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Money managers under the microscope

Nickels and black swans

May 26, 2009

Some investors may not be fully aware of the risks they face as career-conscious hedge fund managers plump for strategies that build a convincing-looking track record but occasionally backfire badly.

rtr1b3szAccording to a paper by Yale academic Hongjun Yan, hedge fund managers are far more likely to choose so-called ‘nickel’ strategies than ‘black swan’ strategies, even if returns are ultimately lower and they risk the occasional huge loss.

Nickel strategies are — rather like the contrived image of picking up nickels in front of a steamroller — those that yield small returns most of the time with the occasional disaster.

Yan says the carry trade, merger arbitrage and convertible arbitrage fall into this category.

The problem for unwary investors, as witnessed by last year’s big losses by some funds, is that these trades occasionally go wrong, especially if a lot of other funds are doing the same thing.

“Investors should be aware of the risk (of) potential large losses,” Yan tells me. “It is quite possible that many individual investors are not.”

‘Black swan’ strategies, named after best-selling author Nassim Nicholas Taleb’s credit crisis hit, take years of small losses but hit the jackpot when rare events — such as the credit crisis — occur.rtrgo8v

John Paulson’s $3.7 billion earnings in 2007, according to Alpha Magazine, show how successful bets on events few people expect can be.

The trouble is that investors can lose patience in the meantime and pull out their money — hardly an attractive proposition for hedge fund managers already battling outflows — whereas they’re much happier to accept the steady gains that ‘nickel’ strategies give you most of the time.

That suits everyone very nicely until the trade suddenly unwinds, by which time it’s too late and you’re under the steamroller.

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