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In a completely theoretical way what you say is possible. But in practice does anyone actually do this? What's the time frame you'd be willing to stake your ca

by wmfiv 11y ago

In a completely theoretical way what you say is possible. But in practice does anyone actually do this? What's the time frame you'd be willing to stake your career on for a startup (event a fairly mature one) to be meaningfully impacting the overall profitability of it's astronomically larger competitors? And you'd be simultaneously betting against overall bull markets and that the incumbents won't adapt, whether in the market directly against the startup or in any of the other markets they're in. To my knowledge you can't even trade in stock futures with sufficiently distant expiration dates to do this.

iaw 11y ago
"To my knowledge you can't even trade in stock futures with sufficiently distant expiration dates to do this." To put this as politely as possible, you are incorrect. When you have more than $1 billion under management there are numerous counter parties more than willing to design bespoke financial instruments to suit your needs. My first role in finance involved modeling the risk associated with the bespoke instruments that people were asking my tiny (<$1 billion) firm to create. If you watch 'The Big Short' 1/3rd of the movie is devoted the creation, acquisition, and distribution of a bespoke financial instrument traded upon layers of bespoke instruments (Credit Default Swaps, Credit Default Obligitions, rolled bond instruments, etc.) Remember when Christian Bale's character gets chewed out for losing so much money a month? It's because he's paying to maintain his bespoke put options on mortgage backed securities. "What's the time frame you'd be willing to stake your career on for a startup" I left the industry, I find it pretty disgusting to be quite honest. However you're missing the fact that these hedge funds don't invest in one startup, they invest in dozens in an effort to diversify their risk. Furthermore, if you think a fund manager is "staking their career" by making these bets you missed two important facts: * 2 and 20, they're taking home 2% under management even if they lose it all. * By the time someone is in the position to manage that many investments they are both able to retire and sell themselves into any position. There's as many, if not more, investment managers that lose money as make it. Their job is to quantify and tolerate risk, quite often that entails losing money on some investments. Anecdotally, when I first started in the industry we had a director who lost $30MM in the course of 2 weeks on an investment. We had hit a risk case that exceeded the 99th percentile on an investment strategy he had developed. A month later we had recouped the $30MM with an additional $60MM of profit. He took an educated risk and it could have made us take a loss for the year. Importantly, all of our other investments performed wholly within expectations during that time frame. So, while we were losing money hand over fist during those weeks it was never an existential risk to the company.
- wmfiv 11y ago
  Fair enough about the bespoke products. But does anyone really do this? Are there published examples of people doing this or talking about doing it? I can find plenty of examples of hedge funds betting on single mid or late stage startups but not doing what you're suggesting here. What you're suggesting is incredibly interesting so I don't intend to be rude but the concept strikes me as ludicrous. The assumptions that would go into a financial model for something like this seem ridiculous to me. You'd be betting/guessing/hedging on countless company, industry and macro-economic variables over a long, long time frame.
  - iaw 11y ago
    I very much doubt that they do it in the exact methodology I described but I assure you that market participants do this. There is probably published material available on 70's and 80's hedging techniques but now that they are known the market converges. The problem with what you're asking now is that anyone privy to modern strategies would be sued out of existence for divulging them. A successful hedging strategy is very much classified as a trade secret. The only thing of value a hedge fund provides, if it does indeed provide any value, is it's investment strategy. There are no perfect hedges because they'll typically be arbitraged out of existence but the logic that goes into hedging is the reason liquidity preferences exist now. The finance industry has a wholly different outlook on things than normal people so I understand the confusion here, it took me a bit to fully grasp why and how to do things even once I was immersed in the industry. Also, I should emphasize here: the theory behind the concept looks pretty but in application the assumptions can completely obliterate the success of the investment. The book "A Random Walk Down Wall Street" by Burton Malkiel covers a lot of the finance industry from an academically rational perspective. If you read that book you'll take away the counter point to everything I've said here. Which is, there is no evidence in advance that a hedge fund can successfully hedge. After the fact, survivor bias may mislead us into believing that what appeared to be a sound strategy may have just been luck. At the end, the challenges to hedging aren't obtaining the appropriate instruments or taking on the risk, these are problems that all major financial entities are comfortable dealing with. The challenge in hedging is that you don't know how accurate your assumptions are until the hedge is complete. Essentially when crafting a hedge you are playing a binary scenario (A wins and B fails, or A fails and B wins). The problem is that the input assumptions also need to hedged, and then you have assumptions on those hedges, and so on.

