Who can tell the future?
Most people are not that good at predicting the future of the economy and the stock market, but there are quite a few pretty talented people who are. Most importantly, they are willing to bet their money (and a whole lot of it) on their vision of the future, instead of just yapping about it on television with no real consequences to themselves (think Ben Stein or Jim Cramer). These people are hedge fund managers, especially those who follow directional global economy based strategies.
Hedge funds are run by smart guys. They strive to generate attractive risk-and-return patterns for their investors through a wide variety of investment strategies. Broadly speaking, these strategies could be classified as “search for alpha” (e.g. “equity market neutral”) and “bets on beta” (e.g. “global macro”). Alpha strategies aim at generating returns patterns that are not related to the market or any known economic risk factors. Beta active strategies, on the other hand, generate returns by taking positions driven by underlying economic factors. The best beta active hedge fund managers are pretty good as a group in anticipating which of the economic factors would deliver superior performance in the future. If we could only see these positions, we would’ve been able to peek into the future (as perceived by a group of really smart hedge fund managers)…
Cloning hedge fund returns is a tricky business. Some hedge fund strategies, like S.A.C. Capital Advisors’ trading in Elan and Wyeth shares off insider tips, cannot be replicated by any algorithmic cloning procedure. On the other hand, returns for many hedge funds appear to be driven by exposures to latent risk factors not readily discernible to average investors. As John H. Cochrane of the University of Chicago observes:
As I look across the hedge fund universe, 90% of what I see is not “picking assets to exploit information not reflected in prices,” it is “taking exposure to factors that managers understand and can trade better than clients.”