Thursday, August 02, 2007

The hedge attraction

Excessive supervision over their weekly returns is the greatest risk faced by a fund manager than the market risk itself. Poor fellow, can never take a longer term view or be a contrarian and buy stocks that come cheap (now in India, IT/sugar stocks) because peer pressure forces him to ape his counterpart in another fund house or worse, the one that sits next to him. He has no choice but to play the momentum that becomes the fundamental instead of intrinsic value. As a result, investors are exposed to the vagaries of the market sentiment even though they are inherently momentum averse and have a longer term appetite.

But why blame supervision that eggs on weekly performance – any attempt to mitigate risky element from investment avenues like stocks is sure to dent returns together with risk that it seeks to reduce. Think of CAPM, that suggested non-market risk should be eliminated through diversification, and hence market risk should be the only risk that an investor should be exposed to.

Warren Buffett says the only reason people diversify their stock positions is because they don't know what they are doing. This makes them use the "spray and pray" approach -- buying a lot of stocks and praying that some of them go up. Market guru Peter Lynch calls diversification "di-worse-ification," highlighting the fact that concentrated portfolios are better.

Perhaps that explains why investors flock to hedge funds even as many fold up…

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