by wmfiv 11y ago

iaw 11y ago

"To my knowledge you can't even trade in stock futures with sufficiently distant expiration dates to do this." To put this as politely as possible, you are incorrect. When you have more than $1 billion under management there are numerous counter parties more than willing to design bespoke financial instruments to suit your needs. My first role in finance involved modeling the risk associated with the bespoke instruments that people were asking my tiny (<$1 billion) firm to create. If you watch 'The Big Short' 1/3rd of the movie is devoted the creation, acquisition, and distribution of a bespoke financial instrument traded upon layers of bespoke instruments (Credit Default Swaps, Credit Default Obligitions, rolled bond instruments, etc.) Remember when Christian Bale's character gets chewed out for losing so much money a month? It's because he's paying to maintain his bespoke put options on mortgage backed securities. "What's the time frame you'd be willing to stake your career on for a startup" I left the industry, I find it pretty disgusting to be quite honest. However you're missing the fact that these hedge funds don't invest in one startup, they invest in dozens in an effort to diversify their risk. Furthermore, if you think a fund manager is "staking their career" by making these bets you missed two important facts: * 2 and 20, they're taking home 2% under management even if they lose it all. * By the time someone is in the position to manage that many investments they are both able to retire and sell themselves into any position. There's as many, if not more, investment managers that lose money as make it. Their job is to quantify and tolerate risk, quite often that entails losing money on some investments. Anecdotally, when I first started in the industry we had a director who lost $30MM in the course of 2 weeks on an investment. We had hit a risk case that exceeded the 99th percentile on an investment strategy he had developed. A month later we had recouped the $30MM with an additional $60MM of profit. He took an educated risk and it could have made us take a loss for the year. Importantly, all of our other investments performed wholly within expectations during that time frame. So, while we were losing money hand over fist during those weeks it was never an existential risk to the company.

wmfiv 11y ago
Fair enough about the bespoke products. But does anyone really do this? Are there published examples of people doing this or talking about doing it? I can find plenty of examples of hedge funds betting on single mid or late stage startups but not doing what you're suggesting here. What you're suggesting is incredibly interesting so I don't intend to be rude but the concept strikes me as ludicrous. The assumptions that would go into a financial model for something like this seem ridiculous to me. You'd be betting/guessing/hedging on countless company, industry and macro-economic variables over a long, long time frame.
- iaw 11y ago
  I very much doubt that they do it in the exact methodology I described but I assure you that market participants do this. There is probably published material available on 70's and 80's hedging techniques but now that they are known the market converges. The problem with what you're asking now is that anyone privy to modern strategies would be sued out of existence for divulging them. A successful hedging strategy is very much classified as a trade secret. The only thing of value a hedge fund provides, if it does indeed provide any value, is it's investment strategy. There are no perfect hedges because they'll typically be arbitraged out of existence but the logic that goes into hedging is the reason liquidity preferences exist now. The finance industry has a wholly different outlook on things than normal people so I understand the confusion here, it took me a bit to fully grasp why and how to do things even once I was immersed in the industry. Also, I should emphasize here: the theory behind the concept looks pretty but in application the assumptions can completely obliterate the success of the investment. The book "A Random Walk Down Wall Street" by Burton Malkiel covers a lot of the finance industry from an academically rational perspective. If you read that book you'll take away the counter point to everything I've said here. Which is, there is no evidence in advance that a hedge fund can successfully hedge. After the fact, survivor bias may mislead us into believing that what appeared to be a sound strategy may have just been luck. At the end, the challenges to hedging aren't obtaining the appropriate instruments or taking on the risk, these are problems that all major financial entities are comfortable dealing with. The challenge in hedging is that you don't know how accurate your assumptions are until the hedge is complete. Essentially when crafting a hedge you are playing a binary scenario (A wins and B fails, or A fails and B wins). The problem is that the input assumptions also need to hedged, and then you have assumptions on those hedges, and so on.