S.E.C. Lost Its Hedge-Fund Authority and Will Be Glad It Did

The Rising Role of Private Equity

US regulators to interview Morgan Stanley CEO over hedge fund

 

Apparently the Economist has an article showing that the securities industry is anticipating robust growth.

See Nigel Edelshain's weblog for more information.

Mark Cuban (dot com billionaire, owner of the NBA Dallas Mavericks) weighs in on the difference between speculators and investors:

http://www.blogmaverick.com/entry/1234000660060351/

In general, I like his analysis.  I think it's unfortunate that so much of the mainstream financial press considers "investing" in index mutual funds as an "investment".  It really is speculation.

How would I apply this analysis to hedge funds?  I definitely agree that hedge funds are speculative in nature.  Of all the possible speculative investment opportunities, I might argue that (certain) hedge funds are the least risky.  I would personally much rather own a piece of a hedge fund than own a piece of an index mutual fund.

Hedge Funds and Sources of Liquidity

America's biggest hedge funds

Hedge Fund Demand and Capacity, 2005 - 2015

Absolute Return Funds Could Get Boost From Bayou Fallout

Consultants defend work with Bayou hedge funds

Hennessee Group Strikes Back

Is a Hedge Fund Shakeout Coming Soon? This Insider Thinks So

Job Posting: Senior Programmer: International Fund Services (N.A.) LLC

Mutual Funds are called Unit Trusts outside the USA (filed under the "learn something new everyday category").

MFA's 2005 Sound Practices for Hedge Fund Managers : Press Release - Document

I can only see this as a very good thing.  Often, doing the right thing from a risk management perspective is much different from doing the fun thing.  It's easy to motivate yourself to do what is fun (manage money), it's much tougher to motivate yourself to do what is necessary (risk management and mitigation).  "Best practice" documents like this help to motivate hedge funds to do the right thing.

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Hedge funds' game may be a loser for mutuals to take on

I love reading this kind of analysis.  Given that hedge funds are growing so quickly, why don't mutual funds "embrace and extend" the characteristics that make hedge funds so attractive?  I think there will eventually be popular mutual funds that offer absolute value returns in place of relative value returns, but it may be a long time in coming.  So much of the marketing of the mutual fun industry rotates around (relative value) index funds and managed funds performance relationship to index funds, that it would require quite an adjustment to start comparing mutual funds' absolute performance to safe investments that don't lose principal.

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Deutsche Bank publishes its Fourth Annual Alternative Investment Survey

There are some interesting findings in this press release.  I assume you can purchase the full report for some amount of money.

How do I get started with the Capprime competitive pairs trading application?

It's a web based application, so in just a few clicks you are well on your way.  You may want to do a little bit of planning first about which pairs you are going to trade.  Also, decide if you want to remain anonymous or not.

1. Login anonymously or register with your e-mail address.
2. Create a pair.
3. Create initial orders in the pair (start with relatively small share amounts of 100 or 1000 shares to test the waters).
4. Create more pairs with corresponding orders.
5. Check the leader board after the market closes to see where you place.
6. Check back on the leader board every day or once a week or so to see how you are doing.
7. Make adjustments to your positions as you learn more.
8. Add new pairs that you think of, remove old pairs that aren't working as you predicted.
9. If you are consistently making money, get an account setup at one of the low cost online brokers (E*Trade, etc.) and see how you do with real money.
   

Go to the series overview.  Go to Part 4.

How do I "find pairs"?

• Generally, start with two companies in the same market and industry.
• It helps a lot if they are companies you know about and read about without extra research effort.
• It's usually not hard to identify a market leader (i.e. McDonalds) and then pick one or more companies they compete with whose stock price moves in similar ways.
• Use Yahoo! Finance to look up instrument symbols (http://finance.yahoo.com/l).
• Use Yahoo! Finance to generate comparison graphs for different time periods (http://finance.yahoo.com/).

What makes a good pair?

• Predictability
• Low volatility
• Mature companies
• Long trading histories
• The instruments react to major market movements (interest rate changes, industry downturn, etc.) in different ways
• Touch points on a 1-2 year graph (LUV/NWAC)

What are some sample pairs to get me thinking?

