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Tuesday, 25 November 2008

Welcome to Alphaville

“... where the betas are all smaller than any preassigned number and the alphas are all above average” E.Derman

I can’t remember the number of times I have heard someone say that their hedge fund holdings were down, but it wasn’t that bad given the state of the market. But hang on a moment, I thought hedge funds were supposed to be all about absolute returns, all excess return and no market correlation. Apparently not. My socks appear to have outperformed the market as a repository for excess cash this year and they don’t charge a 2% management fee. Private equity hasn’t worked any better. The firms that have invested in MBI’s and LBO’s have gone south with the market, and the infrastructure funds such as Macquarie, Allco and Babcock & Brown have all but bitten the dust.

Mind you, I never held with the notion that price volatility was a reliable indicator of risk (variations in price could have a direct but volatile causation such as the weather even although the risk of outright default might be low), nor that diversification that reduced volatility necessarily gave rise to reduced risk (two assets might exhibit a negative correlation, but the fact that one does well when the other does badly doesn’t really reduce the risk that either might fail, even though the risk that both will fail at the same time may be very low).

But that diversification doesn’t seem to help any more. There are so many markets linked by alternative investments that any risk diversification seems to be pointless. When the NYSE falls, so do Asian commodities because it is the same money driving both markets. When one market takes fright so does the other. More than that, asset pricing models probably expect some sort of normal behaviour where prices fluctuate within certain reasonable bounds. They don’t really handle catastrophic failure, or fear of the same, very well. In a normal market there may be very little correlation between US housing and the price of Pacific Island coconuts, but when the former nosedives far enough everybody including the coconut farmer gets hurt.

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