Monday, August 25, 2008

A modest proposal (for hedge fund investors)

The news of the demise of former CNBC anchor Ron Insana’s venture has been a catalyst for more questions about the hedge fund business model. Are these project returns persistent (also here)? Are there cheaper alternatives?

Looking for uncorrelated pure alphas
I have a modes proposal for hedge fund investors in light of these difficulties. The story of hedge fund investing has been to look for a pure alpha stream, however you want to define it, that is uncorrelated with the return pattern of existing asset classes.

If that’s the case, why not go into the gaming (or casino) business?

In the gaming business, the house has an edge in any game you play and takes steps to enforce that edge (e.g. tossing out the card counters at Blackjack, etc.) The customers know it, but they still keep coming.

Statistically, the return pattern of every game that a customer plays is uncorrelated with any other. The advantage of being in the gaming business means that you don’t have the problem of the shifting correlation problem: The return correlations of seemingly uncorrelated factors and asset classes converging to 1 during periods of financial crisis.

The main difference is the fee structure. In a hedge fund, you typically pay 2% and 20% with a lockup. In the gaming business, the lockup remains. However, there are significant overhead cost to keep the lights on in a gaming operation. However an investor can gain some of the benefits of economies of scale if there are such a venture can achieve sufficient size.

Addendum: After reading the comments, maybe some readers didn't get the joke which was modeled on Swift's satire A Modest Proposal. This post was meant as a call for a thought experiment as to the rationale behind hedge fund investing.

What this post was not:
  • A call for hedge fund investors to gaming: I am well aware that the gaming industry is economically sensitive and cyclical. These are obvious limitations to the gaming industry.
  • A call to buy gaming stocks: See comment above about the gaming industry. However, do think about the cash flows of the business because when you engage in direct investment you need a long-term horizon, much like the lockups that you see in the hedge fund industry.

to have to explain my jokes...


Henry Bee said...

Very neat idea. And this is true as long as people are able and willing to spend large sums gambling. In a recession and credit bubble unwind, society at large is unwilling and unable to gamble. This is bearish for casino stocks until a economic recovery is well underway, leaving the stocks still highly correlated with the rest of the market. No alpha earned.

Jake said...

Henry- I was about to say the same thing. I don't think the negative (but uncorrelated returns) of Vegas casinos would make any investor happy.