Survival of the fittest Hedge Funds

In 1859, Charles Darwin introduced his theory on “On the origin of species” through this now famous preamble: “As many more individuals of each species are born than can possibly survive; and as, consequently, there is a frequently recurring struggle for existence, it follows that any being, if it vary however slightly in any manner profitable to itself, under the complex and sometimes varying conditions of life, will have a better chance of surviving, and thus be naturally selected.” The (very non organic) species of the hedge fund industry have been aptly playing out this struggle for existence over the last few months as famous names such as Peloton Partners, Carlyle Fund, Carrington Capital, Amaranth Advisors and the mother load at Bear Stearns end up in the obituaries column of financial journals. The much vaunted “strategy” which typifies the various hedge fund species be it equity long-short, event driven, arbitrage or other clearly needs to evolve to be naturally selected under the current complex and varying conditions of the market. As an example, consider Andrew Lahde’s Lahde Capital Management, a California based hedge fund: by betting against sub prime, his fund returned over 1000% in 2007 to investors. Mr. Lahde is already developing other contrarian strategies to prepare for the market’s next set of probable directions.

On March 18th, Martin Wolf wrote in the Financial Times that collapses are inherent in the hedge fund model because hedge fund managers have thus far been more lucky than skilled. I believe there definitely is a certain percentage of Alpha seeking managers who are indeed truly skilled but a large majority of managers have ignored the lessons of the efficient market hypothesis or unlike my MBA students have skipped class when the classic Black-Sholes option pricing model was being discussed. I have always argued that Alpha is a constantly moving target and seekers of Alpha may want to study Heisenberg’s uncertainty principle which describes how the momentum of an uncertainly moving target may be described more accurately through a probabilistic distribution rather than an assumed intermittent occurrence. This failure of managers to constantly seek a changing alpha which may occasionally have low probability occurrences will result in an extinction of their species.

The fittest species to survive in the hedge fund universe will be those who, as Darwin wrote, “vary however slightly in a manner profitable to itself” or in other words constantly seek Alpha by having an evenly spread probabilistic distribution of returns rather than maximize returns from higher probability events. Indeed this will be the species that will not only survive but also thrive.

Note: I have also published this article on Richard Wilson's hedge fund blog.