You Down with OPP? err… OPM?

 

 

OPP err… Other people’s money, this is the Achilles heel of most hedge funds (with the notable exception of family wealth management funds). As a small investor, we have the freedom to determine if we are buyers, sellers or traders over a certain time horizon and this is certainly an advantage we have over funds with other people’s money. Most hedge funds are open ended funds giving their investors the freedom to exit or enter the fund every month. This results in capital inflows and outflows which results in the fund having to re-balance its position with whims of its investors.

For instance if the market is rising, the fund may receive a large amount of inflows causing the fund to invest its new found capital when asset prices are rising. Conversely, if asset prices are falling, fear may cause investors to pull capital from funds at the most inopportune time, when asset prices are falling. The fund would be forced to sell in a weak market to meet demands of redemption. I would argue this makes funds that solicit outside investors to some extent traders despite an investment philosophy that may run counter to this assessment.

So how does the nimble investor take advantage of this shortfall? Before we start investing, we make a determination, are we buyers, sellers or traders and over what time horizon? Let’s say our time horizon is a decade. If we are sellers, that means we have already accumulated a large asset base and are looking to exit our positions (think a married couple entering retirement that has all assets in equities and are transferring their assets into bonds). If we are sellers, we should attempt to exit our positions at times of market strength to get higher valuations on our positions. In other words, we should sell the rallies.

Conversely, if we are a young investor attempting to establish a long term position in the market, we are buyers. As a buyer we should see every market drop as an opportunity to deploy capital. Because we have made the determination that we are buyers over a given time horizon, we should find security that we have a clear plan moving forward and continue buying during times of fear.

Finally, the most difficult position, and perhaps the position requiring the most skill is the trader. The trader believes she can time the market. That she knows the most opportune time to enter and exit assets as to maximize profit. Unfortunately, in order for the trader to maximize profits, she must be able to time the market twice: on entry and exit. This is not easy to do, not only must the trader exit the market at its peak she must also re-enter as it falls (attempting to catch the falling knife).

I would caution against the novice investor taking on the role of trader. Unfortunately, this is precisely the role that most novice investors take. Instead of taking on the buyer or seller role over a given time horizon, they buy and sell assets making them by definition traders because they don’t have a clear plan when they start investing. Although they may be able to time the market well during some transactions, the more trades they execute the higher likelihood that they will make a mistake and suffer a loss.

As an investor with a longer time horizon that is attempting to establish a position, I am taking on the role of buyer in the market place. I can take solace in my time horizon, and look at market declines as buying opportunities to increase my position in the market. It does require discipline to make purchases in a falling market, but I have an understanding of my risk tolerance  and with that I am committed to making asset purchases during times of market declines. What’s your position in the market? Are you a buyer, seller or trader?

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