Hedge fund

Asset allocation?

2009-10-09T08:08:00.109+09:00

Asset allocation? The "endowment model" was seen as the solution to investing for the long term. But as some universities found out, the idea was badly flawed and overexposed to a weak economy. It was heavily long biased, poorly hedged and higher risk. Despite being asset diversified, it was insufficiently strategy diversified. Short term volatility can't be ignored regardless of the investor's ultimate time horizon.

The opportunity cost from overallocating to illiquidity was expensive. A dynamic investment opportunity set is not optimally captured with static or occasional rebalances to a strategic asset allocation. Overweight alpha, not beta and certainly not illiquid alternative betas. Skill is the essential driver of good risk-adjusted returns but assets don't have skill. Good managers do.

Some long term investors didn't realise they still need short term performance and income. Economic fluctuations ought not to have a deleterious effect on capital growth or the asset/liability match. Having so much tied up in illiquid assets makes it difficult to be agile enough to capture changing sources of return and adapt to market conditions. Flexibility, adaptability and liquidity are prerequisites for consistent performance. Hoping to be paid for holding risk assets is dubious. Expecting to also be compensated for illiquidity is dangerous. When liquid markets sneeze, illiquid assets catch pneumonia.

The percentage in marketable alternatives, hedge funds, was too low while the allocation to long only non-marketable alternatives, mostly private equity, was too high. While asset allocation is about attempting to capture ASSUMED risk premia for a given risk tolerance, the endowment model increased the ASSUMPTION RISK by replacing the liquid with the illiquid. While you can generally hedge liquid securities, not so with illiquid assets. Non-marketable alternatives still have to be marked to market. Where was the scenario analysis and stress testing to construct a truly robust portfolio during a recession? Why overcommit to 10 year lockups and ongoing capital calls when there is so much alpha available in inefficient public markets?

A long term investor still needs short term returns. Long term performance neither requires nor implies a long term holding period. Some of the best track records have been by managers with very short term strategies. Interesting how the same people who said you can't make money day trading now say too much money is being made in high frequency trading! Also the long term investor cannot ignore short term volatility or losses. University endowments might survive for centuries but in the short term, professors and other staff have to be paid, spending budgets met and capital projects funded at the same time as alumni contributions reduce due to the economy. Endowment spending policy necessitates retaining liquidity in down markets.

The endowment model was better than the 60/40 in stocks and bonds or "(100-age)% in equities" hubris that people sadly still get sold. But it had zero chance of achieving what endowments, foundations, pension plans, sovereign wealth funds and individual investors actually want. Reliable performance with capital preservation at minimal risk and maximal liquidity EVERY year. For that you need to hedge. And a proper strategy diversification NOT asset allocation. Assets alone do not have the necessary repertoire of return streams to derisk a portfolio. You also need access to skill and expertise for hedging, tactical trading and security selection.

CoRelations are more important than coRRelations. Many illiquid assets like private equity or real estate give the appearance of low volatility because they are valued infrequently. This creates the supposed low correlation to public markets. The disaster that was "Modern" Portfolio Theory favors such assets in a naive mean-variance optimization. But quantitative correlation measures do not give much insight into the coRelationships between risky assets and a risky economy.

While liquid security correlations infamously tend to 1 in down markets, the situation is exacerbated with illiquid assets that cannot be easily sold. Illiquid assets were often able to disguise their high coRelation because of delayed or overoptimistic valuations. However their dependence on a good economy was obvious ahead of time. The notion that liquid markets are efficient but illiquid ones aren't was always ludicrous. Some of the most widely traded and analyzed public securities are the MOST mispriced.

Real estate has been around a lot longer than stocks or bonds. It is not an alternative investment and relies on economic growth and availability of leverage. Real assets? Long only commodities is an even riskier concept than long only equity. Oil and gas partnerships fluctuate with the price of...oil and gas. Long/short commodities trading is safer. Many managed futures CTAs have demonstrated the ability to make money in up AND down markets. Gold and cocoa may be at highs as I write this but they are short term trading vehicles NOT long term investments. Inflation hedging? That's what TIPS and inflation derivatives are for.

Better portfolio optimization requires preparing for short term market tornados and long term economic ice ages. The endowment model carried almost no insurance against a bad financial climate. That is why substantial allocations to skill-based strategies that can make money in bad times are essential. Not enough short sales means not enough hedging. Derivatives are not to be avoided; they are MANDATORY for the risk averse. And the endowment model needed more attention to proper risk management, not basic VaR and CVaR stuff since much worse case scenarios than the assumed "worst" case have a habit of actually occurring. Most Monte-Carlo simulations and stochastic asset/liability models output too much optimism. That is not prudent for a fiduciary.

