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Thursday, February 28, 2008

Can Hedge Funds Time the Market?

Malaysia-Finance Blogspot carried an interesting post today entitled Market Timing- Fool's Gold? In the post the author asked whether it was possible to time the market. He conclusion was a big yes, because if it were not possible then how can all the hedge funds scored alpha and charged their clients a hefty 20% of the profits? He then went on to conclude that because of the relative outperformance of Hedge funds, the random walk theory does not hold water. The post went on to offer idea on how to time the market.

But Hedge Funds didn't not get their alpha by timing the market. They got their excess returns by arbitraging the difference between two similar markets or securities. In order for it to work, they needed to take highly-leverage positions. Theoretically this should be the safest way to make money because similar securities or markets should converge, according to the Efficient Market Hypothesis(EMH). Betting on two similar securities to converge is not the same as timing the market; in fact, they are diagonally opposing each other in the sense that the former relies on EMH whereas the latter rejects EMH.

Given that everyone is doing arbitraging, the margin of profit is very low. Seeking to outperform other hedge funds, some of them place large betting on market directions ( or the lack of direction) , most of the time with leverage. Some of the hedge funds scored amazing success, and they got all the publicity. But a lot more lost in their betting or did not manage to beat the benchmark. As a result, the investors lost confidence and the fund had to be closed down. The most spectacular example is, of course, the notorious LTCM fiasco, which was chaired by a few Nobel Laureates and was dubbed as "too smart to lose" (for a bitter account of other failed hedge funds, read the book Hedgehogging).

If hedge funds did have a crystal ball, they didn't have to go under or even suffer decline in their returns.

Hedge funds did earn an excess of returns with respect to the normal stocks or bonds returns, in general. But it was all because hedge funds' investment was risker than stocks or bonds investment. High risk, high returns. Nothing special here.

Given the explosive growth of hedge funds, won't it possible that there are secrets to their investment? Maybe. Maybe hudge funds managers know things the mere investors don't. But one thing is sure: they can't time the market. No one can.


Prestito said...

Great post thanks for the info and thanks for the sharing your link to the finance

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