The Lie That Will Kill Hedge Funds

When I was in the game, by far the most popular were the "market-neutral" and "arbitrage" funds because they could absorb any amount of money and play all around the world without being hostage to "the market." They make money no matter what, which is the definition of what you are supposed to want if you are a client.

These managers can take advantage of the vast discrepancies that exist in the markets worldwide and borrow a lot of money to exploit them. That's hard if you are a pure stock guy. It is true that Pepsi (PEP Quote - Cramer on PEP - Stock Picks) is cheaper than Coke (KO Quote - Cramer on KO - Stock Picks) on a price-to-growth metric. (Coke grows slower than Pepsi but has a higher multiple.) But does that mean you can go long Pepsi and short Coke and the twain meets? I wouldn't bet that way.

But how about this? American Home Mortgage (AHM Quote - Cramer on AHM - Stock Picks) issues $1 billion in mortgages that Citigroup (C Quote - Cramer on C - Stock Picks) packages. American Home isn't a "deposit" institution with a broad range of businesses to fall back on. It just issues mortgages, 2 and 28, teaser, little documentation, etc., etc.

Citigroup pools all of those mortgages and offers them into a bond that yields 7%, say, as a blend of the payments. A market-neutral and an arbitrage fund manager might say, "OK, I have $1 billion under management. I will go to Citigroup and borrow 10 billion and invest in these kinds of bonds."

They yield 7%, I am borrowing at 5%, I get 2% on all I lever up, which can produce, risk-free, a lot of return. It sure seems risk-free; the bonds are "highly rated" by S&P and Moody's, which gives me ample protection. I am not doing anything reckless. I am doing what every other manager in my class, the biggest and most profitable class, is doing.

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