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October 12, 2005

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mjones

Is there evidence to show that hedge funds pressuring bankers to reveal confidential information is a "common" practice?

toddhenderson

Re mjones's question -- I've edited the entry to be more clear about the source for this claim. Finding hard, empirical evidence for this phenomenon would be a great project. I have only anecdotal evidence (off the record of course) from bankers. This may not be the strongest or only explanation, but if it is going on, it raises some difficult issues.

slevmore

Todd's question as to why hedge funds do so well is intriguing. Is the outpeformance reliable, or do many underperformers simply disappear from the market, change their mission (so they are not counted as hedge funds), or otherwise ruin the study of average hedge fund performance? And as for the dark story, should we worry that the investment bank insiders are not simply holding on to good customers, but even investing privately, themselves, in the hedge fund?

Tim

Do you have systematic data that hedge funds outperform the broader market? This article:

http://www.usatoday.com/money/markets/us/2004-11-21-hedge-funds_x.htm

suggests a couple of reasons hedge fund indexes could be misleading if they're not constructed carefully.

ardent_capitalist

Todd -- Let me get this straight: You are at a loss for an explanation as to why hedge funds outperform the market (if indeed they do), and conclude that there must be illegal and unethical bahavior. That is a rather drastic, unsupported conclusion.

Stock buying and selling is still subject to the the scrutiny of watchdog groups (public and private) and trends would develop; such as buying and selling before events.

Perhaps you should dig a little deeper for a reasonable explanation as to why the top funds make money. Have you asked anyone at top hedge funds? Or did you stick with "off-the-record" quips from (bitter?) bankers?

Henry Mohrman

Sorry I only picked up this topic from The Law School Record now. I hope you are still interested.

An important point is that many hedge funds are "private" and therefore either can make higher returns or can claim to make higher returns with very little ability to be challenged until something goes very wrong (e.g. business failure) or very right (e.g. liquidation at a huge profit).

It will take many years to get a good empirical handle on real returns versus claimed returns. Long-Term Capital Management gives us real information because it liqidated at a very modest profit, and there is a case report telling us so.

The behavior of investment bankers (both legal and illegal) is an agency cost experienced by both private hedge funds and public mutual funds. It is possible that that cost is disproportionately borne by the public mutual fund, but again it would take the release of a lot of private information to get a handle on that. In the Long-Term Capital Management case, the investment bankers killed them with kindness, using their trading information to replicate Long-Term Capital Management's trades, ultimately creating a temporary illiquidity in Long-Term Capital Management's trading positions that the investment banks had to resolve by acquiring 90% of Long-Term Capital Management's equity.

There is a wealth of published information on the case. I would be pleased to send you citations by conventional means.

Henry Mohrman

Sorry I only picked up this topic from The Law School Record now. I hope you are still interested.

An important point is that many hedge funds are "private" and therefore either can make higher returns or can claim to make higher returns with very little ability to be challenged until something goes very wrong (e.g. business failure) or very right (e.g. liquidation at a huge profit).

It will take many years to get a good empirical handle on real returns versus claimed returns. Long-Term Capital Management gives us real information because it liqidated at a very modest profit, and there is a case report telling us so.

The behavior of investment bankers (both legal and illegal) is an agency cost experienced by both private hedge funds and public mutual funds. It is possible that that cost is disproportionately born by the public mutual fund, but again it would take the release of a lot of private information to get a handle on that. In the Long-Term Capital Management case, the investment bankers killed them with kindness, using their trading information to replicate Long-Term Capital Management's trades, ultimately creating a temporary illiquidity in Long-Term Capital Management's trading positions that the investment banks had to resolve by acquiring 90% of Long-Term Capital Management's equity.

There is a wealth of published information on the case. I would be pleased to send you citations by conventional means.

Henry Mohrman

A further thought on hedge funds, if you are still listening. At very high leverage ratios (say, 20:1 or above)the investment bankers really own the funds as its bondholders, with the managers and the investors holding different options on the residual value of the fund. The high compensation to the managers comes from both the investment bankers and the investors. The investment bankers pay the managers to formulate strategies that will (1) attract the investors' capital to buy the investors' option, (2) utilize the investment bankers' lending capital at the rates charged for secured borrowed money by the investment bankers, and (3)implement trading stragies generating brokerage revenue to the investment bankers. The investors pay the managers for the option to the residual after the investment bankers have been paid in the proprietary trading strategy of the managers.

One commentator has found investment in a hedge fund to be most like investment in a private entrepreneurial company. The investor is basically buying the management and the idea, in a very high risk private capital arrangement. Carefully vetted and with some luck, these very high risk investments earn returns comensurate with the risk or greater.

The word "fund" in hedge fund might be misunderstood if the investor thinks the hedge fund is like a mutual fund. They are very different, particularly with respect to leverage. Very few mutual funds use leverage (or much leverage), and therefore mutual fund managers do not work for their lenders in the same way that hedge fund managers do.

In any leveraged firm, the managers must work for the lenders as provided in the lending agreements. If they did not, they would not be in business, because the lenders would not lend to them. There is nothing illegal, immoral or fattening about that, it is just capitalism.

Joan A. Conway

Seeing a really big picture of the structure of different industries and what makes them a bust or a boom belongs to a relatively few men, and it is inconsistently seen by them as well! Uncertainty exists in their perception, like it usually does in ours, but they have a much deeper understanding about the nature and reactions of the global economy. Hedging your bet with the right Hedge fund managers puts the advantage on your side, but remember it isn't a sure thing either.

Hedge Fund Consultant . Richard Wilson

Many if not most hedge funds use no leverage at all. Anyone have a statistic on the % of funds that employ leverage? Something reliable to point towards?

- Richard

Hedge Fund Consultant - Richard Wilson

p.s. Nice post. I referenced your blog posts here in within my blog.

- Richard

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