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When should you pull your money out?
Few questions are more revealingóand few questions are so likely to get you looked at as if you were a moronóthan asking a hedge fund manager under what circumstances you should take your money out of his fund.Should you, as an investor or fund-of-funds manager, have a stop-loss point? Are there any other situations or conditions that should prompt you to remove your money? Hedge fund managers hate stop-losses, even those who use them themselves, and itís not hard to understand why. As long as your money is in their fund, they in effect have an option on part of your money. That option is worth money even when their method is worthless.More important, perhaps, with few exceptions hedge fund managers believe in their methods with all their hearts and souls, and they take your lack of faith personally.
But this hatred of stop-losses doesnít mean they are a bad idea. The fact that an account or fund doesnít have an explicit stop-loss doesnít mean it does not have a stop-loss. It just means that neither the fund-of-funds manager nor the hedge fund manager knows where the stop-loss is. When losses in the account exceed the fund-of-funds managerís tolerance for pain, he closes the account. This can happen even with funds that will eventually make money. If the fund-of-funds manager and hedge fund manager had known what the formerís tolerance for pain really was, the redemption might well have been prevented. This lack of self-knowledge, this lack of communication, makes fund-of-funds management more difficult than it needs to be and makes fund-of-funds investing less profitable than it could be. It may even make hedge fund management less profitable than it could be. A stop-loss for a hedge fund makes sense in the same way a stop-loss for a trade makes sense. Every hedge fund and every trade is based on an idea, and not all ideas are right or even reasonable. Put another way, every drop in equity is another bit of evidence that the hedge fund manager canít do his job. Against this, the fund-of-funds manager must balance evidence that the hedge fund manager really can do what he says he can do. But the positive evidence is never as conclusive as the hedge fund manager believes it is. If the losses continue, the fund-of-funds manager must eventually close the accountóif possible, before all of the money in it is gone. Setting a stop-loss for a fund demands knowledge of its money management system and the distribution of its wins and losses. Given that information, itís sometimes possible to use algebra or Monte Carlo simulations to locate a cumulative percentage loss, which indicates that the manager has lost control, that his trading has changed for the worse. Bizarrely, the hedge fund managerís pro-forma distributions may work better here than his real ones. For a variety of reasons, pro-forma distributions are almost always overly optimistic. When real-world results fall below projections, it is time to talk to the manager. It isnít always possible to set a fund stop-loss and for similar reasons, if not quite the same ones, it isnít always possible with long-only investments. If IBM is underpriced at, say, $50 a share, then for most fundamentally based tradersóespecially those of the Graham and Dodd schoolóit is an even better investment at $40 a share, assuming nothing else has changed.For those traders, the fact that the price has dropped is not evidence their trade is wrong. There are direct analogues in some long-only alternative investments such as precious metals, forestland and rare coins.I canít think of any direct analogues in the hedge fund world.If the investor or FOF manager is buying the hedge fund managerís judgment, there are no analogues.If the investor is buying a portfolio of very long-term hedged investments there can be analogues.The problem here is that hedge fund managers almost invariably sell judgment, not portfolios.Hedge fund marketing presentations to the contrary, a drop in the per-share value never means that the fund is a better value or buying opportunity. Or rather, it is a buying opportunity only if, for some reason, the drop is not evidence of manager incompetence, and if the fund-of-funds manager can use it to do something he could not ordinarily do, such as enter a closed fund or negotiate lower fees.Although a drop in a fundís value is a usually an indication of incompetence, it is not the only indication or even necessarily the best one.Other more sophisticated tools, such as comparison of cumulate returns with the appropriate indices or, better, style analysis, may suggest the situation is really better than it appears.Or worse.If a fund stop-loss cannot reasonably be set, which is often the case, the fund-of-funds manager had better watch these tools closely.
An Earlier Version of This Article Was Published in MARHedge.
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"If your mother says she loves you, check it out." --Old reporters' motto; also our motto. Copyright (C) 2005, 2006, 2007, 2008, 2009 Fred Gehm. All rights reserved.