The night before Christmas - by Craig Chirinda

'Twas the night afore Christmas, just after I had retired to bed.
Tired after a long flight, I couldn't sleep because of a sound I thought I heard.
I peered out of my window, to investigate the sound I thought I heard;
But I saw nothing but pools of a color I thought was red.
Surely this had to be an illusion; was the red wine starting to get to my head?

Then I heard a loud thud downstairs; it seemed there was an intruder in my abode.
And then there was an eerie silence, which was suddenly interrupted by a harmonious chord.
Reaching for my death-stick, I decided I was going to investigate the chord that was vibrating in my abode.
Stealthy, I crept downstairs; wondering about the intruder who was playing chords in my abode.

The sight that confronted me when I got downstairs, I could never forget.
'Twas a chubby man with a snow-white beard; clothed in a shade of red I might never forget.
His visage looked friendly; though he had an unhappy look I can't ever forget.
My intention to bludgeon him vanished; if I harmed him, I knew I would ever regret.
I walked briskly towards him, with the rhythm of a newly-recruited army Cadette.

"You really exist", I said, "I thought everything they said about your existence was a lie!"
But he never looked up to speak to me; he just buried his face in his hands and proceeded to cry.
"Why do you cry dear Santa?", I said, "Why is your disposition acerbic and dry?"
"I don't mean to pry", I again said to Santa, "but do tell me why you cry when everyone else's spirits are high?"
He didn't answer me until I said, "Speak, or fly back to whichever part of the sky you come from. Goodbye!"

Then suddenly, he said, "The stuff you saw in 'Bad Santa' is all true. There is not a single lie."
"I smoke. I drink. I'm supposed to stop but I can't", said Santa, as he again started to cry.
"I'm a dirty old man", he said as he cried profusely, "Oh I'm tired of living a lie!"
"It's alright dear Santa", I replied indifferently, "Please don't continue to cry. In fact, I can see from your bloodshot eyes that you are indeed high."
"But I'm not going to judge you, Santa", I said intending to cut him short, "Don't worry, I'm not going to ask you why."

"My reindeer got butchered by that moose-hunting hockey-mom", said Santa, "I have nothing to travel with."
"And the elves are on strike. I lost their retirement money in Madoff's scheme", continued Santa, "I have nothing to repay them with."
"Oh, the little angels out there won't be getting Christmas presents from me", he added as he sobbed, "I have nothing to appease them with."
"Oh, poor you", I sympathetically replied Santa, "I wonder what I have to help you with?"

"The SS Chirinda", I thought out loud, "I only board her three times a year!"
"I really don't need that boat" I thought, "I'm going to do something good to help out little boys and girls this year!"
"You can have my yacht, Santa", I said, "Sell it, and use the proceeds to buy toys for little boys and girls, so they have something this year!"
"Oh!", replied Santa, "I couldn't accept your boat. You worked so hard to buy it. Didn't you have to save for it for a whole year?"

I ignored Santa as I dragged him to the harbor, and gave him the keys to my yacht.
He started her and started to sail-off in my seventy foot yacht.
"Where are you sailing off to?", I asked Santa, as he sailed off into the depths of the night.
"Sucker!", yelled back Santa, "Didn't I tell you that I was a bad Santa?"
"I'm sailing-off to the Gulf of Aden, and if you want your yacht back, you're going to have to pay me a ransom!"
"What?", I yelled, "You are a pirate, who steals yachts and demands a ransom?"
"Yes!", said Santa, "I was one of the 'haves', now I am one of the 'have-yachts'!"

"Merry Christmas! Ho-ho-ho-with-a-bottle-of-rum!", he yelled, as he sailed off into the night aboard my yacht.

Gold may be significantly under-priced

I was reading a book titled Rich Dad's Advisors Guide to Investing in Gold and Silver by Michael Maloney, when I came to the conclusion, because of a passage I read in the book, that Gold is significantly under-priced!

Infact, Mostafa's assertion, that gold would appreciate rapidly to a price of USD1500 per ounce between 2008 and 2015, could be eminently cautious/conservative.

The passage that caught my attention was there in the preface, in juxtaposition to words that failed to strike me with the force-of-insight that the following excerpt bears:

"For the last 2,400 years a pattern was continually repeated in which governments debase their money supply", and "as the debasement progresses, the population senses the loss of their purchasing power. Then something miraculous happens. Through the free market system, the will of the public causes gold and silver to automatically revalue"

...What is the enumerative translation of the preceding excerpt?

