June 15, 2010

It’s Either Hedge Funds or Balancing on Logs

We were on the bikes at dawn in Denver where on the oval at Washington Park it was 45 degrees as the sun rose.  That’ll wake you up!

Speaking of waking up, did you read Sebastian Mallaby’s article in the weekend Wall Street Journal called “Learning to Love Hedge Funds?” Going back to the first hedge fund in 1949, run by Alfred Jones, Mallaby contends that hedge funds represent the optimal risk-management model.  Government tries to prevent bad things from happening. Hedge funds, where owners put their money at risk and earn returns when profits are produced, view risk as a pathway to opportunity, but one marked by prudent insurance, or hedges, against downside.  Jones produced cumulative returns of 5,000% from 1949-1968, Mallaby notes.

We’ve long contended that the contemporary IR relationship palette should reflect a variety of hedge funds and turnover timeframes. In markets predicated on the making and taking of liquidity and the constant re-allocation of risk and capital, focusing only on buy-and-hold investors is like offering a Monet to a Jackson Pollock collector.  You’ve got a nice product for the wrong buyer.

That leads to current markets.  Let’s talk again about “high frequency trading.” During a panel on trading at NIRI last week, Liquidnet’s John Adam, always an outstanding panelist, mused that “the only thing everybody agrees on about the definition of high frequency trading is that it’s trading at high frequency.”

Great assessment! There’s a bewildering variety of means and methods today by which parties large and small using networks both discrete and diffuse engage in the rapid putting and taking of shares for profit. We shouldn’t mistake it for investing. 

Here’s an analogy.  There are trillions of dollars moving through global markets.  Consider it a barge on land that must be scooted across the ground. If you’re moving a barge overland, you’ll roll it on logs, pulling the last one in the line and putting it in front and continuing to motivate the barge along.

In trading markets, everybody is moving logs now, from hedge funds, to exchanges, to institutions, to broker-dealers. The barge isn’t the best source of profit anymore; moving logs is.   Some high-frequency traders make money by collecting a fee for pulling the logs from behind and others for putting them into place at the front. Some profit by taking the logs from each other and moving them, and some by moving the logs faster than other log movers.  But it’s all intermediary service, for a fee.

While the mix of this activity varies widely from issuer to issuer, in general some 70% of volume is high-speed log-moving, and over 90% of volume is either speculatively driven – a form of intermediation or trading on gaps – or program-driven, which is managing the allocation of risk and capital.

People blame hedge funds for this.  Hedge funds would do the exact opposite, were they in charge of managing risk. These conditions we have now are what you get when you put government in charge of managing risk. What happens is that the best log movers become the most profitable enterprises. 

And you’ve got problems if the log movers decide not to move logs anymore. 

Speaking of which, we reiterate what we said last week. Despite strong market moves this week, we remain concerned that quantitative order flow might take sudden leave. Programs are responsible for positive performance since June 8. We can see it in the data. We cannot possibly predict what that means. But the allocation of risk and capital is transient today. That makes us wary.

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