do not put it in the investment universe.

Question 4 is self-explanatory—the whole new economy was based on it being different this time—and question 5 was also easy to predict, as everything fell apart when the days of easy funding ended.

I’m not claiming, by the way, that I got this one right. I can swap stories with the best about this era, very few of which show me as a prophet. But let’s look at the housing bubble.

Question 1 seems acceptable: housing typically has gone up, for excellent and well-understood reasons. Same for question 2—although, later in the game, with prices increasing to higher levels, buyers and investors should have been asking more questions. Questions 3 and 4 were the core issues in this bubble, with housing prices in relation to income at unsustainable levels and further appreciation predicated on it being different—“it,” in this case, was the mortgage market continuing to expand. Question 5 was also easy to answer; the fact that ridiculous mortgage lending policies provided the base for ridiculous housing values was quite clear starting at least in 2006. I (along with many others) did get this one right.

When we consider hedge fund investing, we should be asking these same questions. Again, the message is simple. Understand what is being done, how it is being done, and how it could fail. Long-Term Capital Management, one of the largest hedge fund failures, based its portfolio on a number of assumptions derived from a very limited data set. Questions 1 and 2 made sense; 3 was (incorrectly) deemed irrelevant given the fund’s strategies; 4 was wrong, but in a different way, as the managers assumed everything would be exactly the same as their data set. If things are exactly the same, though, that’s indeed different, which led to a failure on question 5: they didn’t consider what would happen if events didn’t mirror their data.

So much for history. On Monday, I want to look at two current examples to which we can apply these questions: the Chinese economy and the U.S. stock market. Have a great weekend!

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