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Hedge funds in trouble?

The Economist implies hedge fund AUM doubling in 4 years is evidence of unsustainable growth. Hardly. If there had been zero NEW investment in hedge funds, assets would still have grown substantially. In 4 years a compounded return of 19% doubles the money. Many of the funds managing multiple billions are that size due MORE to internal capital growth than new investor commitments.

Do hedge funds hedge? Proper ones - absolutely. They either hedge their own portfolio or act as a hedge as part of a larger diversified portfolio. The cited studies look at the entire hedge fund universe and the conclusions are neither surprising nor disturbing. Skill is rare, by definition, therefore the AVERAGE hedge fund will not be skilled or have impressive returns.

Long short equity is the most crowded and easily implemented strategy. Empirical studies get skewed by the vast swathes of the unskilled managers in that space who are beta dependent rather than alpha generators. Yes illiquid securities pricing has always been an issue but good third party solutions are available for that. The Sharpe ratio is not a "fancy risk-reward measure"; it is basic high school basic statistics that provides NO information on the risks being taken and unfairly penalizes some of the best managers because their POSITIVE months have a wide range.

Scandals? Really? 1% of 10,000 is 100. From memory please cite 100 hedge fund scandals NOW. At least 99% of hedge funds are honest. As for performance, the target is to make an uncorrelated source of return at limited risk and many funds will deliver that as usual. The cowboys are not at the heart of hedge fund land, they are at the periphery. No industry trend is a straight line and a temporary hiatus and a few redemptions are trivial. Sure some strategies are crowded but many are not and others have yet to be discovered. WHEN the three year equity bull and twenty-three year credit bull markets end the stampede into hedge funds will be faster than ever.

Then there is the disclosure issue. Transparency is the enemy of performance. What exactly is a "middle-income investor" going to do with a daily transparency of thousands of positions in complex trades? I've had several lucrative arbitrages vanish over the years because others started finding them. In checking out a hedge fund, a fund of funds sends over their quant jocks as part of their due diligence. Unlike Coke or Microsoft, the manager is obliged to reveal his edge, its source code, its methods of making money in situations where most will lose it. The fund of fund invests - fine. A few months later their quant jocks have quit to set up a fund trading that technique! Investors should choose - performance OR transparency - because they are not going to get both. If it is in the public domain I question the viability of FUTURE returns. Keep the secret sauce secret or underperform T-bills.

As to regulation, professional investors, their consultants and advisers regulate hedge funds to a greater degree than ANYTHING the SEC could do. Regulation will have the following results: fewer start-ups running innovative strategies, lower returns across the board due to management distraction, European and Asian funds kicking out US investors just as those markets offer vast opportunities, as many frauds and scandals as before and, of course, compliance officer bar tabs in the six figures.

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