Two Facts About Hedge Funds Everyone Should Know

Managing a hedge fund, or even a managed accounts operation, nowadays is far from trivial given the market timing challenges and regulatory requirements. But there are also some other facts that are not so widely understood.

I would like to make sure in advance that everyone understands that these two facts listed below may apply to a small number of hedge funds.

A. Going private

Some hedge funds use client money to test strategies and when they find a good edge they go private.

This is probably unfair to those who invest early in the fund and provide the equivalent of “seed capital” for this research. It may not be enough to return the money back to investors, even if they have made significant returns. Of course this has also happened with listed companies in the stock market that went private. Investors with significant shares in hedge funds may want to negotiate in advance what will happen in case there is a move to private operation. Some of these hedge funds claim to manage only employee capital but where would these employees be without the initial investment from the clients who took the risk? Needless to say those employees are smart and manage to be successful but kicking out the investors that allowed them to become rich may not be fair. However, these moral issues may not have a universal answer but only in the context of private contracts.

B. Hedge funds and CTAs need losers to profit

Neal Berger also said that recently but I have mentioned this fact in several articles in the past. It is amazing to me how many, even professionals, do not understand that the market is not an abstract entity when it comes to profit and losses but a clear rule holds: profits must come from other participants, there is no other way.

Often, arguments are based on open profit in favor of a perpetual positive-sum game but these are naive attempts to deny the reality of the zero-sum game of trading and investing. Of course, one can find a reference system to turn every game into positive or negative but the truth remains: no one pockets profits unless someone provides them, even if that is a central bank.

It is not surprising to me then why some fund managers and CTAs have touted simple technical analysis and vehemently have opposed anyone who tried to warn traders about its perils. In the past, simple technical analysis provided profits to disciplined traders who followed trends against which random traders using these simple technical analysis were ruined in large numbers.  The result was large profits for hedge funds and CTAs. Due to this, the population of random traders significantly decreased and professionals, especially CTAs as a group, are now having hard time to generate absolute returns and have to resort to arguments about low correlation to equities and smart beta. Their real problem is, as Neal Berger pointed out recently, that there is no large influx of losers to profit from as most random traders have learned their lessons and turned to passive investors.

When I hear any professional touting simple technical analysis methods, I get immediately suspicious. I suspect some clueless technical analysis gurus and wizards were financed by an industry that needed the influx of losers they helped to create.

Summary

Two things about hedge funds: (a) the ultimate objective of some of them, but not all, is to use investor money to find an edge (many will never succeed) and then go private, depriving initial investors of the benefits of the research they financed and (b) a constant influx of losers is required for hedge funds and CTAs to generate absolute returns and this has become more difficult recently due to the fact that old practices of enticing people to get into a game where they are going to lose are not as effective.

As I wrote in another article regarding the new crypto mania:

Finally, many traders, especially the new crypto traders, think they are trading but in reality they are manipulated in a game where they are enticed to increase their stakes so that their loss will be maximum when the proper time comes and some market forces or political events can be blamed instead of those who have conceived the game.

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