Posted on 5/09/2014 @ 10:58AM
Article from http://www.forbes.com/
Dam McCrum over at FT Alphaville has a look at why the top hedge fund managers are making so much darn money. I don’t disagree with anything he says I just want to pick up on a point and expand it. For we can explain some of what has been happening just with some pure Adam Smith from a couple of centuries ago. what is being said here about new and small hedge funds also rather applies to the entire industry:
Small and young hedge funds are nimble, their managers are focused, and they can concentrate their capital in a small number of good ideas without moving prices or attracting attention. One study by Barclays found that funds under two year’s old, and managing less than $100m typically make better investment returns than their larger older peers.
They’re also more likely to blow up entirely of course. However, back to Smith.
Adam Smith pointed out, not in exactly these words but we can modernise his prose, put it in the demotic, that capitalists are greedy little so and sos. They’re always looking to make larger profits than they are currently. We can look around us and see that there’s an average rate of return to capital in the economy: we might adjust that for risk these days in the way that Smith didn’t. But his point was that there is this average and everyone’s always looking for ways to make more than this average. This is what drives people into looking for new businesses, new ways of doing business, to see if they offer super, or above this average level of, profits.
Of course this doesn’t stop there: some will find a method of making these higher profit levels. At which point others will note what is happening and start to move their own capital over into this new field. At which point we’ve several people competing for these super-profits and they get competed away. Thus, possibly with a bit of overshoot, that newly colonised business area reverts back to the average profit level of the entire economy.
We can see this in those new and small hedge funds. They come up with a new tactic, a new method of investing, perhaps they spot some correlation that no one else has as yet. When new and small they can make their profits out of what they’ve understood about the economy better than anyone else. But if they consistently make those extra profits then people are going to come looking at what they’re doing and start to copy them. And no inefficiency in the economy is large enough for everyone to exploit it at the same time. It’s the very success of the new techniques that attracts more capital and thus competes away those extra profits.
We can also say much the same about the hedge fund industry as a whole. Back a couple of decades there were a few hundred billions in the entire global industry. A decade and more before that only a few tens of billions. Those early funds really did have vast success: they were very definitely making super profits. Thus more capital flooded into the sector until there’s $2.7 trillion in it now. It might be premature to say that the industry is now entirely mature and creating only the average profit level of the entire economy (recall, we must adjust for risk to make this comparison) but it would certainly be true to say that it is maturing. The average return of the average fund is not notably above general investment returns elsewhere.
All of which is as Adam Smith would have predicted: the early success of the new method attracted ever more capital to the sector until those super profits are being competed away.
Posted on 5/09/2014 @ 10:58AM
Article from http://www.forbes.com/