Despite all that alternative beta, there was still a large bet on a good economy of rising equity, easy credit and real estate. Replacing liquid assets with illiquid assets relied on the notion that there is such a thing as a liquidity premium. Many investors, even now, expect to be "paid" for taking higher risk. Despite what the economics journals claim, there is NO link between risk and return. Just because "stocks" are riskier than "bonds" does not guarantee outperformance over ANY time period. Replacing long only public equity with long only private equity was asking for trouble but was widely popularized by David Swensen, CIO at the Yale Endowment. Private equity was a misnomer anyway; the correct term was private debt with a bit of equity. The alternative assets weren't very alternative.

I don't believe in asset allocation. It is an anachronism and fails to emphasize RISK. The world has moved on in financial engineering and portfolio innovation. As a conservative long term investor I favor strategy diversification and hedging. It works if you know what you are doing and conduct due diligence properly.

Construct a portfolio that can adapt to market conditions and achieve a RELIABLE absolute return at the LOWEST necessary risk. Hedge funds are NOT an asset class and cannot be fitted into an asset allocation methodology. The only thing to overweight is SKILL, not assumed risk premia. Wealth should be protected and increased regardless of economic volatility. A bear market is no excuse for any manager to lose money. Portfolio choice? Simple, choose alpha. Only alpha.

Trend following?

2009-08-23T08:08:00.105+09:00

Some financial equations do work. Good hedge fund + bad quarter = buying opportunity. As I expected most hedge funds have performed well so far in 2009. It is no surprise that market dislocations, misvaluations and panic-selling hysteria created fantastic opportunities for skilled managers. Inevitably performance was bound to be strong when so many "experts" even recommended to avoid hedge funds! Redemptions by those that didn't understand TRUE diversification have benefited investors who REDUCED risk by having lots of good hedge funds in their portfolios.

Even more impressive are the hedge funds that made money in both 2008 and 2009. Market timing is difficult but some have the talent. A way to evaluate any investment strategy is its return on risk. Even with the recent stock and credit market rally, the return on risk of long only funds has been very low. Is the equity risk premium zero or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve their capital. Invest in managers with the skills to MAKE MONEY when things go pear-shaped - ie markets or economies go bad.

All trends end. Bizarrely inconsistent how those who argue trend following hedge funds have no value yet continue to advocate long only equity funds because of an upward trend that can supposedly be extrapolated far into the future. Their insouciant belief in past being prologue is dangerous for investors. The volatility of recent years has shown pear-shaped times provide the best risk management stress test. As we saw with stock, credit and commodity markets recently, the more long lasting the trend, the more violent the end. The trend is your friend until it ends. And they ALWAYS do.

The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fund groupies sell a rosy view of a future that we can apparently look forward to...eventually. I hope they are right but CONSISTENT CAPITAL GROWTH requires mitigating the downside. Few investors can afford to ignore drawdowns or volatility. Follow the trend? Into the abyss? Many equities drop to zero but NONE has ever gone to infinity. Portfolios need to be structured for ANY possibility including a dystopian long term.

Unfortunately the crowd STILL uses normal assumptions which is fine UNTIL things cease to be normal. Pear-shaped situations require pear-shaped analysis. I've always preferred non-linear pear-shaped equations since they capture the initial quasi-linear uptrend and then model the volatile end game. WE DON'T KNOW THE FUTURE but we do know that there are always securities to short sell and others to buy.

Linear math is easy which is why most financial "professionals" rely on it to their CLIENTS heavy cost. But since most phenomena are non-linear it stands to reason that linear equations are of limited use. The simplest pear-shaped formula is y^2=x^3-x^4 which only has solutions in the real world for the infinity of inputs between 0 and 1. We can define the beginning of anything at zero and ending at one to transform any process into that range. Identifying and jumping onto a trend is relatively easy. Lots of people make money in bull markets. Knowing when to get out or reverse into a short position is what separates the alpha players from the beta repackagers.

Many things exhibit pear-shaped characteristics. The universe is pear-shaped. Time is certainly pear-shaped. Just ask Professor Stephen Hawking. Atoms are too. If the largest and smallest physical systems are pear-shaped, it would seem possible that financial processes could also exhibit a similar form. Bonds and loans are great assets till the borrower defaults. Mortgage backed securities are fine unless real estate goes pear-shaped. Bull markets last longer and have low volatility while bear markets (pear markets?) are quicker but often eviscerate years of growth from the prior bull market.

