Battling Dispersion Blues

A shorthand like “hedge fund” is just a convenient catchall for what are in fact widely different strategies and businesses. Look at the latest returns and you can’t help noticing striking disparities. Not only do various investment styles yield sharply varying returns, within each style are managers whose performance diverges from each other even as they pursue a generally similar investment program.

Certain strategies show greater divergence than others. Among major sectors, futures trading shows the most extreme variation.

Averages, as is often remarked, can be misleading. The Barclay commodity futures trading index is about flat with negative 0.09%year-to-date through May. You could find managers clustered around the index—Winton Capital, the big London futures manager, for instance, beat the index but was close. Winton’s diversified program was up 0.16%.

But if you invested in e360 Power Fund based in Austin, Texas, you gained 42%. Then again, if you picked the wrong futures trader, you lost as much as half your capital in the first quarter. There is a spread of 90 or more percentage points between the best and worst performers.

It’s the huge differences that so complicate investing in hedge funds. So investors pay consultants or fund of funds people in an effort to get not only the “right” strategies but also the best managers. Many of them seek safety in the few large firms that account for much of the assets in the industry.

For the variation in returns is the tip of the iceberg. Below it lies the many risks that can suddenly turn a smooth sailing fund into the financial version of the Titanic. These risks also vary across strategies, time and managers.

A serious handbook for investors – such as David Belmont’s Managing Hedge Fund Risk and Financing: Adapting to a New Era (Wiley 2011) – looks at each risk separately for each hedge fund type. Mr. Belmont, currently chief risk officer at institutional asset manager Commonfund, was at UBS during the crisis and led private equity and hedge fund risk containment for the bank.

He compares the practices of crisis casualties to those of survivors. If one is to take a single lesson from his complex analysis, it would be that managers, investors and brokerages should craft specialized agreements with each other to mitigate risks—at the outset, long before disaster strikes.

Failing to do that can land you in a truly bad situation. See my book Ponzi Regulation for what happened in the aftermath of some debacles.

(This post originally appeared 6/5/2014.)

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