Sunday, April 18, 2010

ACA Selection process, alpha, and due diligence

If a sophisticated hedge fund manager came up to you today and gave you a list of 100 bonds he wanted to short, but you could pick and choose the ones you wanted to select, would knowing the intent of that manager effect your decision-making process? You bet.

The supposed basis for "alpha" is knowledge investors have that the general market does not. That means that the 100+ bonds Paulson selected for ACA may have been risky in ways that not even due diligence by a sophisticated investor could detect. If ACA had understood the selection process--even without knowing the identity of the shorting investor--it likely would have had real effects on its decision-making process.

ACA probably would have lost most of $950mil no matter how it selected bonds for its CDOs. However, even without the meltdown in the housing market, Goldman's actions objectively lowered ACA's expected return by exposing it to risks that it could not reasonably be expected to uncover. So I find the argument that ACA's "due diligence" should have negated the negative impacts of the selection process to be weaker than it might appear at first glance.