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Hedge Funds and The Pareto Principle   (February 19, 2007)

Frequent contributor Harun I. invokes The Pareto Principle (the 80/20 rule) in an incisive analysis of last week's entry on hedge fund returns and alpha:

What BGI (Barclays) does is what every technical trader attempts to do: develop a trading model with a statistical edge. The statistics sited are constant with the Pareto Principle (see below). I have found that what limits the trivial many investors and traders is an unwillingness to turn off the news, learn something about statistics, develop and rigorously test trading models and money management models and to understand the process of Group Rotation.

The trivial many donít understand the level of commitment it takes to succeed in what is a very Darwinian environment. While the trivial many is making decisions based mostly on funny-mentals (ED: traderspeak for 'fundamentals') they hear on CNBC and from government hacks, or worse, their gut or tips, the vital few are using applied mathematics and the power of computers to take the lion's share of returns in the market. However, in the sphere of finance and all other areas, it is and always will be the vital few that cause the most pain for the trivial many. In this instance, it will be the vital few hedge funds within hedge funds that will wreak havoc for the trivial many (LTCM). It must work both ways.

I still don't quite understand what unregulated" means, it is federal regulation that does not allow hedge funds to advertise and confines their client base to "accredited investors". There is a quagmire of accounting and reporting regulation (in most large firms the trading dept. is the smallest and accounting the largest). The only thing I found to be unregulated is in what hedge funds can invest, direction (short or long), and how much they charge their clients for their services.

I do agree that unregulated derivatives pose a threat to the global financial system and there should be performance guarantees as afforded by a regulated exchange.

How much of the alpha that makes it into investorís hands is it up to the investor. Being a rational being means that if a service or good is too expensive one will actively seek out alternatives. When the market finds these fees unbearable hedge funds will adapt or they will close their doors.

In other words, "the vital few" (20%) influence effects more than the "trivial many" (80%). I must cop to not thinking through what "unregulated" means, given that who is allowed to invest in "risky" hedge funds is in fact highly regulated. This reminds me yet again not to take easy phrases for granted.

Here is the Wikipedia link to The Pareto principle.

This is a special case of the wider phenomenon of Pareto distributions. If the parameters in the Pareto distribution are suitably chosen, then one would have not only 80% of effects coming from 20% of causes, but also 80% of that top 80% of effects coming from 20% of that top 20% of causes, and so on (80% of 80% is 64%; 20% of 20% is 4%, so this implies a "64-4 law").
If the "vital few" make most of the money in the hedge fund world--the Pareto distribution suggests 20% of the funds garner 80% of the returns, and only 4% have more influence on the markets than 64% of the "trivial many"--then we also discern the outlines of how a financial meltdown can occur with sudden, unexpected speed: the 4% of hedge funds who have over-extended leveraged bets on derivatives could bring down the entire derivatives market, even though it appears that their holdings are too limited to trigger such widespread havoc.

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