Three Exhibits

Gah, investors. Can’t live with them, can’t shoot them in the kneecaps. (Well, you probably can shoot them in the kneecaps but then you’d have to register with the SEC and fill out Form 3126, Schedule B, to get an Investor Kneecapping License or something equally ridiculous. Who has the time? But I digress.)

Everybody talks about how tough it is to beat the market. But take it from me, knowing what the market will do is an absolute cakewalk compared to knowing what investors want. After double-digit years in the industry, I am convinced that I have barely scratched the surface of the mystery that is the investor mind. Consider:

Exhibit Number One: it’s January 2003, and we at Sopwith have just received a redemption notice from a large fund of funds that has invested with us. They want to pull their money.

Now, you would think that this meant we lost money in 2002. You would be wrong. We made money in 2002, quite a bit of it. And not just in absolute terms; we outperformed in relative terms as well. Indeed, this particular investor had money in about ten different hedge funds, and nine of them lost money in 2002. We at Sopwith, through superior competence, divine intervention or (most likely) sheer random luck, actually managed to eke out a profit. Our reward for this? A redemption notice.

Blame accounting rules. The portfolio manager at this fund of funds, like everyone else in the asset management industry, was paid an annual bonus based on the market value of his portfolio. But how do you calculate the market value of an investment in an illiquid and secretive vehicle like a hedge fund? The answer: you pretend that the current market value of an unredeemed investment is equal to the amount you paid to make the investment in the first place. Of course, for a redeemed investment, the market value is the amount you get for redeeming it.

In the case of Sopwith, the portfolio manager thus had an incentive to redeem his investment, since we made money in 2002 and hence the redemption amount was greater than the investment amount. But for the other hedge funds in his portfolio, it was in his interests to stay invested, and thus avoid realizing his losses.

I was ticked off at the time, but looking back, I have to say it made sense, in a perverse, twisted kind of way. But wait! It gets better! Now we come to:

Exhibit Number Two: it’s January 2007, and we at Sopwith have just received a redemption notice from another large fund of funds that has invested with us. They want to pull their money.

Once again, this seems perverse, because we made money in 2006. But this time, the problem was that other hedge funds made more money than us; in some cases, a lot more. And this time the driving factor was not short-term bonus-grabbing, but good old-fashioned long-term greed. Yes; our fund of funds investor was disappointed in us because we batted singles while others were hitting home runs; he thought that by switching his money elsewhere he would have a better shot at winning the pennant.

So you can’t win. If you lose less money than other people, you have your funds pulled. If you make less money than other people, you have your funds pulled. It appears that investors don’t want competent mediocrity; they want spectacular ups and downs.

But not to worry! We at Sopwith are nothing if not flexible in our ideology, and we quickly adjusted our trading strategy to conform to these revealed preferences. We decided to swing for the fences on every trade. Never again would we be left behind in the race for volatility.

Unfortunately, every other hedge fund in the world reached the same conclusion at around the same time, leading directly to the recent unpleasantness in the market. To wit:

Exhibit Number Three: it’s January 2009, and we at Sopwith have just received a redemption notice from four different funds of funds that had invested with us. They all want to pull their money.

Argh! What’s going on? We lost a ton of money in 2008, but so did everyone else; some lost more, some lost less. Why single us out for special punishment? Why not just replay the 2002 scenario?

Well, it turns out that each of these four fund managers had a different reasoning for pulling their money. Here’s what they had to say:

“Sopwith lost money, but Fund X lost less money. They are obviously better traders than you, so I’m switching my investment from Sopwith to Fund X.”

“Sopwith lost money, but Fund Y lost more money. This means there is obviously more opportunity in the market that Fund Y trades, so I’m switching my investment from Sopwith to Fund Y.”

“Sopwith lost money, and so did Fund Z. I have therefore decided to panic, take my investment out of both Sopwith and Fund Z, and hide it under the mattress.”

“Sopwith lost money. Hey, that’s great news! I can redeem my investment at a loss and claim a tax credit for future years. Thanks, guys!”

The moral is clear. In my next life I shall devote less time to studying the intricacies of the stock market, and more time to fathoming the depths of the investor mind.