Efficiently Inefficient

How Smart Money Invests and Market Prices Are Determined

Lasse Heje Pedersen

• Éditeur: Princeton University Press
• Année: 2015
• ISBN:
  9781400865734
• Sujet: Business
• Sous-sujet: Trading

Financial market behavior and key trading strategies—illuminated by interviews with top hedge fund experts Efficiently Inefficient describes the key trading strategies used by hedge funds and demystifies the secret world of active investing. Leading financial economist Lasse Heje Pedersen combines the latest research with real-world examples and interviews with top hedge fund managers to show how certain trading strategies make money—and why they sometimes don't.Pedersen views markets as neither perfectly efficient nor completely inefficient. Rather, they are inefficient enough that money managers can be compensated for their costs through the profits of their trading strategies and efficient enough that the profits after costs do not encourage additional active investing. Understanding how to trade in this efficiently inefficient market provides a new, engaging way to learn finance. Pedersen analyzes how the market price of stocks and bonds can differ from the model price, leading to new perspectives on the relationship between trading results and finance theory. He explores several different areas in depth—fundamental tools for investment management, equity strategies, macro strategies, and arbitrage strategies—and he looks at such diverse topics as portfolio choice, risk management, equity valuation, and yield curve logic. The book's strategies are illuminated further by interviews with leading hedge fund managers: Lee Ainslie, Cliff Asness, Jim Chanos, Ken Griffin, David Harding, John Paulson, Myron Scholes, and George Soros. Efficiently Inefficient effectively demonstrates how financial markets really work.Free problem sets are available online at http://www.lhpedersen.com

PART I

Active Investment

CHAPTER 1

Understanding Hedge Funds and Other Smart Money

There are many types of active investors who make markets efficiently inefficient. These investors include large sophisticated pension funds with in-house trading operations, endowments, dealers and proprietary traders at investment banks, trading arms at commodity producing firms, mutual funds, proprietary trading firms, and hedge funds. In each case, the traders have slightly different contracts or profit-sharing agreements and face different political and firm-specific pressures and concerns. Since the focus of this book is the trading strategies, not the players, it would take us too far astray to discuss each of these trading set-ups in detail. However, to relate the trading strategies to real-life investors, it is worthwhile to understand the most pure-play bet on beating the market, namely hedge funds.

It is notoriously difficult to define what hedge funds are. Said simply, they are investment vehicles pursuing a variety of complex trading strategies to make money. The word hedge refers to reducing market risk by investing in both long and short positions, and the word fund refers to a pool of money contributed by the manager and investors. Asness has provided a tongue-in-cheek definition:

Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.

—Cliff Asness (2004)

Hedge funds are exempt from much of the regulation that applies to other investment companies, such as mutual funds. Hedge funds have a lot of freedom in the trading that they do, as well as limited disclosure requirements, but in exchange for this freedom, they are restricted in how they can raise money. In terms of freedom, hedge funds can use leverage, short-selling, derivatives, and incentive fees. In terms of restrictions, hedge fund investors must be “accredited investors,” meaning that they need a certain amount of financial wealth and/or financial knowledge to be allowed to invest (to protect smaller, presumably less sophisticated, investors from the complexities encompassed in hedge fund strategies and risks that they may not understand). Also, hedge funds have historically been subject to a non-solicitation requirement, meaning that they cannot advertise or actively approach people for investments (although the regulation is being tightened in certain ways and loosened in others, e.g., in connection with the recent JOBS (Jumpstart Our Business Startups) Act in the United States).

Active investment has been around as long as markets have, and hedge funds have existed for more than half a century. The first formal hedge fund is believed to have been a fund created by Alfred Winslow Jones in 1949. Jones took long and short positions in stocks and reportedly earned a phenomenal 670% return from 1955 to 1965. While short-selling had been widely used long before Jones, he had the insight that, by balancing long and short positions, he would be relatively immune to overall market moves but profit from the relative outperformance of his long positions relative to his short positions. After Fortune magazine published Jones’s results in 1966, interest in hedge funds started to grow, and in 1968 the U.S. Securities and Exchange Commission (SEC) counted 140 hedge funds. In the 1990s, the hedge fund industry saw a dramatically increased interest as institutional investors began to embrace hedge funds. In the 2000s, hedge funds with billions of dollars under management became commonplace, with total assets in the hedge fund industry reaching a peak of about $2 trillion before the global financial crisis, falling during the crisis, and since reaching a new peak.

