Sunday, September 4, 2011

Interesting Financial Investment Trends

Leonard Mlodinow wrote a fascinating book: The Drunkard’s Walk: How Randomness Rules Our Lives. In it, he devoted a large section to trying to convince the reader that success in the stock market was consistent with random chance. He applied this to people who ran mutual funds and had to make many bets. The reasoning was that the world is so complex and there are so many variables that can affect a given stock’s price that making good selections is mostly luck. If there are a thousand people flipping coins and heads is a win, there will be someone who gets perhaps ten straight heads. Does this make them smart, or just lucky?

One way or another, investors seem to have come to accept Mlodinow’s point of view. A recent article by Charles Stein in Businessweek, Americans Lose Faith in Stock Pickers, confirms a definite trend toward indexed funds. These are funds that are structured to duplicate the movement of one of the market indexes such as the S&P 500. Investors are guaranteed to at least do as well as the market index. This graphic is provided in support.

Between 2000 and now there has been a net flow out of traditionally managed funds (Domestic stock funds). People who are investing in stocks are overwhelmingly choosing indexed funds (Exchange-traded funds). There is increased interest in international markets, but the big winners are bond funds. That is more indicative of disenchantment with stocks as an investment than unhappiness with fund managers.

So if you think your managed fund is behaving erratically—that’s what randomness is.

One becomes weary of hearing of billionaire hedge fund operators being taxed at 15%. An article in The Economist brings us a different perspective. It leads with this comment.

“A difficult year for many hedge funds may prove a fatal one for some.”

Hedge funds are supposed to do well in times of volatility, but apparently that is not the case.

“These are the very conditions in which hedge funds are meant to prosper, yet many struggled to make sense of the markets. Some long-short equity funds fell by as much as 15%. Even John Paulson, an acclaimed hedge-fund manager who made billions betting against the housing bubble, has suffered losses. His leveraged flagship fund, Advantage Plus, was down by 31% for the year on August 5....”

The article claims that many small funds run the risk of losing their investors.

“August is on track to be one of hedge funds’ worst months ever. The effects will be felt most by some of the weakest funds, many of which need a quarter or two of good performance to restore the morale of their investors and traders. Should they continue to underwhelm in the coming months, investors are likely to withdraw their money.”

This chart is provided to compare percentage total returns for a hedge fund index and for the S&P 500.

As the article points out, the hedge funds are struggling to keep up with the general market—not what investors like to see given the lofty fees exacted by the funds.

To the extent that a given hedge fund actually contributes to the “efficient allocation of capital,” then welcome to the party. However if they are just involved in placing bets against each other in some zero-sum game, they won’t be missed.

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