I searched hard for an answer, and found it in an article by 'The Mogambo Guru', Richard Daughty - COO of Smith Consultant Group, titled Not Quite Like That. Which basically says that, as of September 2008, the United States had in circulation approximately US$829 billion in actual (never mind the electronic money, and 'other cash' securities) US Federal Reserve cash-and-coins, i.e currency securities based on 'physical presence'; whose transactions have a temporal simultaneity. This was against the Fed's aggregate gold reserves of 261 million ounces.

Therefore, if you seek to find out the price of gold per ounce according to the information above, you'd divide US$829 billion by 261 million ounces to get a price per ounce of USD3176.24 per ounce. That is the 'real price' of gold according to US aggregate-currency-in-circulation figures, and US aggregate gold reserves.

Hence, If you convert all 'currencies in circulation as cash' in the world to their USD equivalent, and divide that figure by the total gold reserves held by reserve banks all over the world, you should be able to come-up with a rough estimate of the 'real-price' of gold.

Assuming that the 'will of the public causes gold and silver to automatically revalue' in the future, that is the figure that the price of gold will converge towards!

Interesting stuff!

'Madoff Magic' / 'Madoffia' / 'Madoff-con'

Human beings generally have a difficult time incorporating highly improbable events into their thought-processes. Improbable events, specifically black-swan events - like Madoff's epic fraud, are generally ignored, or regarded as irrelevant before they occur. But after these events precipitate, human consciousness moves to the opposite extreme of ignoring these events; obsession with these 'improbable' events takes-over beyond any justifiable degree of concern; like what is happening right now. Understandably, this current hypersensitivity to extreme-tail-events is being induced by recurrent news stories about the Madoff saga and the uncertainty surrounding it.

Nevertheless, it is important to begin exploring these questions: (1) How did he manage to pull this off for such a longtime?; (2) How did he manage to live with himself, while he was committing those frauds? (Where was his conscience?); (3) Why did he do it?

The answers to those questions will help us prevent similar events from occurring in the future, and will provide direction to the regulatory establishment's efforts to curb illicit activities in the largely-unregulated hedge fund industry.

This Coming Week: Financial Market Armageddon

At around 1715 GMT on Friday (11 October 2008), while I was caught-up in the 'Miss World 2008 Pageant euphoria', I learned of a very unsettling event: the unearthing of Bernard Madoff's (a former Nasdaq CEO) Ponzi scheme which cost the world's elite private and institutional investors an estimated US$50 billion.

As I absorbed the news feed, I recalled an insight I gained from Gerding (2006): The bursting of asset price bubbles always coincides with the discovery of scandals and irregular practices in financial markets. Evidently, Madoff's fraud validates Gerding's assertion, and subtly points towards more impending doom and gloom.

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Among the 'known' institutional casualties are: a leading Spanish bank called Santander; Bramdean Alternatives - a UK-based asset management company with 10% of its NAV invested with Mr. Madoff; Fairfield Greenwich Group - a hedge-fund that invested $7.5bn of its clients' money with Madoff's firm; French bank BNP Paribas; Japan's Nomura Holdings; and; Zurich's Neue Privat Bank.


...Potential Impact

Firstly, financial service counters, across all major bourses, are going to fall precipitously in value during the coming week; because this development will intensify the crisis of confidence that the global financial system is already facing. This will in turn fuel a selling and short-selling spree of financial services counters across all major bourses. Therefore, with some financial counters already trading at anorexic prices; it is reasonable to say that some financial services firms face a great risk of being sold and short-sold to death, over the coming week.

Market volatility is already high and such a shock, when the market is highly sensitive to perturbations - like it currently is, will definitely put a lot of ailing financial services firms in a comatose state which they may never come-out of. Hence, this would undermine all efforts by governments (in most of the developed world) to bolster confidence in the financial services sector by injecting liquidity. Therefore, regulatory bodies and governments need to act decisively to avert from precipitating, an acute second-wave of the market tsunami we've been enduring since August of 2007.

I think it would be prudent for governments to dig deep into their bags of tricks, and prepare to implement tools they have used previously to mitigate the effects of similar crises. To state it more clearly, I'm advocating for the re-introduction of short-selling bans (of financial services counters) until the full-extent of the crisis is understood clearly, as I believe that the fraud is much greater than the stated USD50 billion.

