What do hedge funds do, and how do they make money?
These are questions everyone wants answers to. And most people would like those answers to not be too technical.
Reddit user gadela08, who claims to be a hedge fund insider, provides a brief, crystal clear explanation of how hedge funds operate.
1) On securities research and analysis
Here are the Redditor’s key points:
- ignore the “pop-finance” media like CNBC and Bloomberg
- conduct original research using primary sources
- build mock portfolios and stress test them
- avoid bias as much as possible
- speak directly to CFOs
- share snippets with “friends in the market”
- maintain contact with tons of brokers
That last bullet includes testing legal limitations. Here’s exactly what the Redditor said (emphasis added):
We maintain open contact with over 40 different brokers in various markets. Every day, these guys send me hundreds of emails and text messages over bloomberg telling me as much as they legally can about what kind of flows they’re seeing. When they buy a large block of securities from a client, they let me know what they just bought and offer me a structured trade for those products so they clear the risk off their books. sometimes they call me to tell me interesting or urgent news about a particular trade that i currently have on that I may have missed in the news that morning.
This gives you a sense of how the big players can have an edge over mum-and-pop.
2) On the Efficient Market Hypothesis (EMH)
The EMH more or less argues that the all available information is already priced into the market. And therefore, it is basically impossible to beat the market.
However, many dispute this theory and believe it’s a mistake to take it too seriously.
Another Redditor identified six ways a trader could theoretically take advantage of inefficiencies. We paraphrase here.
- Small, but costly returns: With the right strategy and technology, there are opportunities to make small amounts of money. But 1) it’s difficult to justify the costs (e.g. traders, computers, fees, etc) and 2) those returns could disappear.
- Betting against unlikely events: You can earn premiums by selling out-of-the-money-put options, which effectively insure against low probability events. “The problem is the strategy occasionally blows up and loses a lot,” said the Redditor. “As long as you size your exposure correctly over time the premium you earn will make up for your blowups.”
- An opportunity few know about: Sometimes, there are opporunities to truly take advantage of a market inefficiency. But those opportunities often attract attention and disappear.
- An opportunity everyone knows about: “A classic example is the January effect,” said the Redditor. “The stock market used to return more in January than other months. Even when this was widely published it took a decade or more for it to go away. ”
- An informational edge: This could easily be confused for insider trading. But it can be done legally. “For example a hedge fund sending people into stores and counting the number of shoppers to try to get a guess about a company’s upcoming quarterly earnings,” said the Redditor.
- Regulatory arbitrage: “Market participants are restricted by some set of rules that prevent them from making certain investments,” said the Redditor. “This gives opportunities for counter-parties that aren’t bound by such rules.” This could include hedge funds cheaply buying into credit deals that were once the dominated by the big banks.
Again, all this just goes to show that mum-and-pop are likely to have a disadvantage relative to the big players.
Read the whole thread at Reddit.
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