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When Hedging Bets Just Didn't Work

January 18, 2007 By:
Fred D. Snitzer, JE Feature
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The investment surprise for 2006 was the greater-than-expected rise in the broader markets, such as the S&P 500.

For the last several years, market sages have been telling us to curb our expectations and expect single-digit returns, at best, for the foreseeable future.

While the modest owner of a Vanguard Index Fund is probably quite pleased with its 2006 performance of more than a 15 percent return, there are, no doubt -- among the more than 8,000 hedge-fund managers populating the shores of tony towns like Greenwich, Conn., and Bedford, N.Y. -- some pretty unhappy Masters of the Universe.

Despite charging their clients -- in the lingo of the day -- two and 20 (a 2 percent flat fee, plus 20 percent of an agreed-upon performance benchmark), many of these frustrated geniuses are now cursing this unmanaged index fund, which couldn't generate enough fees to buy an inflatable raft, let alone a luxury yacht.

If you're a smart hedge-fund manager who's getting richly compensated to make macro-bets on currencies, distressed debt, commodities, real estate derivatives, and other risky and arcane investment vehicles like credit-default swaps, and you've just been grossly outperformed by the equivalent of a monkey throwing darts at the stock pages of The Wall Street Journal, 2006 was not a very good year.

And if you're a pure short-seller -- ouch! -- it was a very, very, very painful year.

What happened that not even the hedge-fund managers could anticipate?

Lack of Energy
The primary culprit for their misery was the unanticipated drop in energy prices, which the market, always leaning toward optimism, interpreted as evidence that the Fed would be less worried about inflation, and would therefore stop raising short-term interest rates. This relative cooling of inflation, together with the absence of any spectacularly awful terrorist event (the market seems to have "priced in" merely awful events, like unrelenting bloodshed in Iraq and nuclear tests in North Korea), produced an environment that market participants concluded was "benign," and they responded by delivering double-digit returns in equities.

Another surprise was the continued outperformance of value stocks over growth stocks, and of small-cap stocks over large. The rotation from value to growth funds, which seemed to be getting started during 2005, failed to continue during 2006, as once again value beat growth and small-cap trumped large-cap.

So, will 2007 be the year that large-cap and growth stocks overtake small-cap and value? Maybe.

If you have ice in your veins, go ahead and play the style game -- sell your value funds and put it all into growth; get out of small caps, which have had a great run, and stick it in large caps. There's another alternative -- avoid playing the style game by diversifying across all sectors, taking an Ambien and getting a good night's sleep.

Fred D. Snitzer is chief operating officer in the investment-management firm of Prudent Management Associates, specializing in high-net-worth and tax-deferred asset management.


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