Consider the investment value of noise.
The subject here isn’t sound. It’s market noise, the endless up and down of stock prices that signifies little but causes hopes to soar and crash. Most investors try to screen out noise, looking for the “signal” in the market or in a single stock. They try to look beyond the noise of daily markets to see where a stock, a sector or the market is going.
In fact, mere noise has great value if you are a hedge fund and have special dispensation from a mutual fund firm to market-time one of its funds. Then it’s just a matter of finding a volatile fund — one with lots of “noise” — and you can trade on it.
Let’s try a small example.
Suppose the Asian Intergalactic Technology Fund has 10 million shares outstanding and a net asset value per share of $10. That means the portfolio is worth $100 million. After the close of the Asian markets you hear news that is likely to drive the stocks in the fund up by, say, 1 percent. That means the fund will be worth $101 million the next day. Each share will be worth $10.10.
So you buy 1 million shares at the closing price of $10, an investment of $10 million, with the intention of selling the shares the next day. As a result, the fund ends the next day with 11 million shares outstanding. It also has your $10 million in (uninvested) cash plus the $101 million portfolio. That’s a total of $111 million or $10.09 a share.
Your million shares are now worth $10,090,000. That’s a one-day profit of $90,000 or 0.9 percent. Not bad for a day’s “work.” (Readers should note: In practice, investments would be much smaller in relation to the fund.)
After your sale, the remaining 10 million shares are worth $111 million less $10,090,000 or $100,910,000. They still show a one-day profit, but it has been skinned for $90,000 by your market-timing trade.
This isn’t a sure thing. You have simply acted on information that was likely to cause the fund to rise significantly the next day. There is nothing criminal in your action, but the fund company has allowed you to walk off with a portion of the gain that would otherwise have accrued to the long-term shareholders.
Now take timing a step further. Suppose you could make that 0.9 percent profit on each of 240 trading days a year. Your $10 million would grow to $85.9 million. With only the prospect of such an enormous return, you’d probably be willing to park a spare $10 million in another fund. Since the fund management company is probably making 1 percent on that money, they’re making $100,000 a year for giving you the opportunity to make $75 million in the same time period.
Think of it as a tip for the croupier. (If you remember your James Bond movies, it’s good form to be generous with the man who turns the roulette wheel.)
Are 1 percent changes in market value common?
Quite.
According to data compiled by the Leuthold Group in Minneapolis, Nasdaq stocks averaged moves of 1 percent or more in 75 percent of all trading days in 2000, 68 percent in 2001, and 67 percent in 2002. So far this year the volatility level is lower, but it’s around the 50 percent level.
The S&P 500 stocks are less volatile (40 percent of all days they rose 1 percent or more in 2000, 49 percent in 2002) but still present major opportunity.
Note that these figures are for moves of 1 percent or more. For Nasdaq, stocks moved 2 percent or more in 40 percent (2002) to 53 percent (2000) of trading days. Compound larger profits over fewer days and you’ll still make a real killing. Make just 2 percent on 100 trades, for instance, and $10 million will blossom to $72.4 million.
Small wonder so many hedge funds were eager to capitalize on market noise.
The thing that’s difficult to understand: Why were some fund companies willing to do it for a croupier’s tip?
(Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: scott@scottburns.com. Check the Web site: www.scottburns.com. Questions of general interest will be answered in future columns.)
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