Thursday, August 8, 2013

Ideal Hedge Fund

A friend asked me an interesting question today:

"If you could design an ideal, i.e. optimally efficient and proficient hedgefund, how would you go about it?  What features would make it unique?"

As I was answering, I realized that it would make a good blog post. So:

Short answer to question 1: The optimal hedge fund is a venture capital firm that either operates in an industry served by no other venture capital firms, or uses validated testing methods to judge the people they invest in.

Short answer to question 2: Actually pay your traders for alpha, by correcting their returns for both average market returns and the beta of whatever they are doing. None of this '2 and 20' nonsense that just rewards people for sitting on a lot of risky assets in a bull market.

Long answer: Asking an economist to design an ideal hedge fund is like asking an engineer to design an ideal motor. The structure, size, and organization depend in the intended use and a lot of other design constraints. If you are actually looking for a way to hedge risk, then it matters what risk you are trying to hedge against.

If by 'hedge fund' you mean a way to make excess returns by taking advantage of market inefficiencies, which I assume, then the important thing to remember is that the only way to beat the market is to be smarter than the market. That means being not only smarter than every individual trading in the market, but smarter than their entire combined intelligence as coordinated by prices and institutional knowledge.

It is basically impossible to be smarter than a large, liquid, well-analyzed market (unless you have access to Strong AI and nobody else does). You have to look for markets that are underanalyzed and illiquid, where highly specialized knowledge is needed to operate or that trained finance people have neglected so far. For example, the Harvard endowment was known for investing in things like timber land.

Of course, finding such markets is also a hard problem, because you have to be smarter or have better connections than everyone else attempting the task. However, you may have success by hiring subject matter experts with esoteric knowledge, and then spending the time and money to teach them about finance and markets. These experts should probably be experienced industry insiders rather than academic experts, although you will need a few people with technical and quantitative skills for the serious number-crunching.

Then you have to give them the right incentives. You have to make sure that you are not rewarding churn, but also not rewarding just sitting on assets. Actually pay your traders for alpha, by correcting their returns for both average market returns and the beta of whatever they are doing. This would be the unique internal organization of my ideally managed hedge fund.

I'd guess that the biggest market inefficiency in our economy today is that small companies are starved for investment because banks are trying to recover their balance sheets. They are being crazy strict with their small business loans, but in their defense, knowing which small businesses are worth investing in is a hard problem. You need good industry experience, good finance knowledge, and probably most important, good skills at reading people and judging their competence and character.

If you can get away with it, maybe you could use tests of various kinds, from personality tests to practical tests related to important business skills, to judge the loan applicants. That would be unique, and almost certainly more effective than standard interviewing techniques. However, be warned that the character traits that make good employees, like IQ and conscientiousness, are not the most important for entrepreneurial success. That seems to be based on perseverance, networking skills, and other things that valid testing instruments do not exist for.

If you invested in researching and validating such tests, then perhaps it could be a source of competitive advantage. I understand tech forms like Google do similar things for choosing employees. But the fact that nobody uses applicant aptitude tests to make venture capital investment decisions may suggest that there are legal problems. If your tests were discriminatory, you might get in trouble. That would require legal analysis.

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