Ratios – Hedge Funds’ Meat and Poison

Friday, November 20, 2009

x-353759_mushroom_orgie_1To close out this week’s focus on ratios, let’s look at hedge funds, the most sophisticated users. Their offsetting, push-me/pull-me risk strategies often win in normal times. However, occasionally the unexpected happens…

Everyone would like to earn more return for less risk. Hedge funds try to satisfy this dual desire by using an offsetting risk strategy. An example is the basic common stock approach, where the hedge fund manager buys (or sells short) a stock believed to be incorrectly priced. Then, to counterbalance the risk, the manager “hedges” by selling/buying a comparable risk investment (e.g., a similar stock or index) that is not mispriced. If everything works out, a gain is earned when the under-/over-pricing disappears, regardless of what happens in the stock market, itself.

Notice we’re talking about relative valuations here, meaning “ratios.” Ratio-based investing is not limited to common stocks (yesterday we discussed gold/silver and oil/natural gas). Computers (i.e., extensive databases and fast calculations), combined with many kinds of securities, provide the opportunity to analyze and pick an investment approach from slews of different ratios.

Most well-designed hedge fund strategies can work most of the time. After a period of steady returns, however, the expectation can become overly optimistic – that the strategy will work all of the time. This no-risk belief, in turn, leads to acceptance of leverage for increasing returns. And, for hedge funds, leverage is the Achilles’ heel. Here’s why…

Even in normal times, something “unexpected” can happen to produce a significant or extended change in a ratio. That’s when the dam breaks. Savvy investors (think Goldman Sachs) know that ratio-investors willingly step into such dangerous situations, so they seek to take advantage through counter-positions, driving the ratios futher afield. It’s at these times that leverage really cripples a hedge fund, depleting its capital and potentially forcing sales or, worse, the fund’s liquidation. Many years of good returns can be wiped out  in one of these adverse events. Recent history is filled with examples.

So, why do hedge funds remain popular? Probably because such situations are viewed as aberrations, comparable to 100-year floods that no one could have foreseen. A good example is John Meriwether’s current plans to create a third fund after his previous two, Long Term Capital Management (*) and JWM Partners, collapsed due to “no one could have seen that coming” events.

The lack of foresight, though, isn’t the problem. Rather, it’s the belief that any ratio can be stable through time and not suffer an upheaval. So long as managers and investors think there is a way to use ratios successfully and without interruption, they will continue to take on – and experience – the bombshell risks inherent is such strategies.

So, do not rely on ratios to drive an investment management strategy – even if experts are at the controls.

(*) Click here for a good summary of Long Term Capital Management’s highly professional underpinnings and the cause of its undoing.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

November 2009