Wednesday, January 21, 2009

Why the economy nose-dived, in one easy-to-read article.


Basically, money market managers and their clients have mutually exclusive interests. That is, the worst the manager (because he exposes his clients to unnecessary risk), the wealthier (because clients flock to the funds with the bigger returns). So, all the money lemmings to those funds most likely to fall off a cliff, as we have just witnessed. Good to know now.

From the article:
Let’s say for instance that you’re managing a hedge fund which invests in stocks. ... you can generate an average return of 6% per year, and so can most of your equally qualified competitors who have access to the same talent pool and knowledge base as you do.

But then one of your competitors realizes that he can automatically increase his return to 9% by selling something called “out of the money puts” on the market. This means that the competitor’s fund essentially sells insurance against the market crashing dramatically. In normal times his fund will gain the premium from selling this insurance which boosts his returns.

However, in the rare event of an extreme market crash his investors will lose everything. ...

When investors see a fund manager generate a higher return than his competitors, they will move their money into that fund and out of the other ones....

The managers who have the discipline to understand and avoid [such] tricks will not be able to compete on the basis of their returns over a few years, and will eventually lose their funds and their jobs.

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