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How do you short the HF industry ?


SharperDingaan
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Just to stir the pot.

There is an interesting article in the Jan/Feb 2011 FAJ entitled the ABCs of Hedge Funds: Alphas, Betas, and Costs.

 

Notable points are 1) Median fee is 1.5% + 20% incentive fee, 2) 2 in 3 hedge funds cease to exist < 10 yrs of posting results, 3) Survivorship Bias (only get the winners results) is around 5.1%, 4) Backfill bias (only start posting when you have good history) is around 2.05%, 5)Average Alpha is roughly 3% - but up to 80% of it may be nothing more than momentum (ie: Beta)

 

In short, you need to deduct 8.7% (5.1%+2.05%+1.5%) from a HF return just to eliminate the bias & fees. You also pay the HF outlandishly for their Alpha (ie: long-short gains), & it would appear that most of it (per the universe of HFs) is bull. 

 

Given that HFs are consistent targets for most regulators in their ‘new orders’,

& that if you can’t beat them – join them; 

A) How do you short specific types of HF ?

B) How do you short the HF industry itself ?

C) Why is there no ‘standard’ lot for what would clearly be very profitable ?

 

If you’re the regulator, you can control the industry by simply shorting it - or individual HFs within it. Muscular regulation that results in the regulator &/or central bank getting paid for it if the HF fails, or closes?

 

If the private XYZ HF takes a run at you, all you can do to preserve value is buy puts on your own shares – which XYZ is selling to you. Why can you not do the same thing on XYZ HF?

 

SD

 

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Without getting into the merits of hedge fund specific types, the industry, etc., you could short in certain ways by entering into a derivative agreement (straight or by structured product) via an ISDA with one of the banks using one of the hedge fund indices as your reference obligation.  Obviously not for most individual investors.  I don't know of any kind of "retail" product that would allow you to do the same.  This would of course be a customized investment.  The only products I am aware of that used hedge fund indices (which was a number of years ago), were all long.  Because of course who would want to short!

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Guest Bronco

Perhaps you can create synthetic hedge fund obligations and then short them.  I here a GS subsidiary in the Cayman Islands is creating these products as we speak.

 

I here there is an AIG subsidiary in a secret location (only known to insiders as monkey island) where they are creating swaps against the synthetic hedge fund products created by GS).

 

 

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You can certainly do so synthetically.  That's what I was attempting to refer to in my first post in this thread.  You wouldn't even need to create it synthetically and then short it.  You could simply create the synthetic short if someone would take the other side.

 

Very nice reference to secret shorts by AIG.  I laughed at that.  I do chuckle though at the reference to Cayman Islands subsidiaries.  These are all shell entities (generally) housed in one of about 3 buildings with the same set of officers and directors.  They are subsidiaries in name only. 

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Guest Bronco

To be clear - everything I wrote was BS and not true.  Don't want to tarnish the name of AIG or GS.

 

I also spelled here (hear) wrong - comes with quick emails when you should be working.

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Assume that for now, to bet against the industry you need a ‘bespoke’ agreement. It’s going to cost a lot (legal, accounting, ISDA, etc) to structure, the counterparty will have to be a ‘name’, & you’re going to have to effectively bribe them to take the position. It’s highly sensitive, & there’s a risk that its existence (& the counter-party name) could ‘leak’ into the public domain. The counterparty could be a cephalopod or a member of the industry – but it’s much easier to persuade a squid. You might be one or many central bankers. Our agreement gets done.

 

A prominent HF, anywhere in the world, goofs - & one of the counterparties starts to purposely leak. The leaks will stop if a standardized contract is set-up & traded – the HF industry on one side attempting to hedge its regulatory risk, our central-bankers & speculators on the other - with the squid running the book (persuasion). Our market gets born & starts growing.

 

Capitalism does its thing, the players start to drop/consolidate. Safety is sought in ‘too big to fail’, & our market making squids book becomes less profitable. That original ‘bespoke’ agreement matures, & becomes subject to freedom of information searches. Our counterparties huddle & agree to resolve the reputational image problem - with new (& evergreen) agreements on each of the industry’s main players. Protection.

 

Lo & behold – we have a ‘market’ solution to the HF industry, without the need for regulation! ....... And a ‘too big to fail’ solution. Fail to behave - & suffer a material increase in the size of the bet on your failure. To stop the fund withdrawals you need to either side-bar, or have you & your supporters take the other side of the additional bet – with all parties have to post more & more margin the closer you get to failure. Way too damaging on the ego.

