Wednesday, February 23, 2005

Smart money reaches $1 trillion

The Economist reports that hedge fund assets under management have reached $1 trillion, even while returns have diminished. Only qualified investors (an SEC classification) are eligible to invest - the requirement is $1M in net worth or $300K per year of family income. I guess most physics profs are stuck with mutual funds, which might not be so bad given the 2/20 fee structure charged by hedge funds ;-)

If your kid is mathematically gifted, I suggest pointing him (or her :-) to the nearest "relative value arbitrage" fund, rather than grad school in physics :-) With the glut of money heading into hedge funds, I've been told that the number one shortage is in investment ideas! You can see this in the graph below - the variation in returns is going down as more and more funds pile onto similar strategies.

Institutional Investor's obsessively read list of most-highly-paid hedge-fund managers starts with familiar names (George Soros: $750m), but 16 others made at least $100m in 2003... Successful managers become rich, possibly too rich to care about work, in just a few years.

I've discussed the role these funds are playing in the bond market, plying the carry or curve-flattening trades: sell the short end and buy the long end of the yield curve. Hedge funds are the third largest holders of US Treasury debt after Japan and China.


Carson C. Chow said...

I just read the Economist article and it sounds like one big pyramid scheme. What ever happened to wanting to do something good for society?

Anonymous said...

What do you make of Warren Buffet's comments about derivatives being 'financial weapons of mass destruction'?

Also, my understanding is that the Fed can (usually) prevent a run of the banks which are well-regulated. Is it true that there is less regulation of the hedge funds, and the Fed could be powerless to handle major collapse (which persumably hapens when they stop hedging and start taking greater risks)?

(Of course, LTCM had to bailed out by the Fed and a crisis was averted.)


Anonymous said...

Correct me, but I understand that Long Term Credit was "saved" not by selling its assets at a discount to an asset rich corporation. Berkshire Hathaway has the deepest of pockets and might have bought LTCM, but decided there was not enough in protected discount assets for the purchase. The New York Federal Reserve Bank and Robert Rubin had to get Wall Street competitors of LTCM to agree to limit going against LTCM open positions. The Wall Street finance houses that took control of what assets there were acted together to allow LTCM position to recover. A buyer like Berkshire Hathaway could have been further hurt if competitors had continued going after LTCM position.

No; I did not explain this properly, but there may be no value at all in derivative positions that go wrong and add many times the assets of the holder in liabilities.

General Re, the Berkshire Hathaway catastrophe insurer probably no longer has derivative positions.


Anonymous said...

Now, please explain to me what I have tried to write :)


Anonymous said...

When an investment style becomes the market, as hedge funds are becoming, the retuns that will be gained will be market returns. But, the cost of hedge funds assures they will perform considerably more poorly than index funds. My guess is Berkshire Hathaway will have much the edge.


Anonymous said...

A foolish foolish question. Lots of these in philosophy. Suppose the Bank of Japan loses 20% on dollar reserves. A 20% increase in the value of the Yen more than makes up for the loss in reserve value. Where then is the problem from this foolish perspective?


Anonymous said...

The mention was of hedge fund fees that run 2 and 20. Think about how much hedge funds had better out-perform the market. Berkshire Hathaway by the way has management fees of about 3 basis points. The owned companies pay well, but there are no options, and directors have minimal salaries. There have seldom been cuts in employment.


Steve Hsu said...

Carson: efficient markets are good for society ;-)

Re: LTCM, their positions eventually came back and the bank consortium that bailed them out evntually made money. I will post something about LTCM in the future...

Anne: Firstly, BoJ would then have been better off having ALL their reserves in Yen, no? If they can see the 20% correction coming, why not shift to Yen earlier? A loss is a loss :-) Also, BoJ may have obligations (issued bonds) denominated in Yen. If the capital backing up those bonds is in dollars, they might be in trouble if the dollar falls. (Imagine you have to make your rent payments in Yen but you foolishly have your savings in dollars. What happens if the dollar drops vs the Yen?)

Anonymous said...

Thanks Steve,

The prolem them is that assets and liabilities must be properly matched. Yes, yes. Yen debt can not be matched with dollars that are losing value. Thank you :)

My underststanding was that the LTCM only recovered because Wall Street Banks did not take positions against the portfolio, and so allowed for the recovery. Yes, the consortium made money on the portfolio, but no portfolio that could not rely on others to lay off could have made money. Is this correct?


Anonymous said...

Thanks so much!

Brad Setser:

consider the following example.

a "speculator" manages to buy renminbi from China's central bank.

the speculator ends up with 8.28 renminbi, the central bank with a dollar.

the central bank's balance sheet shows a renminbi liability, and a dollar asset. (I could make this more complicated by introducing sterilization, but that more or less just means that the speculator sells its renminbi cash to the central bank for a renminbi denominate treasury bill, so the amount of cash in circulation does not go up; similarly, rather than holding a dollar cash the central bank could buy a treasury bill and get some interest).

now suppose the renminbi is revalued, so one renminbi is now worth say 6 to the dollar.

