demon of our design

This is the second post on this book which will try to summarize the chapters on Hedge funds from this book.

Brave new world of Hedge Funds


Hedge funds exploded in to the financial world in the recent years. There are various types of hedge funds, classic one being top down. A few nice take aways from this chapter is the discussion of tulip mania where the author reasons that the existence and flourishing of futures market was the reason for speculative mania. Also a discussion of the importance of float in the market is discussed in the context of Internet bubble.
The biggest takeaway from this chapter is the answer to the following : Why does the price move ? It moves because of liquidity. Unlike the MBA crap that information moves price, this explanation is nifty . Broker dealers provide liquidity to the clients and they trade in suck liquidity. Elegant view to look at intra day price movements.
The author talks about the rise of pairs trading technique, relative value trades, LTCM and the recent evolution of long/short portfolios . I never knew that Bamberger from Morgan Stanley was the actual brain child between Pairs trading and Tartaglia stole it and scaled it .

Cockroaches and Hedge Funds


Well, this item of the book gained a lot of popularity.This chapter rocks for the author discusses examples from evolutionary biology and discusses about its relation to financial markets. Cockroaches, over centuries of evolution have developed response mechanisms that carry responses from sensory hairs to its legs. They are not filtered by the brain. This is a coarse decision rules in action. In another example, crayfish, also has developed a stimuli triggers a set of stimuli and then one set of action is taken up amongst all the alternative actions.

Another contrasting example is Furu, which is a specific type of fish which has developed a very specialized kind of response behavior, however, it just could not sustain sudden changes in the environment. Thus the author says that a coarse ruled based system is better for evolutionary systems. In that sense, a better risk management need not mean, more reporting, more metrics ..In fact, the more specialized the risk management becomes, the more it carries a risk of being ineffective. This chapter resonates with black swan where the conclusion is more or less similar to black swan. Risk management needs one to be prepared to deal with black swans, the unobservable. Sometimes, the danger to the system is the system itself . A beautiful description and comparison between evolutionary behavior and financial markets. JUST THIS CHAPTER MAKES THE BOOK WORTH BUYING

Hedge Fund Existential


Talks about hedge funds in general and talks about the difficulties in classifying Hedge funds. The author manages to give his own classification with the attributes being Asset Class, Direction, Investment Type, Geographic region and Liquidity. Author ends the chapter with a prediction that ultimately hedge funds will become standardized investment vehicles. Reasoning: Hedge funds cannot be classified. As many investment strategies there are in the world, there can be that many hedge funds. Whats the advantage with a hedge fund ? An short term opportunity which is passed up established regulated funds will be lapped up by hedge funds..So, it is clear that over a period of time, hedge funds will dominate

To conclude

What's the answer to the paradox that this book seeks to answer ?

"Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets. These modifications will lead to a financial marketplace that will be apparently less finely tuned and less responsive to investor needs. But, like the coarse response mechanism of the cockroach, when faced with the inevitable march of the events that we cant even contemplate, simpler financial instruments and less leverage will create a market that is more robust and survivable"

Overall fantastic book and a wonderfully spent 24 hours.

Link : A Demon Of Our Own Design : Summary -Part I