Today I had a big debate with two traders. Here is the long and short of it.
Minus perhaps the super amazing ones like Rentec, their claim is that most hedge funds out-sized returns is almost all due to aggressive use of leverage. Note this does not mean using leveraged instruments like options or futures, it means using more than 1:1 leverage on their account. They portend that if these hedge funds used 1:1 leverage, that they would do about the same as the long term average of the SP500, or about 7%, and perhaps a little more alpha, something along 12% returns for a total of 10% over the risk free rate. They claim that the hedge fund industry would implode if leverage was not allowed.
I claim that this is preposterous, and that even using 1:1 leverage, as long as you are allowed to trade leveraged instruments, that 100% returns would not be that uncommon.
In essence, they are basically saying that skilled use of the Kelly Criterion is of no value, and that their returns are gotten by using huge leverage to skin tiny amounts from the markets. Nickels and dimes in front of a bulldozer. When they blow out because this enormous leverage one day bites you in the ass big, like LTCM etc, they get bailed out.
So who is right?
Minus perhaps the super amazing ones like Rentec, their claim is that most hedge funds out-sized returns is almost all due to aggressive use of leverage. Note this does not mean using leveraged instruments like options or futures, it means using more than 1:1 leverage on their account. They portend that if these hedge funds used 1:1 leverage, that they would do about the same as the long term average of the SP500, or about 7%, and perhaps a little more alpha, something along 12% returns for a total of 10% over the risk free rate. They claim that the hedge fund industry would implode if leverage was not allowed.
I claim that this is preposterous, and that even using 1:1 leverage, as long as you are allowed to trade leveraged instruments, that 100% returns would not be that uncommon.
In essence, they are basically saying that skilled use of the Kelly Criterion is of no value, and that their returns are gotten by using huge leverage to skin tiny amounts from the markets. Nickels and dimes in front of a bulldozer. When they blow out because this enormous leverage one day bites you in the ass big, like LTCM etc, they get bailed out.
So who is right?