If the bans are not implemented forthwith, the financial services sector will crumble (from being 'short-sold to death'), setting into motion a domino-effect of subsequent events, that will plunge the global economy into a deep recession; one that would prevail for a very, very long time.

Secondly, this development will inspire cannibalistic trading strategies, that will accelerate the downfall of the victims of this Ponzi scheme; particularly the hedge-funds (e.g. Fairfield Greenwich Group and Bramdean Alternatives) that fell prey to what is now popularly known as Madoff Magic.


...What do I mean by this?

Other hedge funds will short-sell the portfolio holdings of funds and 'strategies' affected by this crisis. They'll do this because they'll understandably believe that this crisis would trigger a series of redemption requests in the affected funds; which would then trigger forced liquidation of their holdings to meet the requirements of the redemption requests. This would in turn depress prices of some of the securities in the portfolio of the 'victim-funds'; as forced liquidation of a large chunk of securities, within an environment characterized by high market volatility, generally has a security price-reducing effect. To summarise what I've stated, 'other-hedge-funds' will short-sell the holdings of the 'victim-funds', anticipating to capture easy profits that will subsequently flow from the price reduction caused by the 'forced-liquidation-to-meet-redemption-requests phenomena'.

The net effect of all this market activity (on the broader financial markets), is largely dependent on the extent of overlap between the portfolios of 'other market players' and those of the 'victim-funds'. Where the effect of the crisis on the global financial system, is positively correlated to the degree of overlap between the portfolios of the 'victim funds' and those of 'other players' in the broader financial markets. This means that a high portfolio overlap between 'other market players' and 'victim funds', would translate into cascading of the negative effects of the fraud across the entire global financial system.

Therefore, we could be seeing in the near future a more dramatic replay of: bank collapses; the development of multiple layers of correlation among 'disparate' securities; a credit crisis; the drying-up of liquidity in most security markets and; the widening of spreads. In short the worst may be on its way.

Be prepared because it may be a bumpy ride!

High-End Housing Price Bubble in Egypt

Background Facts:

• Construction of residential housing lots contributes an aggregate 3.6% towards Egypt's GDP.
• Egypt's mortgage market (in terms of mortgages financed, not the entire market) has an aggregate size of EGP 3 billion; a minuscule 0.3% of Egypt's current GDP .
• Egypt has the lowest owner occupancy ratio in the world in 10 years; currently standing at only 32%.
• Egypt currently requires the supply of 5 million low-income housing units.
  

(Note: Facts are according to statistics provided by Mr. Suha Najar, Managing Partner and Head of Research at Pharos Holdings when he made a presentation before attendees of the American Chamber of Commerce's November 23rd Real Estate Conference. )

...Inflating the Bubble

Over the last decade or so, excess liquidity in the global markets resulted in the creation of a paper market for Egyptian high-end real estate: a market that is driven entirely by speculation; a market in which fundamental forces are totally ignored; and a market in which the underlying dynamics of supply and demand are blatantly disregarded.

The supply and demand situation of high-end real estate in Egypt is in a dynamic state of disequilibrium; with the demand for high-end residential units currently standing at 15 000 units per annum, and supply currently standing at 40 000 units per annum. Hence, this means that there is a supply-demand imbalance in the market; which in this case, is an excess supply of housing units.

Supply-and-Demand economics dictates that prices should fall when supply far exceeds demand, but in the case of the Egyptain high-end property market, this law doesn't currently hold: prices are still sky-high; with prices of unfinished properties far exceeding those of finished properties, i.e. high-end properties in Egypt are increasingly becoming more expensive, when they are actually supposed to be increasingly becoming cheaper. A curious situation indeed.

Therefore, if one were to plot the supply curve for the Egyptian high-end property market it would be slopping backwards; consistent with the nature of supply curves when asset price bubbles are being inflated.

The deviation of high-end housing-prices from their fundamental or intrinsic value cannot continue ad infinitum, because this pattern of divergence of high-end property prices from their fundamental / intrinsic value is unsustainable. Therefore implying that the observed market price of high-end units would have to converge with reality at some point: the bubble is guaranteed to burst one day.

The interesting question is when, and what will trigger the burst?

Wither the UK Economy: Boom, Bust or Stagnation?

I recently watched a video of iconoclast fund-manager, Hugh Hendry, of Electra Asset Management UK, in which he uttered the following interesting hypothesis on the near future (starting 2009) of the UK economy:

'The UK economy is due for its worst round of deflation since the great depression.'

