Arnold Kling  

Where are the Hedge Funds?

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Tyler Cowen asks,


Is/was the subprime crisis simply a mask for a more general revaluation of the meaning and extent of liquidity? Are such revaluations always so bumpy and so lacking in locally stable iterative processes?

Earlier, he wrote,

we are seeing negative real rates of return in some credit markets. I don't read this as a reflection of intertemporal preferences and constraints. I read this as a (scary) sign of how segmented some credit markets have become. More concretely, lots of people are running to Treasuries but out of a general sense of fear rather than from rational calculation.

The real interest rate on Treasuries is negative. Yields on many low-risk tax-free bonds are higher than yields on taxable Treasuries. The Agency/Treasury spread (the difference between yields on instruments from Fannie or Freddie and yields on Treasuries) is at levels not seen in decades.

Two years ago, hedge funds were going after microscopic anomalies. Now that the anomalies are so large that they are visible to the naked eye, where are the hedge funds?

Can I start a hedge fund? Surely, if I could short Treasuries and buy other fixed-income instruments, I can pick up a lot alpha, no?


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COMMENTS (6 to date)
Buzzcut writes:

Could you call this a bubble in Treasuries?

If I remember correctly, a bunch of the current round of hedge fund margin calls are funds which tried exactly that trade (short treasuries and long munis). The fact that they are being forced to unwind the trade at a loss is a big part of the reason why the irrational pricing persists.

As I heard a lot in the dot-com bubble days (both before the peak and after), "The market can remain irrational a lot longer than you can remain solvent."

8 writes:

You'll have higher capital costs, if you can even get access to capital. Without leverage and/or cheap capital, these anomolies are not as attractive as they would have been 1 year ago.

Alex writes:

The hedge funds also need to employ extremely high leverage to obtain the outsized returns they proclaim to investors. No one will lend to a fund buying these secutities.

Patrick writes:

"The hedge funds also need to employ extremely high leverage to obtain the outsized returns they proclaim to investors. No one will lend to a fund buying these secutities."

This is spot-on commentary by Alex...it also highlights the silliness of people who claim that hedge funds make the market more efficient. Unfortunately, hedge funds (particularly during times of liquidity crises) are at the mercy of credit markets. At exactly the moment when the efficient market needs hedge fund-like behavior, hedge funds are unable to operate freely.

Ray writes:

There could be alpha in this trade in the long run. Of course, to make money in a long-short trade that offers a few basis points of spread, you will have to lever up your position substantially with cheap credit from your prime broker. Then, you have to hope that the mean reversion happens fairly soon; at least before your prime broker becomes nervous about your leverage (or faces its own margin calls from its credit suppliers) and forces you to unwind your trade early or put up more margin.

In that case you will be just another hedge fund genius that makes the front of the Wall Street Journal for spectacular losses despite having a superior IQ.

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