Monday, May 6, 2013

Another Bad Reason To Invest In Hedge Funds

I know, we need bad arguments for hedge fund investing like we need...bad advice from big banks?

In an May 2nd "Eye on the Market" piece from J. P. Morgan's Private Bank, Michael Cembalest suggests that investing in hedge funds in a low yield/low spread/low everything environment might be an interesting idea. He bases this argument on this very pretty picture:
This picture shows the annualized performance of randomly generated portfolios of five hedge funds that happen to have a ten year history. Cembalest argues that because the volatility of these portfolios apparently falls below the volatility of BBB bonds, and the returns fall pretty reliably in the 4%-7% range, this might be a good time to invest in smartly constructed portfolios of hedge funds.

Here's the thing: Hedge fund managers trade spreads, they don't perform alchemy.

So-called "arbitrage" strategies earn a spread over cash returns! The annualized return on three month Treasury Bills over this period plotted above is about 3.1%.  So, at least we should knock 3.1% off the annualized returns because even hedge fund managers aren't making that return in today's environment.

Now, 1% - 4% returns with slightly lower than BBB corporate volatility doesn't look as good anymore, does it?

I guess we should rethink randomly picking portfolios of hedge funds.

P.S. Yes, I should recalculate the vol measures as spreads too.

P.P.S. You disagree that hedge fund managers earn spreads over cash?  Please send me an example.  I probably disagree!