Fundamental risk and arbitrage

The first barrier is the common danger (not present in the Shell example) that fundamental risk may undermine any effort to arbitrage away an anomaly. An example would be where one company in an industry is thought to be expensive and a similar one to be more sensibly priced. A hedge fund manager might sell the former and buy the latter, but the size of these positions will be limited because the arbitrageur will know that unexpected events could cause the expensive stock to appreciate in price and the cheap stock to decline, causing losses to both sides of the "hedge". A graphic illustration of an apparently good hedge resulting in large losses was provided in May 2005 when in the space of two days Kirk Kerkorian, an American billionaire investor, announced his intention to increase his holding in General Motors (gm) stock (which increased in price) and Standard & Poor's (see Chapter 8) downgraded the debt of both gm and Ford from investment grade to sub-investment grade, which fell in price. The problem was that a number of hedge funds thought they were "hedging" gm equity (which they had sold) with gm debt (which they believed to be cheap, and so had bought). The result was substantial losses for a number of hedge funds on both sides of the hedge whose prices, unusually, moved in opposite directions. The simple lesson is to make sure the hedge is a good hedge. The more substantive one is that even the best hedges may fail and the risk of this happening puts a limit on the scale of the arbitrage position that will be applied to correct apparent market anomalies.

To risk money on an arbitrage position, the investor must consider the time horizon for the position. A hedge fund that correctly identified in the late 1990s that "new economy" (technology, media, telecom) sectors of the stockmarket were overpriced relative to so-called "old economy" sectors could easily have bankrupted itself before the validity of its analysis was demonstrated by the collapse of "new economy" stock prices. This illustrates that some types of market anomaly, whose identification will always be subject to margins of uncertainty, may require such long time horizons that the investors best suited to try to exploit them will be long-term investment funds, not hedge funds. In a hedge fund, the balance of long and short positions, which require daily marking to market of profits and losses, will not be able to support large long-term positions. It follows that hedge funds are not ideally suited to correct all pricing anomalies.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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