“Unwinding” Explained

We happened across this beautiful explanation of the dynamics of "unwinding", which many believe to have been a factor in the sell off of financial assets this year:

Professional arbitrageurs [e.g., hedge funds] must convince wealthy but uninformed investors to entrust them with investment capital in order to exploit mispricing and push the market back toward the ideal of efficiency. Unfortunately, arbitrageurs cannot prove that they recognize the intrinsic (or “fundamental”) values of the assets they claim are mispriced. Even worse, it is possible the assets will become even more mispriced before reverting eventually to their intrinsic values [as JM Keynes allegedly said, the market can remain irrational longer than you can remain solvent]. Having incurred losses, the outside investors may demand their money back at this point even though the expected profit of staying invested actually has increased. Thus, market efficiency may depend ultimately on the successful resolution of a principal-agent problem that exists between informed but wealth constrained arbitrageurs and uninformed wealthy investors. The resulting degree of market efficiency may change over time and differ across markets, and it could depend importantly on factors such as the outside investors’ use of performance-based (“feedback”) strategies when deciding on the possible termination of ongoing investment mandates. 

As we say on our website:

Although we believe in the relative efficiency of markets, we also believe that, because human existence unfolds across physical time, efficiency is a process, not a state. Thus, markets spend most of their time in an equilibrium seeking process, but a true state of quilibrium is rarely, if ever, attained…

We’re learning in 2008 what the unwinding process looks like when it is preceded by very high leverage and the widespread employment of similar quantitative processes that result in herd behavior. And boy, it sure is ugly. At one time, we actually considered going into the arbitrage line of work. But we decided that there was a larger need going unmet, which was the provision of sophisticated investment advice to regular people and organizations at a price that wouldn’t break their bank accounts. This Oscar Wilde quote reaffirms our belief in what we’re seeking to do here:

I have found that all ugly things are made by those who strive to make something beautiful, and that all beautiful things are made by those who strive to make something useful.

URLs:

http://www.symmetrycapital.net/profile.htm 

http://www.freebase.com/view/quotationsbook/quote/3947