Note to Institutions: I Can Save You $600 Million

I was talking to a friend of mine who used to work for former hedge fund manager, Bernie Madoff (he was a market maker on the legitimate market-making side of the business).

"Are hedge funds dead?" I asked him.

"Of course not," he said. "With the current volatility and 0% interest rates you have to have your money in the game."

In fact, hedge fund total assets at $2 trillion are now higher than their pre-2008 levels.

But here’s my problem, I explained to him.

Goldman Sachs just put out the top positions held by hedge funds.

1. Apple : 75 of the top hedge funds (assets of $100mm or more) hold Apple.
2. JPMorgan Chase : 42 of the top hedge funds hold JPM
3. Pfizer : 36
4. Bank of America : 34
5. Microsoft : 34
6. Citigroup : 32
7. Alcon : 30
8. Google : 24
9. Exxon Mobil : 23
10. Mastercard : 22

Hat tip to Market Folly.

Why should I pay 2% of all my money plus 20% of all of my profits so some guy living in a $20 million apartment in the Upper East Side of Manhattan (and that’s the cheap ones) can own Apple and Pfizer.

"Don’t forget hedge funds can short," he said.

No problem. There’s a lot of evidence that suggests that the top stocks shorted by hedge funds are simply the stocks with the highest short interest. Who else is shorting with such size on these stocks?

So now we have the top short interest stocks in the Russell 1000: (hat tip to Bespoke Investment Group, an excellent data-driven blog).

Now I can create my own hedge fund owning the top 20 long stocks and the top 20 short stocks (AN, MGM, CIEN, MYL, etc). How about everyone pay me 2% of assets and 20% of profits?

Well, one can ask, what about the high frequency trading funds. Its starting to turn out (like it did with the last "black box" wave of mutual fund timers) that much of the activity of the HFT funds is gradually being deemed illegal (“layering”, “quote stuffing”, etc where fines are already being levied against funds).

"But," my friend suggested, "there are still many markets that are unregulated. Carbon credits in Europe, for instance. Also, there’s an information edge that can be had if you invest in underfollowed microcaps."

The only problem is that if you have $10 billion of institutional money to put to work, you can’t really put it to work in hedge funds that focus on microcaps or on funds trading whatever illiquid unregulated markets are still out there on the financial frontier.

So, a message to all the massive institutions out there putting $10 billion into funds of hedge funds that will diversify your money into long-short hedge funds (the most popular hedge fund strategy). I can save you $600 million (2 and 20 on the hedge funds and 1 and 10 on the funds of funds — two layers of fees, plus I assume a mediocre performance).

Just go long the stocks that are the most concentrated long positions and short the most concentrated short positions.

And for any your aspiring hedge fund entrepreneurs: focus purely on microcaps and markets for things like carbon credits. Leave Apple to the big boys.

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