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Post Europeans are Happy with a 3 to 4% Return
Created by John Eipper on 02/23/21 1:29 PM

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Europeans are Happy with a 3 to 4% Return (Jordi Molins, -Spain, 02/23/21 1:29 pm)

Ric Mauricio (February 23rd) is right that Hedge Funds yield, on the long term, about 7.3%. Since the Hedge Fund manager of the strategy we have been discussing so far is able to get 50% of the (positive) returns, this means the investor in such a strategy gets about 3 to 4% per year.

The flipside is the Hedge Fund manager needs to post 10% of the assets he will manage as cash in an escrow account. The strategy will be able to draw from that escrow account, if there are losses. So, the 10% guarantee is real.

From conversations with Americans, I see a return of 3 to 4% per year is considered to be irrelevant. However, in Europe investors are desperate to get any guaranteed return (even 0%! cash yields -0.5% nowadays). An insurance company that is able to get, with a high probability, a 3 to 4% return (and with a low capital consumption in Solvency II, due to the 10% guarantee) will find this deal to be an exceptional one. The problem with this strategy, according to my friend, is that it looks "too good to be true."

As discussed, this strategy has its own merits. For sure, it is a better strategy than most. However, it reveals that the market is pricing a non-negligible amount of gap risk. I believe this is mostly unappreciated, so far.

Finally, there is a second unappreciated risk: if the gap risk materializes, the Hedge Funds that now are willing to risk 10% of cash to get the 50% upside could become reluctant to continue to do so. As a consequence, the strategy would cease to be practicable, and my friend should return capital to investors.

JE comments:  Jordi, you mention Europe's negative .5% yield on cash.  WAISer Bert Westbrook once tried to explain this phenomenon to me (while sitting on this very couch!), but I confess I still don't follow.  What is the incentive to pay someone to hold your cash?  US 10-year Treasuries yield 1.37%, and a coffee can in the back yard at least gives you a guaranteed zero.

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