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Tickers in this Article: TIVO
We are starting a fund that employs leverage and derivatives to invest in prime real estate on the moon. The dark side appears undervalued.

Our lunar fund employs strategies that are "complex" and too difficult to explain to you, dear investor, but if you look at our historical performance chart, you will see we have found a proven money-maker: of the 10 lunar funds started last year, we are one of the five lucky survivors– true, it was a random outcome but when you only count the survivors, you can see how the asset class outperforms!

This is called survivorship bias: when you eliminate zeros from the average. It is like when I come back from Vegas, I always joke (un-funnily) that I won big, if you exclude my losses.

Are most hedge funds any different than investing in lunar real estate? CNBC is running a series this week on hedge funds. Please don't TiVo (TIVO) it. Here is today's lesson: hedge funds are a compensation scheme disguised as an asset class. The lunar real estate analogy is deliberately chosen. Real estate is a good investment, as are many common stocks.

But why would you give your money to a company that obliquely and indirectly invests in real estate on a distant planet, essentially inserting themselves and an entire orbit of distance between you and worthwhile investments. An orbital layer of fee-generating swamp-mist.

This is the problem with most (not all) hedge funds: in trying to be "too clever by half," they are playing games in the orbital ether of the financial marketplace rather than investing in value-producing or income-generating assets. Playing games in the financial ether is a zero-sum game where trading winners exactly offset trading losers – this year's random winners will be actively marketing to you next year; the losers will simply shut-down and re-open as a new fund next year. Investing in companies over the long run is a positive sum-game because the economy grows.

I am always amazed that "complexity" and financial alchemy, er I mean, financial engineering serve as some kind of magnetic elixir. In utter seriousness, the most common hedge fund strategy is to call the other hedge fund manager and see what he or she is buying or selling. And that is why there will be meltdown, because all of those frenetic phone calls back and forth do not add value. Not all hedge funds, of course. I am proposing the following test, if you are considering a hedge fund: how does the fund transparently connect their strategy to investments in value-creating assets (e.g., companies).

The truth about the various hedge fund strategies is that they each have their strong season or winning cycle, but it is very difficult to predict the next cycle's winners. Long/short funds do better in bear markets, but if you are betting on-or hedging against-a bear market, you can also buy an S&P index put. Arbitrage strategies have been, er, mostly arbitraged way. And don't get me started on most market neutral funds.

The idea here is to eliminate exposure to market "beta" and isolate on "alpha"-the extra returns that accompany pure stock-picking skill. This sound great, but the vast majority of funds do not go to the trouble to correctly parse their beta exposures from their "true alpha" – in other words, in many cases, returns are the result of exposure to some unidentified beta risks. In general, the hedge fund industry tends to re-classify (market) beta exposure as alpha.

Doing this correctly is called performance attribution and it is very important; thankfully, some industry participants are leading the charge to get better at attribution. In the meantime, the point is that if you have a hedge fund that has outperformed in the past, they should be able to parse the beta from the alpha, because you do not need a hedge fund to buy exposure to beta. And don't insert too many layers of orbital swamp-mist between you and your investments.

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