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According to Hedge Fund Research (HFR), macro hedge funds - those that bet on any asset in any direction - have lost more than 9 per cent so far this quarter. During the same time, commodity prices have fallen more than 19 per cent.
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That's no coincidence. Many funds were betting on rising commodity prices - hence their decent returns earlier this year - and have been caught out by their recent falls. Which reminds us that we should be sceptical of the industry generally.
One reason for this is simply that their long-run average returns are low - 4.3 per cent a year after fees in dollar terms since the start of 2003, according to HFR. This is not much better than cash in a bank account.
A second reason is that what look like quite attractive funds in mean-variance terms - good returns, low correlations with share prices and lowish volatility - can be the result merely of risk being shovelled elsewhere. In his book, Hedge Funds , Andrew Lo of the Massachusetts Institute of Technology describes how a fund could achieve a good track record merely by selling out-of-the-money put options on the S&P 500. This is just selling insurance against a big fall in prices; in ordinary times you pick up a premium, but in rare bad times you lose heavily. There's no great skill in this - indeed, less skill than in selling household insurance. It's just taking on tail risk.
Of course, few hedge funds do just this alone. But many don't do much more. Harry Kat of Cass Business School has shown that funds' returns and risk profile can be replicated by futures and options strategies. There's no alchemy involved.
I say all this not (merely) to decry the hedge fund industry. Instead, what this suggests is that we should be very wary of anything that claims to be a "skill-based" strategy. The truth is that it's very rare to make money by skill alone. Far more often, returns are merely a reward for taking risk, and risk comes in many flavours. And, as macro hedge funds have been the latest to learn, risks have a nasty habit of materialising sometimes.
Read more of Chris's comment pieces on his Columnist page, or his macroeconomic analysis on the markets page.
IC Advantage (what's this?) users can put their own numbers into his spreadsheets to generate forecasts for the stock market.
Chris blogs at http://stumblingandmumbling.typepad.com
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-IC-1.5.4a-prod - 31/10/2008 13:11:34 - carlos.princz