I think that I replayed that statement about five times in my mind; contemplating why his hypothesis may be valid/invalid, and here is what I mustered:

The UK is a mature post-industrial or service-based economy, and therefore the majority of its GDP is generated by its services sector; which in this particular case, is its financial services sector. Hence, this implies that state of the UK's economy is a magnified reflection of the prevalent state of the country's financial services sector. Which in turn implies that the UK's economy would be in a bearish state, if its financial services industry is in a state of pandemonium, and/or that the UK's economy would be bullish when the financial services industry is booming.

Currently, the UK's financial services sector is caught in a deadly spiral of evaporating confidence owing to: bank collapses; the development of multiple layers of correlation among 'disparate' securities; a currently-prevailing credit crisis that is exacerbating the economic downturn; the drying-up of liquidity in most security markets and; the widening of spreads.

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Quite a number of United Kingdom-based market players still have toxic and illiquid subprime-mortgage-backed securities on their balance sheets (which would be practically impossible to 'park into' the portfolio of a government-sponsored market stabilization investment fund all at once - because the British government may not have that kind of money; as tax revenue shrinks when an economy is experiencing recessionary pressures, and it would also be irresponsible to finance a bailout of this magnitude through debt issues--just too risky!), and a lot of them have a growing number of asset redemption requests to honor in 2009.

Therefore, investment entities will be forced to sell the 'liquid' securities in their portfolios to honor client redemption requests; setting-off a chain of negative market events.

...Here is why:

Rapid liquidation of a large chunk of securities, in an environment of high market volatility, would move market prices downwards. Which would inturn trigger a chain of margin calls, as the counter-parties of market-players demand more collateral; precipitating another wave of forced-selling of securities; which sets into motion a self-magnifying & self-reinforcing downward movement of prices across an array of 'liquid' securities in the market-player's portfolio. Hence, in such a scenario, forced selling of securities would trigger margin calls; and margin calls would in turn trigger even more forced selling of securities; which would consequentially trigger another wave of margin calls, and so on. Generally, when this positive-feedback loop is at play, observed market prices of securities increasingly deviate away from the fundamental/intrinsic prices of the securities.

Furthermore, a portfolio's structure morphs (in an environment of; limited asset inflows - the UK fund management industry's aggregate AUM has fallen 11% to 339 billion pounds year to date, high-volatility, and increasing market illiquidity) when 'liquid' assets are continually being sold-off to meet client redemption requests and counter-party demands for more collateral. This therefore implies that the original investors of a portfolio will eventually end-up with an unbalanced portfolio; which is structurally different to the portfolio they invested in, and is largely comprised of illiquid assets.

Hence, this may set into motion, a second wave of redemption requests (who wants to keep what they don't like?), which triggers an acute pernicious cycle of: sell security - > margin-call + redemption request - > sell security - > margin-call + redemption request, and so on. This sends markets into a tailspin that is difficult to arrest.

Continual forced security liquidations, against the backdrop of a volatile market, generally have a security-price-reducing multiplier effect, which iterates itself across different security markets in an economy, and (in the case of the UK) may culminate in the manifestation of a secular economic downturn.

The duration and intensity of this downturn is largely dependent of the extent of overlap between the portfolios of entities that trade the entire spectrum of UK-issued securities; where the extent of overlap is positively correlated to the magnitude, intensity and length of the economic downturn, i.e. the greater the overlap, the more protracted the economic downturn.

Investment strategies of different market players are increasingly becoming homogeneous because of two factors; 1) investment entities that invest in UK-issued securities generally have common lineage (or the same DNA) which leads to an overlap of investment focus, and 2) Increasing imitation of strategies of alpha-entities (by beta-market players) that invest in UK-issued securities also results in a growing level of portfolio overlap.

Therefore, from a systems theory perspective i.e when we postulate that financial markets are engineered systems, UK securities markets can be considered to be deterministic i.e. they are not stochastic, although they generate what may at times, appear to be random behavior. Deterministic systems are generally slower (than stochastic) systems when it comes to dissipating extreme perturbations, and are therefore prone to entrainment. Otherwise stated: the economic downturn in the UK may be protracted, and the downturn may increase in intensity!

Therefore in my view, Hendry's hypothesis is correct!

Wither the UK markets? Answer: Secular bust!

