Saturday, August 11, 2007

Hedge Funds <> Sub Prime

I expect the media to increase its attacks on hedge funds, using their typical broad-brush tactics. I think this excerpt from John Mauldin's letter (quoting from Jon Sundt) does a good job in explaining why such grouping makes no sense and why it should not be considered a market failure when avowed risk-takers suffer a loss on a risky bet:
"Indeed, if you look at the indices for different hedge fund strategies out there, you will find a large dispersion of results for July, with some strategies gaining money and some losing money. The differences between a long/short US manager, a multi-strategy Asia manager, and a leveraged CDO manager are too numerous to mention in this article, but the press would have you believe that these managers are all bound together.

"Let me reinforce my point with a basic but very appropriate analogy. In Japan, there is a distinctive puffer fish called the Fugu. It is served in special sushi restaurants by master chefs. Fugu tingles in your mouth when you eat it. It is supposed to be an exotic aphrodisiac in Japan, where diners spend hundreds of dollars a serving to eat it. The problem is that eating Fugu can kill you. There is an old saying in Japan, 'I want to eat Fugu, but I don't want to die.' People have been known to literally drop dead in sushi bars from cardiac arrest and pulmonary failure if the Fugu they ate wasn't prepared correctly. You have to be a specially trained and licensed Fugu chef to prepare and serve it. Personally, I would want to see the stats of the chef before eating Fugu...just a simple 'number of customers killed' would work for me.

"Now imagine a family in your town called the Griswolds. (You may remember them from the National Lampoon 'Vacation' films.) Suppose for their next trip, the Griswolds decide to travel to Japan and pursue some gastronomical thrills and eat the infamous Fugu. So they do some cursory research, march into a Tokyo Fugu restaurant, plunk down $1,000 and order a huge plate of Fugu. And die on the spot.

"The next morning as you sit at your breakfast table sipping coffee, you read the following headline:

"LOCAL FAMILY DIES EATING EXOTIC POISONOUS FISH IN TOKYO"

"You think to yourself, no problem... you continue sipping coffee... and maybe mutter... 'They should have known better.'

"Now imagine instead that you read the following headline:

"LOCAL FAMILY DIES IN FISH RESTAURANT"

"Your reaction may be very different. You are likely going to cancel your reservation at the local sushi bar until you hear more. What if all fish are tainted? Or is it just that restaurant? Or is it a specific type of fish? You'll have lots of questions, and you might assume, until you know more, that no fish are worth eating.

"My point is that events like these and potential losses should not come as a surprise to knowledgeable and well-educated investors, whether in Bear Stearns' funds (the current focal point of media attention) or other funds. The name of one of the Bear Stearns' funds was 'The High-Grade Structured Credit Strategies Enhanced Leverage Fund.' If this name alone didn't suggest possible concentrations in potentially high-risk investments, I don't know what would. According to one Citibank report, the fund at one point was 80:1 leveraged! In March of this year, the subprime story was all over the news. At a time when most news sources were already talking about interest rate increases hurting subprime borrowers, Bear Stearns appears to have been marketing a fund that invested in illiquid/exotic mortgage credit instruments with high levels of leverage.

"While I don't personally know the full details behind the reasons Bear sponsored this fund, it is clear in my mind that investors seem to have been taken by surprise as to what they had invested in. As I see it, and to return to my analogy, this fund may have been serving up large plates of Fugu to investors clamoring for a bite. The 'diners' appear to have either been unaware of the risks, or more likely, had not seriously considered what could, and in fact did, go wrong.

"Not all CDOs have danger written all over them, but those backed by subprimes would, with the benefit of hindsight, seem to have been quite clearly headed for trouble. It is a very narrow and specialized breed of hedge fund that trades in such a space. Like a sushi 'Fugu' bar, such investing is not typical of all hedge funds. That doesn't mean there aren't billions of dollars exposed to it... it just means it isn't your everyday long/short hedge fund."

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