July 'herd mentality' may result in worst hedge fund month in 5 years

The best laid plans of mice and men, ...and hedge fund managers

Economist David H. Wang told BloggingStocks Monday the to-date July swoon in HFI's hedge fund index dispels at least one, and perhaps two, myths regarding the hedge fund sector.

The first concerns the notion of absolute return -- or the theory that argues that a complex mathematical formula, computation, or other derivative can be constructed so as to 'guarantee' a return on investment in any market condition. "For a while there were practitioners who argued that a formula could guarantee a return. Not too many people are supporting that view now," Wang said. "There has never been a formula that could guarantee a return in every climate. The financial world has too many variables, and there are too many irrational and unpredictable events that can ruin a model."

The second concerns the so-called increasing diversity of hedge fund strategies that would mitigate hedge fund sector losses. Lately, the sector is looking considerably less diverse, Wang said. Paul Meander, co-managing director of Corazon Capital Management, which invests in hedge funds, told Bloomberg News Monday, "You have to believe that everyone had the same trade on" concerning a decline in financial stocks and homebuilders and a rise in oil prices.

Wang said both trades have backfired in July, with oil dropping more than 10% and selected financial stocks and homebuilders recovering somewhat. "That hedge fund mosaic is looking a lot like a herd, which would repeat a historical pattern on Wall Street, with investment managers concentrating tactics on a hot sector or asset class," Wang said.

Does the above mean Wang is no longer a hedge fund fan? No. "Hedge funds remain acceptable asset instruments for selected, accredited investors. When deployed appropriately, they can enhance an accredited investor's portfolio," Wang said. "But at no time should anyone think they [hedge funds] can 'guarantee' a return or are 'guaranteed' to perform better than other asset classes. These are myths. No one knows with 100% certainty what asset class will perform best, or even if any will perform well at all."

Sector Analysis: On to economist Wang's prudent advice, we'll add the tip that unless you have at least $1 million, preferably more than $2 million, in liquid assets (wealth that does not include the value of your home), the argument here is that hedge funds are not for you.