Because of hedge fund leverage, their aggregate positions are much larger than their assets under management and, given their high turnover, their trading volume is a much larger part of the aggregate trading volume than their relative position sizes, so hedge fund trading is now a significant proportion of all trading. In an efficiently inefficient market, the amount of capital allocated to hedge funds cannot keep growing since, given a limited demand for liquidity, there is a limited amount of profit to be made and a limited need for active investment.¹

1.1. OBJECTIVES AND FEES

The objective of asset managers is to add value to their investors by making money relative to a benchmark. Mutual funds typically have a market index as a benchmark and try to outperform the market, whereas hedge funds typically have a cash benchmark (also called an “absolute return benchmark”). Hedge funds are not trying to beat the stock market but, rather, trying to make money in any environment. This is where the “hedge” part comes in. In contrast, mutual fund returns are usually benchmarked to a stock market (or bond market) index such as the Standard & Poor’s 500 (S&P 500). Hence, if the S&P 500 is down 10% and a mutual fund is down 8%, it is outperforming its benchmark and applauded by its investors, whereas a hedge fund down 8% would be punished by its investors for the loss since its bets should not depend on market moves. Conversely, if the S&P 500 is up 20%, investors in a mutual fund that is up 16% will complain that it picked stocks that underperformed. Investors in a hedge fund that is truly market neutral (many are not) are satisfied that the hedged bets paid off in absolute terms. A hedge fund with returns that are independent of the market has the potential to be very diversifying to investors.

Asset managers charge fees for their investment service. Mutual funds charge a management fee (a fixed proportion of the assets), and hedge funds often also charge a performance fee. The management fee is meant to cover the manager’s fixed expenses, and the performance fee is meant to strengthen the manager’s incentive to perform well. The performance fee also enables the hedge fund to pay performance-based bonuses to its employees.²

While fees vary greatly across funds, the classic hedge fund fee structure has been “2 and 20,” meaning a 2% management fee paid regardless of returns, and a 20% performance fee. For instance, if the hedge fund has a return of 12%, then the return is 10% after the management fee. The performance fee is then 20% of the 10%, that is, 2%, leaving 8% for the investors. Sometimes the performance fee is subject to a hurdle rate, such as the Treasury Bill rate, meaning that the hedge fund only earns performance fees on the return that exceeds the hurdle rate. However, performance fees typically do not depend on whether the fund beats the stock market return.

A hedge fund’s performance fee is often subject to a high water mark (HWM). This means that, if the hedge fund loses money, it only starts to charge performance fees when the losses have been recovered. Just as you can see how high the water has reached by looking at the marks on the piers supporting a dock, a hedge fund keeps track of its cumulative performance and only charges performance fees when it reaches new highs. Note, however, that the HWM is investor specific. If a hedge fund gets a new investor just after suffering losses, the hedge fund can charge performance fees from the new investor as soon as it makes money (since the new investor has not incurred any losses that need to be made up).

While fees are income for asset managers, they are costs for investors. Investors should be aware of the fees they pay since fees in money management are very large, both in terms of the total amount of money paid, the fraction of the value added by the manager, and the effect of the long-term investment performance. There exist managers who track an index (explicitly or implicitly) while charging high fees, resulting in performance that underperforms the index by the fee each year, significantly hurting the long-run returns.

The fee should be viewed in relation to the amount of effective money management that the manager provides and the quality of this management. The amount of effective management can be measured as the “active risk,” i.e., the volatility of the deviation from the benchmark (or tracking error). Hence, if a manager does not deviate from the benchmark, the fee should be very small. Similarly, a hedge fund manager who runs a high-risk and low-risk version of the same hedge fund typically charges a larger fee for the high-risk fund. This measure of the amount of effective management helps explain why hedge funds charge larger fees than mutual funds, namely because hedge funds effectively deliver more asset management services (since a large part of mutual fund returns is just delivering the benchmark).

To understand the importance of costs in the financial sector, consider how costs build up for a household saving for retirement. The retirement savings are managed in a pension fund with costs to pay its staff. The pension fund may hire investment consultants who charge fees to help pick the asset managers, and the asset managers charge another layer of fees. If the pension fund invests in a fund-of-funds, that adds yet another layer of fees. A final layer of costs comes from the transaction costs incurred through the turnover of the active manager (and earned by dealers and banks). Unless the fees in each layer are very competitive relative to the costs of passive management, the asset manager must add a lot of value through his trading. For an end investor to beat the market, a “double inefficiency” must exist: First, the security market must be inefficient enough that active managers can outperform, and second, the money management market must be inefficient enough that the end investor can find a money manager whose fee is below the...