Nickels, Steamrollers, & Hedge Funds

I just got through reading a couple of extremely interesting articles -- one from The Economist and the other from The New York Times -- on hedge funds.

The Economist article (from the Buttonwood column), Instant Returns: Why investors have become addicted to the carry trade (Oct. 5, 2006), dissects a strategy -- the carry trade -- that is widely deployed, in one form or another, by hedge funds. (The article focuses on one variant involving foreign exchange, but the following analysis can be applied to other variants.)

Basically, the carry trade is a bet that volatility will be low. As the article aptly points out, it is the functional equivalent of writing (or selling) an option. Ceteris paribus, option writers benefit from low volatility while option holders (buyers) benefit from high volatility. The benefit from the carry trade is that traders can make a small but relatively steady stream of gains (analogous to the premium from selling options). Usually, these small series of positive returns add up to a sizable amount of profit for the hedge fund.

So what's the catch? (And there is always a catch.) This steady stream of returns come at the cost of exposing traders to the risk that there will be a punctuated jump of prices against their positions (i.e., catastrophic risk). So traders are gaining a steady paycheck at the expense that one day they might be completely ruined. As Buttonwood points out, the carry trade is like "picking up nickels in front of steamrollers."

Fortunately (or unfortunately, depending on your frame of mind) for hedge funds, investors in hedge funds create incentives for hedge fund traders/managers to use this type of strategy. For marketing, logistical, and financial reasons (and, I suppose, psychological reasons as well), hedge funds have an incentive "to produce nice, smooth returns that can be plugged into the models" of pension funds, funds of hedge funds, endowments, and investment advisors to wealthy individuals.

Unfortunately for hedge funds, according to the New York Times article, Weak Results Dim Hedge Funds’ Luster (Oct. 5, 2006), strategies, like the carry trade, employed by hedge funds are losing their edge in a complex and adaptive financial marketplace. Nonetheless, as the Times article points out, there doesn't seem to be a let up in the amount of investment (especially institutional) money chasing after hedge fund opportunities. This is despite the fact that the trend appears to be for as many hedge funds to be liquidated (or 'blow up' as has recently happened to Amaranth Advisors) as they are started. The S&P 500, up 8.5% as of September vs. hedge funds' collective 7.23%, seems to have been the better bet (especially after factoring in the high costs associated with investing in hedge funds).

The response to all of this by hedge fund supporters would be that their investment returns are somehow uncorrelated with more traditional asset classes (like vanilla investments in stocks and bonds). Even if that was true (which I doubt as a general matter), return correlations change over time (they are non-stationary in mathematical statistics-speak). So I find these claims, which attempt to overplay the notion of diversification, to be as dubious as the justifications for the carry trade.