Thursday, October 11, 2007

Hedge Fund Seminar Data Points - Day 2: The Power to Exploit

Sometimes the deeper you dig the more you get to appreciate the many nuances and special wrinkles that make up a given complex subject such as alternative investments. Such is the case with yesterday's hedge fund seminars that I conducted. To my ear, two points among the many superb and often insightful comments made by my excellent expert panelists stood out and I share them with you here.

At my luncheon session, Rob Blabey with Jim Hedges' firm noted that there are no secrets among hedge fund players, particularly the equity players who are reasonably well informed. As with traditional positions (say long only) taken by your typical portfolio manager, the positions taken by most hedgies are fairly well known among those who make it point to know their markets. This occurs despite the opacity that is part and parcel of a largely unregulated business because the information network can be rather porous in areas. Nothing new here. However, where this gets most interesting is when things go wrong.

During such times, the Darwinian approach to money management kicks in and those that are in difficulties are left to twist in the wind until the pain can be taken no more. The pack then swoops in and makes the most hay out from the residue of the bad bet made.

I suppose none of the above should come as a surprise. It is, after all, the nature of the free market system. You place your bets, you take your chances. I guess I just never gave it much thought as to how ruthlessly it all plays out, especially during times of market stress.

The dinner session produced a piece of actionable information for all investors.

As this year wraps up in a couple of months, there is likely to much window dressing conducted by the hedgies. Given the summer experience of the pre Bernanke put era ("we didn't bail anyone out", wink, wink) and the fact that so much remains to be uncovered (including the real value of the assets on the books), it is quite reasonable to assume that many market-related cross currents will continue to occur and will likely intensify as the year comes to a close. For with the end of the year comes the auditors and audited investor reports as well as the performance fees "earned". Since mark to the market is still absent from many alternative investment instruments, alternative pricing methods (mark to model, to ratings, to marketing, and/or to myth) set the stage for a number of potentially suspect "transactions". With so much money (and careers) at stake, the free market system operating in a largely unregulated space could produce a number of, shall we say, interesting "transactions".

Investment Strategy Implications

There will be additional points in next Monday's weekly report (subscription required). For now, the central issue is the exploitative mindset that the rest of us, the more traditionally-oriented investor should develop. When it comes to thinking about the alternative investments space, much like the Darwinian example above, it is what an investor can do to exploit the situation that matters most.

With knowledge comes power. From an investment perpsective, that power is expressed in the ability to exploit the situation.

For despite the once in a century storm that actually occurs every five years*, alternative investments (hedge funds, private equity, structured products, etc.) are here to stay. An investor's mission, therefore, is not to bemoan the situation but to exploit it. The power to exploit is in the ears and minds of all investors attuned to changed game of investing.

*With the implications for equity valuation models via the destruction of the normative bell curve distribution of returns. A point made before and one that I will return to in future reports and blog entries.

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