Friday, October 7, 2011

Why Do You Start A Hedge Fund?

I cannot believe I missed the release of this paper by Pertrac, discussing performance differences across different age and size hedge funds.  We're going to try a fun, iterative and interactive approach to this paper.

I've downloaded it, but I have not read it.  In fact, I've only read the tagline from Albourne Village that says "Pertrac Finds Younger of Smaller Hedge Funds Outperform".

(Some readers may know my dissertation covered this topic for mutual funds.  The hedge fund conclusions fall in the category of "Duh!")

This should be entertaining.  It's too bad Yom Kippur starts so soon, or I could go all day with this one.  There will be more.

So, why do you start a hedge fund?  Other than the obvious: You want to make a lot of money.

Obvious Answer #2: You work at a hedge fund, and you have a really good idea, so you want to take a lot of risk with it, but your boss won't allow you to take enough risk.  This idea will take a while to play out.  (See last paragraph!)

You start a new hedge fund with a well developed, carefully researched plan.  You manage to raise a bit of money. Your idea works, over whatever (not too long, or you are out of business) time frame.  But, now you need a new strategy.  You had a trade, not a strategy.

Most people who think they have a strategy actually have a trade.  Now you need a new one.  You're larger, and you don't have the great, risky idea with which you started.  You now officially have weaker performance when you're bigger and older.

Obvious Answer #3: You work at a ledge fund with a strategy any moron could implement, but your boss is a greedy bastard, doesn't pay you and managed too much money, so you decide to do it right, start a new fund managing his strategy.  (Sandy Grossman once had a nerve to announce publicly that if you work at a hedge fund that manages $500 million, and hits capacity limits for the strategy, simply leaving the firm and starting a $100 million fund does not actually raise the capacity of the strategy!!)

Guess what?  You can outperform him for a while because you're not a moron!  But, the only reason you outperform is because you can do the same trades (think merger arb as a great example) with more of your portfolio in the sweet illiquid trades with no capacity.  You figure this isn't much more risky, because you're small and nimble.  You can get out of illiquid positions, the bastard can't. (See last paragraph!) This works for a while, until you also have too many dollars under management.  You are now your old boss.  Your head portfolio manager now quits.

Last Paragraph: Survivorship Bias.  Where is the guy who had John Paulson's view on housing three years earlier?  He was right...but early.  He's pumping gas in New Jersey.  Go find him...really!  Hedge funds self report to databases.  They aren't regulated.  Even weak performing ones just stop telling their story.  Everyone looks the other way. "Sure, there's survivorship bias, but the results are interesting."  That's wrong.  For my dissertation, I constructed a survivorship bias free database of mutual funds where reporting is legally required.  Survivorship bias matters.  Answers #2 and #3 give you a perfectly good hypothesis why small, young funds might outperform.  Survivorship bias gives you a perfectly good hypothesis why you'll observe that small young funds outperform.  You cannot separate the two without the data.

(So, I'll read the paper while I repent, and I'll report.  Since Kol Nidre allows me to repent for acts I will commit in the future, I'm repenting right now if for some reason the data is not biased!)