For a town so small, Louisburg is blessed to have four banks operating in its vicinity. They are:
- First Option Bank
- First National Bank
- People’s Bank
- Landmark National Bank
In addition, the prime brokerage Edward Jones Investment Services is run by Craig Holtzen down on S. Broadway.
This seems to prove that the good people of Louisburg, Kansas, are a financially responsible lot. You don’t see a hedge fund there yet, but it’s only a matter of time. Let us explain why.
We predict that, with hedge funds now becoming registered as per last year’s Dodd-Frank legislation, the push will be on to begin offering hedge fund investing for the common person, not just rich fatcats. There is a misconception among many that hedge funds are these high-flying risky ventures, and some are, but think about their name: hedge funds. Hedging is a risk-reduction strategy: the fund tries to extract profits by taking advantage of market inefficiencies rather than trying to guess the fate of a particular stock or market. That is, hedge funds most often use some form of arbitrage to try and wring money out of inefficient relationships between two or more different (though possibly related) assets.
Let’s take an example. Convertible arbitrage is a strategy favored by some hedge funds, especially international ones. The strategy looks for mispricings between a common stock and its derivatives, in this case convertible bonds or preferred stocks. The trick is to discover the price inefficiencies, then buy the underpriced assets and sell the overpriced ones. In theory this gives you a risk-free profit.
However, before you start digging the money out from beneath your mattress, know that it is extremely unlikely anymore to find many cases of price inefficiency; markets are computerized and the computers tend to quickly trade away price inefficiencies. So maybe convertible arbitrage is no longer a great strategy, because it has successfully wrung out most of these kinds of mispricings in the market.
But there are all kinds of strategies open to hedge funds nowadays that rely on more complex models and algorithms than those based on incorrect pricing of derivatives. A whole generation of physics PhD’s and mathematicians has devoted itself to quantitative analysis, the holy grail of hedge fund strategies. Through the use of sophisticated models, hedge funds apply quantitative analysis to a variety of situations to try and extract profits from relationships among assets. For instance, a long/short strategy pairs strong and weak stocks such that you profit by any substantial market movement, up or down.
So hang in there, Louisburg. Someday, you might be able to walk over to the First National Hedge Fund and invest some of those savings in something a little more exotic.