Investment fund strategies demystified

(Photo © EM Karuna)

By Claus Rosenkrantz Hansen, CBS Library

In the preface to his new book Pedersen relates how, as an investment fund employee, he was in the thick of it when the financial crisis erupted and millions of dollars were being lost by the minute.

The experience of the losses, which simply continued unabated, is still ingrained in his memory. To vividly illustrate the impact of what he experienced, he cites as an analogy the fact that you cannot truly understand what it is like to be at war unless you have actually experienced bullets whizzing over your head.   

Thus this first-hand experience of the crisis left behind a deep impression on Pedersen the practitioner, while as a researcher it raised a great many questions, which, as we gather from the preface, acted as a catalyst for his new book Efficiently Inefficient: How smart Money Invests and Market Prices Are Determined, which now, eight years on, has arrived on the shelves.

The eight investment strategies
This book does not deal with the financial crisis as such.

In fact it deals with how the financial markets operate. And it does this by describing eight of the investment strategies used by investors and investment funds to make money on the markets. In some ways the book allows the reader to have a peek behind the scenes, a look at what is otherwise a very clandestine world.

"The book helps to demystify what goes on in major investment funds. Now and again we hear about investors almost magically generating huge stock market returns. The point I'm making is that these enormous returns should not be described as something magical, but as the result of a number of tried-and-tested financial strategies mastered by investors that can be combined according to the circumstances. I present these strategies in my book," explains Pedersen.

That is not to say that learning about these strategies will make you a guaranteed winner on the stock markets. Making high returns requires hard work, capital, skill and infrastructure.

Pedersen classifies the eight investment strategies into three so-called archetypes, namely equity strategies, macro strategies and arbitrage strategies.

Three of the eight strategies are equity strategies, where investments are concentrated on individual companies or sectors. Two are macro strategies involving the observation of movements on the entire stock market and on the currency and bond markets. The last three are arbitrage strategies, where you exploit the relative price differences on stocks and other securities.   

What investors actually do
The book is more than just an explanation of the theory behind the eight strategies, however. Pedersen the practitioner comes alive as he interviews investors who have gained prominence for their highly successful mastery of the different strategies.

The names listed are not any old names, and Pedersen can hardly conceal his pride when the subject comes round to who he interviewed for the book.

"One of the interviewees is George Soros, famous for his macro investments and ideas on the evolution of the markets. He shot to fame for causing the Bank of England to withdraw the pound sterling from the European Exchange Rate Mechanism. The book also contains interviews with people such as Ken Griffin, John Paulson and Myron Scholes, the last-mentioned being known for using his Nobel Prize-winning research as a basis for investment in, for example, bond markets," explains Pedersen.

Are the markets efficient or inefficient?
The title of the book refers to one of the big questions in the financial world: How efficient are the financial markets really?

Efficiency means whether the prices in the financial markets reflect all the available information. If the prices reflected all available information, this would give the most correct price, in which case investors could never hope to beat the market.

The academic world has long stuck to the belief that the markets are fully efficient. However this standpoint has been challenged by behavioural finance, which says that people are irrational and that their market behaviour is thus also irrational – does that make the markets inefficient and the prices wrong?

Pedersen thinks that the truth lies somewhere in between.

"I believe that the markets are neither completely efficient nor completely inefficient. They are somewhere in between, although not in a random position. There is certainly a degree of inefficiency present. In fact just enough inefficiency to slightly compensate investment managers and active investors for their efforts, expense and risk, but no more than that, otherwise active investment would increase," Pedersen explains.