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TMFMmbop (39.20)

On betting against hedge funds

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December 19, 2006 – Comments (0)

Someone, I can't remember who and I can't seem to find the link of Forbes.com, was opining in the most recent issue of Forbes that individual investors would be well served to bet against hedge funds. Of course, this seems counterintuitive. After all, hedge funds are run by some of the smartest and most successful financial minds in the business.

But here's the thing...

Hedge fund managers, like all professional investors, answer in the end to their customers. And the reason people want to invest in hedge funds is to make outsized gains. So what are hedge funds doing? They're making fat tail bets. Now that the market has been on a tear for a while, hedge funds are assuming larger and larger risks to keep trying to beat the market by a significant margin. And it's only high-risk, low-probability events that can earn them these kinds of return.

And if they go belly up in the process, so what?

As the Forbes columnist pointed out, if a hedge fund fails, the managers don't have to refund their salaries from previous years. They may be out of business, but they're certainly not going to the poor house.

So, and I loved this point and wish I could find the link, if you're betting against hedge funds, you're not actually betting against their smart investors, you're betting against the greedy SOBs that are their cusomters.

And that's a good bet.

Similarly, this is why mutual funds, although they're often headed by very smart investors, lose to index funds -- they have to deal with dumb individual investors who force them to invest more money after they've had great runs. In other words, buy high and sell low. Mutual fund managers don't make the big bucks by holding cash.

So, whether you invest in stocks, funds, or hedge funds, it pays to be a smart investor regardless.

Tim

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