Henry C.K Liu
Jordan Hayes wrote:
> From hliu at mindspring.com Fri May 21 17:24:11 1999
>
> As the following table shows, most shorts are part of an
> arbitrage strategy.
>
> I don't understand how "the following table shows" that "most shorts
> are part of an arbitrage strategy" ...
>
> In looking at a table of hedge fund strategies, you must remember that
> nearly all self-styled 'hedge-funds' (as misused of a term these days
> as 'think-tank') have one thing in common: their prospectus
> specifically allows the manager to short financial instruments. Many
> of the biggest mutual funds are not allowed to short anything. So this
> table doesn't show any relationship between shorting and arbitrage.
> All of these strategies involve, at times, shorting. It's only the
> "short only" type of fund that places any real significance on shorting
> at all. Once you're allowed to short, the question of how to make
> money becomes, in a sense, easier: if it's going down, short it; if
> it's going up, go long.
>
> Getting an education in anticipation of high future income is
> an act of arbitrage. Aiming for longevity in hope of a better
> future in also an act of arbitrage.
>
> I think you need a better definition of arbitrage; neither of these two
> examples qualify. The key aspect of arbitrage is risk: arbitrage
> captures, relatively risk-free, the disparity in pricing between two or
> more markets. A non-market example I noticed the other day is that if
> you buy a 'meal' at a fast food restaurant *plus* an additional
> sandwich, you can change the overall price to your advantage by
> choosing the 'meal' with the greatest package discount. As an example,
> note the following prices:
>
> Quarter Pounder $2.89
> Quarter Pounder Meal $3.99
> Big Mac $2.29
> Big Mac Meal $3.29
>
> If you buy a Quarter Pounder Meal plus an individual Big Mac, you pay
> ($3.99 + $2.29 = $6.28) whereas if you buy a Big Mac Meal and an
> individual Quarter Pounder you pay ($3.29 + $2.89 = $6.18). The items
> are identical, yet the prices (presumably for marketing reasons) are
> slightly different. It's up to you what you'll do with all the money
> you save (and it might easily "cost" you $0.10 just to figure this out,
> thus eating up, so to speak, all your arbitrage profits), but pricing
> disparities do exist and can be captured.
>
> Now: 'arbitrage' as a strategy has also been abused. The strict
> definition includes 'relatively risk-free' -- measuring risk is a
> tricky business. In our McDonalds example, all the items on your tray
> (Quarter Pounder, Big Mac, fries, beverage) are the same in the two
> sides of the inequality -- because of this, the arbitrage in question
> is not only 'relatively' risk-free, it's 100% risk-free. It's not like
> if you order in one way or the other that you might wind up with a
> Filet-o-fish instead. What a bummer that would be.
>
> But how much substitution is tolerable? The most common form of
> self-styled 'arbitrage' activity in the US equity markets is concerned
> with the difference in the sum total of all the components of an index
> (the S&P 500 being the largest and most liquid for this, but any of the
> indexes can be and are used) and the appropriate futures contract that
> represents, theoretically, the index (this is called, not surprisingly,
> "index arbitrage"). These values do not precisely track each other,
> and at times can become far enough out of whack that it can make sense
> to try to buy all of the stocks in the index and sell the corresponding
> amount of futures contract (or the opposite: buy the contract, sell the
> stocks), capturing the "relatively risk-free" difference. The risk
> here can be quantified in terms of 'slippage' (the difference between
> the price that you used to make your decision and the actual price you
> get at some time later) and, from the looks of the recent
> program-trading activities (published weekly in, among other places,
> the WSJ), are still a fertile ground for opportunities. As these
> markets (the US equities market and the S&P 500 futures market) get
> more efficient, these pricing disparities are fewer and further
> between. So what to do? Cheat. Skew your tolerance of "equal" to
> suit your own technology and risk appetite. Maybe you just buy 450 of
> the 500 stocks (it's quicker and cheaper, obviously) before you'll be
> ready to short the future. But then the 'realtively risk-free' aspect
> of this activity comes back to haunt you.
>
> Even further out, a place like LTCM (and Nick Leeson, for that matter)
> had "determined" (through whatever pseudo-science was fashionable that
> day) that two things that weren't the same (in our example, let's use a
> Quarter Pounder and a Big Mac) *were to be viewed* as being the same
> for this equation. In our example, you could squint your eyes or move
> far enough away in space or time (take 10 steps back; can you tell the
> difference between a Big Mac and a Quarter Pounder? Similarly, think
> back three weeks: can you remember the difference between eating a
> Quarter Pounder or a Big Mac?) to make them the same, and thus your
> preference for either would be neutral. The choice is then obvious:
> sell what's expensive, buy what's cheap.
>
> The problem of course is that if whatever you used to determine they
> were "the same" fails one day (like you actually decide you hate
> special sauce), the equation falls apart and you lose.
>
> The unfair part of hedge funds as they are current constituted
> in the economy is that they are by law available only to the
> rich ($2-5 million net asset, so call qualified investors) ...
>
> "Qualified investors" have much less than $2-$5M; I think the
> definition is more like $200k of current year income or $1M of total
> net worth. But the real barrier to getting in on a hedge fund is that
> many of the boutique funds don't want small accounts because it's more
> expensive to manage 1,000 $100k accounts than it is to manage 100 $1M
> accounts. Also, it's easier to not have to deal with things like
> redemptions more than once or twice a year.
>
> An average borrower can borrow 2 times his asset (equity), but
> hedge fund investors can borrow several thousand times their
> assets.
>
> This is misleading; the amount of margin required for the purchase of
> securities is the same for everyone: hedge funds and housewives alike
> must put up 50% of a US equity purchase, for example. But access to
> credit can vary, just as a student and a lawyer can have a different
> number of credit cards -- it's not uncommon these days for individuals
> to have access to credit lines that represent many times their annual
> income or even net worth. As a simple example, real estate is often
> available to non-high-net-worth-individuals for 3% down these days.
>
> So the large fund may have access to credit lines that allow the
> purchase of securities that add up to a net value that far exceeds
> their asset base. The leverage involved in certain kinds of securities
> can be much higher, and even you can buy a futures contract with only a
> 10% margin requirement.
>
> Reports of the rich getting richer even during the global
> financial crises is due to the fact that most money making
> channels in the markets are opened only to the rich (in the
> name of protecting the poor who cannot afford to lose).
>
> It's even worse than that: I saw a report the other day that said that
> in the US blacks have not participated as much as whites in the
> spectacular rise in the stock market because, for a variety of reasons
> (one mentioned is they, statistically, *don't trust* financial
> advisors!), they are under-represented in the equity markets with their
> investments. So given two people, one black, one white, who started
> out this bull market as financial equals, the white one is further
> ahead today.
>
> /jordan