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Apr 10 2008 9:41AM EDT

Why Hedge Funds Lose Money in Volatile Markets

Insight from Baruch:

The strategists at my beloved employer told the punters, correctly, that this year would see a lot of volatility in equities. So, they said, increase allocation to equity long short, which struck me as precisely the wrong thing to do. Paradoxically in times like this it is the dumb, directional money, the long only crowd, who can ride out volatility better.

This makes sense to me, and helps explain why volatility is bad for hedge funds. If you're doing any kind of relative-value play, then volatility works against you in that it increases the chances that you'll get stopped out before you make any profits. It's only the noise traders who really make money from volatility, and they're actually a minority in the hedge-fund world.

No hedge is perfect, and in periods of unusual volatility, hedges are more likely to fail. Hedge funds, it seems, are much more likely to outperform in a low-volatility bear market than in a high-volatility messy market like we have right now. But there isn't an asset class devoted to making money from volatility, so investors throw their money at hedge funds anyway, generally in the hope that if a fund hasn't blown up yet, it might somehow avoid blowing up in future.

Update: After four comments saying exactly the same thing, I clearly nead to clarify. Of course there are ways of making money from volatility: you just, well, go long volatility, normally in the options market. But that's a strategy, not an asset class. For an investor trying to work out where to put his money, the zero-sum game that is the options market is not really investable, let alone a good idea.

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