The speculator then sells its renminbi to the central bank for dollars. The speculator has 8.28 renminbi, so the speculator can, after the revaluation, now buy 1.38 dollars -- a nice profit.

the central bank effectively sold renminbi at 8.28 to the dollar (one renminbi = 12 cents), and then bought the renminbi back at 6 to the dollar (one renminbi = 17 cents).

So look at it from the central bank's point of view. before the revaluation, it held a dollar (an asset) worth 8.28 renminbi against a 8.28 renminbi in cash (cash = a central bank liability), after the revaluation, it held a dollar worth 6 renminbi against 8.28 renminbi in cash. Its assets no longer cover its liabilities.
that is a problem is all holders of the central bank's liabilities decide they want to trade their liabilities for the central bank's assets.

If all the holders of renminbi wanted to exchange their renminbi for dollars, they could not. there are no longer enough dollars to go around.

Now throw in a twist -- a central bank's balance sheet includes both foreign assets (dollars) and domestic assets (usually government debt), which are held against its liabilities (domestic currency cash, or money). If after, a revaluation, foreign assets are worth 6 renminbi (going back to the example) and domestic liabilities are worth 8.28 renminbi, the central bank's balance sheet can be made solvent if the central bank is given a government bond (a domestic asset) worth 2.28 renminbi. That bond has to be a gift -- the central bank does not buy it, the government just gives it to the central bank. That bond is worth 0.38 dollars (2.28/ 6). so if the central bank sells the bond along with its dollar asset, the central bank has enough money to fully repay speculator who initially bought 8.28 renminbi for a dollar, and now wants to trade the 8.28 renminbi for 1.38 dollars.

The government -- the taxpayer's -- have to service the bond that the government gave the central bank that the central bank then sells in the market to pay off the speculator. That is the real cost of the central bank's loss.

Make any sense?

the central bank's technical insolvency (liabilities in excess of assets) matters if the holders of central bank liabilities (cash) decide they want to trade their liabilities (cash) for the central bank's assets (dollars and government debt). to assure that the central bank has enough assets to cover its liabilities, the government has to give it an additional asset (government debt).

In my story, I left out lots of twists -- notably sterilization -- and I suspect the last transaction (selling the "recap bond" to generate the extra 38 cents I need) is rather unrealistic. It would be more realistic to assume that the extra government bond went to back domestic currency in circulation, and the central bank just ran down its dollar assets. but I hope I still got the basics right. any monetary economist out there should feel free to provide a better explanation.


Anonymous said...

Medical Companies Joining Offshore Trend

Bala S. Manian rarely looked back when he left India to attend graduate school in the United States. Since 1979, he has started one medical technology company after another in Silicon Valley.

But Dr. Manian is now rediscovering his native country. His newest medical venture, ReaMetrix, which makes test kits for pharmaceutical research, is still based in Silicon Valley. But 20 of its 28 employees are in India, where costs for everything from labor to rent are lower.

The exporting of jobs by ReaMetrix is telling evidence that the relentless shifting of employment to countries like India and China that has occurred in manufacturing, back-office work and computer programming is now spreading to a crown jewel of corporate America: the medical and drug industries.

It could be a worrisome sign. The life sciences industry, with its largely white-collar work force and its heavy reliance on scientific innovation, was long thought to be less vulnerable to the outsourcing trend. The industry, moreover, is viewed as an economic growth engine and the source of new jobs, particularly as growth slows in other sectors like information technology.

'What I see in India is the same kind of opportunity I saw in the Valley in 1979,' said Dr. Manian. In the United States, he said, 'a million dollars doesn't go more than three months.' In India, by contrast, 'I can run a group of 20 people for a whole year for half a million dollars.'

While life sciences jobs may be less vulnerable to outsourcing than jobs in information technology, industry officials say many companies are looking at that option as pressures mount to control drug prices and cut development costs....


sjfromm said...

steve said, Carson: efficient markets are good for society ;-)But the efficiencies you're talking about are 10th order effects.

Steve Hsu said...


Yes, I agree. That comment was a bit tongue in cheek.

More seriously, as the world economy becomes more globalized and sophisticated, it seems inevitable that money management (e.g., for pensions, endowments, wealthy individuals) will be a growth industry. Indeed, this activity is an absolutely necessary one. So, I think it is unavoidable that some individuals who are talented in this area are going to become very wealthy.

Information technology and sophisticated markets play a role in this trend - a group of 5 guys with a support staff of 10 can easily manage $1B. For those lucky few in this industry, the compensation is likely to be off-scale.

Anonymous said...

Nice use of a misleading graph. The "downward trend" is for the standard deviation of returns, not the actual returns implied by your text.

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