Do Hedge Funds Earn Abnormal Returns?

The industry, as expected, claims they do.  As a University of Chicago product, I am generally skeptical of claims that hedge funds, on average, produce alpha.  It is certainly possible that the extra returns (if there are any) are due to increased risk.  From the NYT:

Based on Mr. Malkiel’s studies and other academic work, hedge fund investors should probably assume that reported industrywide returns are really as much as four percentage points lower, which makes hedge fund managers look much less special.  This problem of voluntary reporting adds to what is known as survivorship bias, by which poorly performing funds that shut down drop out of the index.

It is still tough to say what this ultimately proves, but it seems clear that until more transparency is adopted in the industry, one should be skeptical of the claim that hedge funds, on average, produce higher risk adjusted returns than alternative investments.

I am not sure how I feel about the skills of individual managers.  It is true that some managers might produce superior returns consistently due to their investing skill, but it is hard to know for sure.  For mutual funds at least, Eugene Fama has found that just by luck alone, there should be more successful managers than exist today.  But the jury is out on hedge fund managers.  Of course, if you are a hedge fund manager collecting your 2/20 fees, transparency is the last thing you want.  That is what regulation is for though.

Full Disclosure:  If someone was willing to give me a chunk of money with a 2/20 fee structure to try to produce alpha, I would give it my best shot.  Of course, I am arrogant so I think I could do it, but people always overestimate their own abilities.

Interview with Rahuram Rajan

Mark Thoma’s summary is here, and the full interview is here if you are interested.  Rajan offers some great information on economic development, the financial crisis, and financial regulation.

He is a University of Chicago professor if anyone was wondering.  Despite the general attitude of the blogosphere, there still is great stuff coming out of the school.

The Racist Right and Terrorism

I suppose the reaction was predictable, but “profiling” of Muslims at airports is a terrible idea.  From Matthew Yglesias:

The United States is a gigantic, diverse country that does business and policy all around the world. Air travel in this country is as safe as it’s ever been. Taking reasonable steps to make it safer would be nice, but cutting ourselves off from a huge swathe of the world and poisoning relations with 1.5 billion Muslims is going to be much worse than an exploding airplane.

People on the right need to stop just standing up for liberty, freedom, and small government for affluent whites.  Profiling of Muslims would clearly curtail the freedom of Muslims.  Any attempt to think about the costs of such a “profiling” policy makes the idea irrelevant very quickly.

Goodbye Pete Carroll

ESPN is reporting that Pete Carroll is going to the NFL to coach Seattle.

Maybe Notre Dame will have a shot against USC in the future.

Bubbles – The Point of No Return

I was reading this recent blog by Paul Krugman about bubbles and I was reminded of this article from Christian Leuz in Forbes, published about a year ago.  In it, Professor Leuz gives one of the clearest descriptions of why bubbles exist I have come across.

During speculative bubbles, there is a point at which sophisticated players lose the incentive to correct a trend away from fundamentals and instead benefit from going along with it.

I am sure many of you have heard the phrase “the market can stay irrational longer than you can stay solvent”, but Leuz’s description doesn’t just describe why it is hard to profit by betting against bubbles, it describes why people that might normally bet against bubbles start to play along with the irrational price appreciation.

Even more importantly, I think this helps to describe one of the biggest problems with our financial system today.  If one bets against the bubble and loses, everybody thinks that person is dumb.  But if one bets with the bubble and loses, that person just did what all the “smart” people were doing too, so they can’t be dumb.  If one works in finance then, it seems pretty clear that betting against the bubble results in a much higher probability of being fired.  But there really isn’t much of a downside to playing along with the bubble in the short term.

Unfortunately, I am not sure how to fix this with regulation.  It is more of a behavioral problem.  I think the best way to fix behavioral problems is to continually make people aware of them. That might make it more socially acceptable to bet against the bubble without the consequences of looking dumb if the bet was made too early.

Big Bonuses Make Financial Reform Easier

Wall Street is set for another round of good earnings, courtesy of the US government, and huge bonuses.

My top legislative priority is not health care.  It is financial reform, and Congress is moving too slow for my tastes.  The longer they wait, and the farther away the economy gets from the recession, the harder financial reform will be.

But Wall Street may be helping me out.  Each and every financial institution on Wall Street is alive today because of government assistance.  So seeing them carrying on as if it was 2005 frustrates me.  But maybe Wall Street’s stubbornness will create the kind of public backlash we need to motivate faster and more complete financial reform.

The Health Care Negotiations Should Not Be Televised

I find the claim that the health care negotiations should be televised ridiculous.  An open and honest discussion would be impossible with the cameras there.  And Republicans who claim that the negotiations remove them from the process should have thought of that over the last year when they decided their strategy of saying no to everything was their best way to win the majority back.

Strategically, I understand the move.  And if all I cared about was having Republicans in power I would support the move.  But I care about having Republicans in power that will govern the country in a reasonable way.  This Republican party is not it.