• McDonalds/Burger King
• Coca-Cola/Pepsi
• Walmart/Target
• Southwest Airlines/Northwest Airlines
• Intel/AMD
• Disney/Pixar
• Apple/Microsoft
• Amazon.com/Barnes and Noble
• Eli Lilly/Merck
• ETrade/Ameritrade
• Wells Fargo/US Bank
• State Farm Insurance/All State Insurance
• Motorola/Nokia
• Dell/Hewlett Packard
• Toyota/Ford
• NVidia/ATI

Go to the series overview.  Go to Part 3.  Go to Part 5.

Why did Capprime create an application around competitive pairs trading?

• It's a learning tool for students and others interested in absolute returns.  Most major financial publications today recommend people invest in index mutual funds that track the S&P 500.  The problem with this advice is that the S&P 500 can easily lose 20% in a year and who wants their investments to lose money?  The alternative is investing for absolute, market neutral returns that can always be positive, but there is very little in the main stream market literature to help people learn the skills and techniques necessary.
• Pairs trading of US equities is one of the simplest forms (i.e. easiest to understand) of market-neutral, absolute return, hedging.
• Capprime's competitive pairs trading application is a (free to users) marketing tool for Capprime's professional (not free to users) portfolio management accounting software which is based on the same underlying technology.
• The Capprime competitive pairs trading application can be used by users for both fun and profit.  It's a great combination of entertainment, education, and competition.
• Eventually, I would love to see a community of people interested in educating each other about hedging techniques develop and help move this dark corner of the investment world much more out into the light.

Go to the series overview.  Go to Part 2.  Go to Part 4.

What is pairs trading?

Pairs trading is a relative value hedging strategy which consists of buying (long) one instrument and selling (short) a second instrument.  Usually the two instruments are in the same industry.  The instruments are thereafter treated conceptually as a pair of instruments and you judge success not on the results of one instrument or the other, but on the combination of the two together.  Each instrument is considered one "side" of the pair.  In general, one "side" will be a winner and the other "side" will be a loser.  The goal is for the winning side to outpace the losing side.

This hedging strategy can be implemented as a market neutral strategy.  A market neutral strategy tries to reduce market risk by being less vulnerable to major moves of the stock market as a whole.

An example pair would be buying Southwest Airlines (symbol: LUV) long and Northwest Airlines (symbol: NWAC) short.  This pair would be chosen based more on fundamental analysis than statistical analysis.  Southwest is one of the most consistently profitable airlines.  Northwest is going through a potentially crippling mechanics strike at the moment.  If you look at the one year comparison graph on Yahoo! Finance, you'll see the recent relative performance of these two stocks.  It appears to be a relatively safe bet that Southwest is going to increase in value relatively faster than Northwest.

There are plenty of other good resources for learning more about pairs trading.

There are quite a few books dedicated to pairs trading:
http://a9.com/%22pairs%20trading%22?ypLoc=&a=sbooks

For further reading on the Internet, here are some good sources:

Options Application in Pairs Trading

Finding Profit in Pairs

Market Neutral Long/Short Equity Trading

PairsTrader.com

A Google search on "pairs trading":
http://www.google.com/search?hl=en&q=%22pairs+trading%22

Go to the series overview.  Go to Part 1.  Go to Part 3.

What is an instrument?

If I just talked about stocks, that would be simpler for everybody.  Fortunately or unfortunately, there are many other "instruments" that trade and act similarly to stocks and can be almost treated as such.  A stock is an instrument.  Equity is another word often used to represent common and/or preferred stock.  Other common instrument types are:

• Mutual Fund
• Bond
• Option
• Future
• Spider/ETF
• Index (S&P 500)
• Currencies

In general, instead of talking about "trading stocks" or "trading equities", I'll instead mostly be talking about "trading instruments".

Go to the series overview.  Go to Part 2.

This week I am going to publish a five part series (FAQ style) on the topic of competitive pairs trading.  I will cover terminology, why you should care, and how to get started.  This entry will be updated as the week progresses with links to each article.

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An introduction to competitive pairs trading

Part 1 (07/24/05): What is an instrument?
Part 2 (07/25/05): What is pairs trading?
Part 3 (07/26/05): Why did Capprime create an application around competitive pairs trading?
Part 4 (07/27/05): How do I "find pairs"?
Part 5 (07/28/05): How do I get started with the Capprime competitive pairs trading application?