Increasing correlation of 'disparate' markets

"I think the world is vastly more complicated today than it was in the past. You see in the past, say 50 years ago, or a 100 years ago... whenever they built the 'Mickey Mouse Economic Theories'; you would not think that going to the store to buy a shirt, would cause the cost of food to rise in the supermarket (you see?)... And the world is too complicated; you cannot forecast what is going on, because you cannot see the link between action and consequence very easily. So it is getting more complicated; the world is more interconnected... And again, you go buy anything made in China, you're causing the price of protein to go up (okay?): Who thought of that!?!"

—N. Nassim Taleb (Verbatim transcript of Taleb's opening remarks in his 14th August 2008 Bloomberg interview with Tom Keene)

In the post titled Regional Integration Increases Correlation of Regional Stock prices, I enunciated that the risk-management benefits of intra-regional diversification of a share portfolio, diminish as regional (political and economic) integration increases. In this post, I'll briefly explore the dynamics of securities' & market correlation. I'll start with a brief discussion of a factor that increases market interconnectedness: a capitalist explosion. I'll proceed by showing how exponential growth of hedge funds can be seen as evidence of a capitalist explosion. Then, I'll illustrate how crowding-out of investment opportunities, forces hedge funds to invest in other disparate markets: acting as a linking mechanism that connects different markets and securities (through portfolio positions). I'll conclude with a brief answer to the question 'What is increasing 'global inter- linkage'?

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...Capitalist Explosion

Nassim Taleb says that the 'world is more interconnected' than it was 50 years ago. Question: What is increasing this 'global inter- linkage'?

The causal factors of increased 'global interconnectedness' are multiple and often pervasive; it would be too cumbersome to identify, and list them exhaustively. However, I have noticed that global interconnectedness is intensified by propellants of asset price bubbles. Nonetheless, for the sake of brevity, I'll briefly expound on just one--which I believe is a key factor--of the augmentative factors of 'global interconnectedness'.

According to Robert Shiller's book titled Irrational Exuberance, the following factor, is a propellant of asset price bubbles (and according to me, this factor also increases the level of global interconnectedness):

Capitalist Explosion: Bloomberg.com defines hedge funds as 'private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested.' I like the Investorwords description of a hedge fund, which describes it as: 'A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%).' The key phrase in the latter definition is 'wealthy individuals and institutions'.

If the media's sociological projection of hedge-funds is anything to go by, then hedge funds are synonymous with capitalism. Therefore, one should be able to decipher the evolution pattern of capitalism (read as 'investment patterns of wealthy individuals') through a continual analysis of the hedge fund industry.

Between the first quarter of 2008 and the second quarter of 2008, (according to a Channel Capital Group report titled HFN Hedge Fund Industry Asset Flow/Performance Report, Second Quarter Ending June 30, 2008) the total assets managed by the hedge fund industry increased by 4.41% to a total of US$2.973 trillion! This compares to an increase of 9.82% in the second quarter 2007 and a decrease of 1.39% in the first quarter 2008. Evidently, the growth rate of hedge funds (in terms of AUM) is slowing, but it is not in negative territory as most would reasonably believe, i.e. the hedge fund industry isn't in a state of atrophy (in terms of AUM).

Interestingly, the hedge fund industry registered the AUM growth (through a combination performance gains and asset inflows) against the backdrop of; spectacular hedge fund implosions, weak global equities markets, bank failures, the drying-up of liquidity in most securities' markets, the exposure of deficiencies of risk-management systems employed by hedge funds, the development of multiple layers of correlation between 'disparate' markets and securities, deteriorating credit default quality, accelerated widening of spreads, the debacle of the mortgage-backed securities market and a global credit binge!

This is quite peculiar; I expected the hedge fund industry to contract (in terms of aggregate AUM) during this time period. The only plausible explanation I could muster for this strange phenomenon: high net worth investors STILL believe that the benefits of investing in hedge-funds outweigh risks associated with investing in these investment vehicles. Could this just be a prodrome of the 'untrammeled, morbid intensification of laissez faire capitalism', that George Soros wrote of in his essay titled The Capitalist Threat: a capitalist explosion? (Side-Note: Sounds like I'm about to blabber commie rhetoric, doesn't it? Read Soros's essay for illuminating insights on the 'flip side' of laissez faire market economics!). The notion of a currently-precipitating capitalist explosion ceases to seem mythical, and assumes greater plausibility when you consider that aggregate assets under the management of the hedge fund industry stood at US$875 billion in 2005 (according to Eric Falkenstein's 2005 article titled The Hedge Fund Advantage in Equity Management); and that now, the figure stands close to US$3 trillion (which translates to an aggregate growth rate of 243% over 3 years; or a growth rate of 81% per annum)! Therefore, we could be in the middle of a capitalist explosion, without even knowing it!

