There have been a lot of bits and bytes spilled recently over whether hedge funds like volatility or not. Here’s a sampling:

• Hedge Fund Losses Blamed on Volatility
• Hedge Funds Come Unstuck on Truth-Twisting, Lies
• Hedgies hate volatility
• Why Hedge Funds Lose Money in Volatile Markets

Here’s the truth, the answer isn’t a simple yes or no.  Hedge funds are limited partnerships that do a wide variety of things in the markets.  Some aim for easily modeled consistent gains through arbitrage.  Others aim for maximum advantage, no matter what.  I call the first group the “nerds” and the second group the “barbarians.”  Neither of these terms are meant to be insulting — I consider myself to be a nerdy barbarian.

Nerds are yield-seekers.  They are attempting to achieve high smooth yields well in excess of the nominal risk-free rate on a constant basis.  They tend to get funded by fund-of-funds who attempt to diversify nerds, and maybe a barbarian or two, who have clients looking for smooth yields in excess of their hurdle rates.

When volatility rises, nerds get hurt.  In the same way that junk bond investors get hurt in volatile times, so do hedge fund nerds.  Almost all simple arbitrages rely on calm markets, where there is enough liquidity to finance every project imaginable, and a few that aren’t imaginable.  Volatility alerts investors to the concept that maybe there will not be enough cash flow to complete the transaction at a positive net present value.

Barbarians are another matter.  They swing for the fences, and are looking for maximum advantage.  They look to earn the returns from big bets that could be right or wrong.  They like increased volatility, because it enables them to take positions when they are despised or enraptured.  They play for the mean reversion, something that the nerds can’t do.

To make matters more complex, some hedge fund groups blend the two attitudes.  Good idea, if you can maintain your competitive advantages.

To close this, there is no simple answer to whether hedge funds like volatility or not.  Some benefit,  some get hurt. In my opinion, because of hedge fund-of-funds, which like nerds, volatility tends to hurt hedge funds in aggregate, but not by much.

With credit spreads wide, and disarray among the nerds, it is probably time to favor high yield investing and nerds in hedge funds.    Don’t jump in with both feet though, I would only allocate 50% of a full position at present.  There is a lot more volatility to be worked out of the system.

This entry was posted on Friday, April 11th, 2008 at 12:11 am and is filed under Bonds, Speculation, Structured Products and Derivatives, Value Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.