 

Elegant solution ....  so why does it appear that it hasn’t happened ?

 

SD

 

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SD - they are all bespoke agreements in something like this.  Cost is an issue, but you may be overestimating how much.  At the end of the day, it would depend on who one is who wants to make this trade.  If you're a big boy, then you can probably get this done relatively cheaply.  If you're Joe Blow, then if you can get it done, then will be pricey.  All would depend on what it is you're looking to synthetically short.  I don't see how you can "bet" on a HF itself.  What is it you would be shorting?  They need to have some kind of obligation to reference.  If it's a private obligation then that's going to be more expensive likely and create informational issues.  There will also be legal issues in terms of disclosure, confidentiality, etc.

 

Other issues:  while you could maybe get someone to take the other side on this trade on a one off or virtually one off basis, there will never be an industry in it so long as the current environment stands.  By that I mean the hedgies pony up too much cash for the banks.  Presumably you want your counterparty to be someone who will likely be there tomorrow.  Forgetting Lehman and Bear for a minute, that leaves the investment banks and the larger banks who play in this area (BofA, Citi, etc.)  They make too much money though to risk the chance that they are known as the guys that make a market in shorting the industry.  I don't see it happening.  None of the banks would risk pissing those guys off.

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The problem with shorting a hedge fund is that while the fee structure and returns net of fees to investors is outrageously low on a risk/adjusted basis, it is still most likely going to be positive. 

 

If you assume the average hedge fund does 8% a year and they charge 1.5 and 20 then the manager is getting a bit under 3% of the 8% total return in fees!  However, the investor is still making + returns.

 

IE, shorting a hedge fund won't make you anything.  What you want to do is short the hedge fund BUSINESS or pair trade hedge fund returns vs index funds w/o fees.  I'm not sure you are able to do this.

 

The best way to short hedge funds is probably to short AMG.  They make GP investments in hedge funds. 

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SD - using your very criteria, the mutual fund industry would come out even worse; on aggregate its members have underperformed their benchmarks (which, I should say, are rather straightforward vs. the more sophisticated bogeys used by different HFT strategies) for more than 30 years and most investors are aware that the industry, again on aggregate, is structurally deficient. Yet such phenomenon is not going anywhere.

 

 

I reckon the topic is more of a mental exercise than anything, but if history is indication, one might need a lifetime investment horizon to realize profit on a targeted industry short.

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The alternative to SharperDingaan's scenario is that the growth of hedge fund derivatives merely promotes consensus movements. It would also be complicated to specify default since a hedge fund structure typically allows for massive external cash flows. A counterparty may find it cheaper to provide liquidity. Also, the proposed derivative isn't a direct reflection of the quality of the notional fund's portfolio, but rather a measure of the fund's ability to survive. How would the counterparties track the fund's partners to avoid a set up? Presumably, the hedge fund would need some incentive to volunteer the information, in addition to updating its portfolio, which raises another kettle of worms.

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  • 3 weeks later...

 

You would be very surprized at just how easy, & relatively cheap, this is to do - & especially at the retail level.

 

For Canada you need only be a qualified & private investor, specify the custodian, go through AML/ATF verification, have the terms of the trade documented in a legal contract, & have independents both confirm the pricing terms & verify the trigger event. If you're on both sides of the trade (RRSP, TFSA, Private Coy accounts, etc) an ISDA agreement, & collateral posting, is not necessary. Assuming the contract is modeled along the lines of a Credit Default Swap, a sample trigger event would be the failure to file on the TASS database by XYZ Hedge Fund, within X months of due date.

 

Not without risk (audit), & very application specific (tax planning), but quite doable. Just expect some  raised eyebrows, & perhaps some unwelcome verification/curiosity, when you talk to your independents.

You end up with a derivative that acts like finite insurance (HF reporting lasts an average 7 yrs) but with the exchange mechanism of a CDS swap - so you better understand it!

 

SD

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There is no market, standardized contract, promotional press, advice, etc - it is entirely bespoke.

 

In Canada you essentially have to approach one of the big 4 tax/wealth-management specialists, tell them EXACTLY what you want to do, & what you want from them - then hand them all your research. They'll give you an opinion, which you give to the custodian (triggering the AML/ATF review process), following which a lawyer who will draft up the contract for you. Cost of replication then becomes just the cost of a new contract. 

 

The simpler, & the less said, the better - as there are many potential applications.

 

SD

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