...Crowding out

Economic pundits from different walks of life, who are usually antagonistic, share a unified opinion on one thing; they all concur that the prospects for the global economy are bleak. Their forecasts of the foreseeable future of the global economy lie on a continuum that ranges from; "the global economy will experience positive, but lower-than-usual growth rates", to, "the global economy will sink into a deep, protracted, never-seen-before, 'black swan-esque' recession". As time passes, each analyst's forecast is progressively approaching a deleterious level of cynicism, and, empirical evidence is increasingly validating the conjectures of the analysts with extremist notions!

Given the current economic turmoil in global financial markets, and the heightened level of uncertainty that is concomitant to the economic pandemonium; it is reasonable for one to ask if exploitable, alpha-generating trading opportunities are still/will still be available in financial markets (?)

My answer to that will be: There are very few alpha-generating opportunities in most markets, and that opportunities will continue to dwindle (at accelerating rates) over time.

Here's why:

In Australia, The United Kingdom and The United States, financial market regulatory authorities have new weapons in their arsenals: short selling bans and their variants. Ostensibly, these legal tools are used to stabilize markets by protecting strategically important, but ailing companies from being 'short-sold' to death (remember what killed/massacred Bear Stearns?). Currently, there is on-going debate on the pros and cons of short selling bans; with the hedge-fund industry echoing more of the 'cons': Hedgies say that 'short selling bans rig the markets in favor of inefficient companies that should not be allowed to survive another day!', some even go as far as calling the bans 'weapons of mass market manipulation'. On the other side, is the Archbishop of Canterbury who has taken it upon himself to pontificate on the ills of short selling (side note: his 'short selling' sermons are heart wrenching). On who is right or wrong: time will tell. But, from my vantage point, it looks like other countries are going to be following suit SOON.

Short selling bans are, by definition, only enforced when the market is bearish. Hence, when regulatory authorities enforce them; hedge funds are prevented from short selling the stock of 'vulnerable' companies when it is most lucrative to do so. Therefore, this has the effect of contracting the alpha opportunity-sphere available to hedge funds; which (potentially) turns hedge funds into beta-generating asset pools with high fees (expensive hybrids of mutual funds). Furthermore, 'bans' (within an environment of; steady growth of the hedge fund industry's aggregate AUM, and a recession which limits the opportunity-set of 'long' trading opportunities), also increase the probability of 'crowding out' of limited lucrative trading opportunities. Hence, this causes the distribution of individual hedge fund alphas to shrink over time: a scenario that is consistent with the hedge fund capacity constraint hypothesis. Otherwise stated: the profitability of hedge funds might progressively deteriorate over time because of short selling bans. Zhaodong (Ken) Zhong wrote in detail about this in his research paper titled Why Does Hedge Fund Alpha Decrease over Time? Evidence from Individual Hedge Funds.

...Cross-Country Market Interconnectedness

The crowding of hedge fund strategies and positions; the progressive decline of aggregate hedge fund alpha over time; are in essence, push factors, that will force hedge funds to either, (1) close shop, or, (2) to search for opportunities in new territories - where strategies and trades are not crowded not.

In the latter scenario, funds will have to reinvent their strategies to allow them to invest in other markets and other geographical locations. This might entail transformation/evolution into a multi-strategy asset management company with a global macro component; a scenario that is analogous to Goldman Sachs' transformation from an investment bank, into a bank holding company (i.e. transformation into a more diversified entity that's perceived to be 'less risky').

When the 'diversified' asset management entity is set up, it takes positions in the new disparate markets, in addition to lucrative alpha-generating positions in markets it operated in previously. This has the effect of linking the 'new disparate markets' to the markets the asset management entity operated in previously: the markets become correlated, albeit subtly, through the asset management entity's portfolio. Any position-specific extreme event that wipes-out the value of the respective position, will have a negative impact on other seemingly disparate positions (in other markets) by stressing the portfolio. Hence, in an abstract sense, the asset management entity's portfolio is a shock transfer mechanism, that transmits shock from one market to other. Therefore, it is evident that global flows of capital are the linking-mechanisms of disparate markets.

So whats causing interconnectedness that Taleb spoke of? Answer: Diversified capital flows