If the newspapers are correct, more and more people are investing in hedge funds. The number of stories about hedge funds are becoming as frequent as those touting the Internet boom in the late 1990s. When everybody starts proclaiming the wonders of a particular type of investment or particular stock, it’s time to watch your wallet.
Andrew Lo, who teaches at MIT’s Sloan School, has been studying hedge funds for almost a decade and has been running a hedge fund for a couple of years. His web site includes some of his papers, including his latest, “Systemic Risk and Hedge Funds”, written with Nicholas Chan, Mila Getmansky, and Shane M. Haas. It is this paper that those considering investing in hedge funds should read.
Basically, Lo warns that investors should be afraid when the funds start posting smooth returns, as, in many cases, these ‘returns’ are based on the fund’s own - not the market’s or an independent party’s - valuation of their illiquid and hard-to-appraise investments, such as real estate and interest-rate swaps. The markets can have an entirely different view of these investments should there be a need to sell them.
His studies of the Long Term Capital brouhaha of 1998 show that it was preceded by months of poor performance by the industry in general. When performance is fading for a period of time, managers tend to ‘leverage up’ and borrow more to invest more. Eventually, when these new investments do not pan out and the old ones are still in the doldrums, the banks turn off the credit spigot and start looking for their money. At this point the only way the funds can pay the banks is by selling their investments. When everybody is selling, prices fall.
In April the hedge fund industry began posting mediocre results, no matter the strategy or the type of fund. To Lo, that is a big warning sign. He thinks conditions are ripe for a ‘perfect storm’ that can be triggered by something such as another spike in the price of oil or a tightening of FNMA’s lending criteria, or......
Don’t you just wish to hear some good news soon?
No comments:
Post a Comment