Recently I reread some books on the economic shape of the world. One was The
World is Flat by Thomas Friedman. While interesting, the premise is incomplete. The world is actually pear-shaped and only gives the illusion of flatness during easy times. Protectionism may be ending the globalization trend. While David Smick's book The
World is Curved is more insightful, we need techniques to prepare for the different scenarios beyond the curve. Perhaps I should write a book called The World is Pear-Shaped.

Invention eliminates the obsolete. The life-cycle for businesses shortens all the time. Corporate and even country hegemony is not as long term as it used to be. Typewriters, slide rules and vinyl records all had rising sales for decades but have not had much "growth" recently. Innovative investment strategies that seep into the public domain and crowded trades are prone to end with a meltdown. Bubbles take a long time to form but a short time to end. The best alpha generators are those managers equipped to navigate difficult markets. Successful trend following requires good entries AND exits.

Some absolute return strategies went pear-shaped in 2008 like CB arbitrage and long biased equity. The returns have stormed back this year by those managers with the skills to achieve them. Meanwhile good managed futures CTAs and short biased funds continue to deliver ESSENTIAL negative correlation to their clients. Fiduciary duty REQUIRES portfolio construction for optimistic AND pessimistic scenarios. Bear markets or bull markets are irrelevant in robust strategy allocation.

Bull market?

2009-03-26T19:08:00.240+09:00

Bull market? Financial services are about achieving CLIENT objectives and good hedge funds have delivered superbly. Over 3,000 absolute return funds had POSITIVE performance in 2008 but few long only equity managers have in 12 YEARS. It's best to invest in quality so I'll stay in the SAFE HAVEN of skill-based strategies. EVERY smart institution I advise is INCREASING allocations to hedge funds. Last year nicely revealed the beta repackagers pretending to be hedge funds. Good riddance.

2008 was actually a great year for PROPERLY diversified portfolios. The future prospects for good hedge funds are outstanding. Bonds have outperformed stocks for a very long time but absolute return has done far better. The investment SKILL premium exists but the equity RISK premium? Naive to expect to be paid for exposure to risky asset classes over the long term. A fall into the ditch makes you wiser and people prefer managers that avoid large losses. The epochal change to REDUCE risk is from long only ASSETS to long/short STRATEGIES.

I suppose stock markets MIGHT eventually get back to where they once were. But even if I was certain that in 2029 the Dow, Nikkei and FTSE will be above 100,000, I still won't be gambling on long only equity. I know good hedge funds will have HIGHER risk-adjusted returns. And if those benchmarks turn out to be LOWER than today, good hedge funds will also have outperformed.

Recessions are bad for beta but good for alpha. Diversified ROBUST hedge fund portfolios beat stock benchmarks on a risk-adjusted basis over all time horizons. Long only equity funds squandered a disasterous -40% in 2008 and remain negative for the decade. Despite a drawdown, even an index of "all" hedge funds produced +22% alpha compared to the stock market. The biggest risk most investors take is the outdated infatuation with the unhedged stock market.

The very rare "hedge fund" that imploded receives saturated media coverage but there have not been many articles on the managers that made +20%, some over +100%, last year. Change is a constant in finance and doesn't faze those with genuine acumen. The "average" fund manager is just that...AVERAGE. The "indices" indicate very little with such wide performance dispersion.

The demand for absolute return is growing unlike that unrequited love affair with stocks that has jilted so many investors. The long only luddites hope risk appetite will rise again but skilled long/short strategies offer a smoother ride. "Buy and hold" has been an acarpous wasteland for too long. Like many investors, I NEVER have an appetite for such risky speculation.

But I do have the simple yet novel requirement that fund managers make money in USEFUL time frames without devastating drawdowns. Anyone who regularly meets with proper hedge funds and bothers to look closely at the performance data concludes that the more conservative an investor's risk tolerance, the MORE of their portfolio they need in proper hedge funds. Long only equity losses of -50% are beyond any acceptable level of risk with +100% needed just to get back to breakeven. The empirical evidence PROVES the lower risk and higher performance of good hedge funds. Many of the largest institutional investors are EXPANDING their hedge fund investments. Individual investors would be prudent to follow.

80% of alpha is made by 20% of managers. The Pareto principle governs hedge funds too. There is nothing unexpected about recent "aggregate" numbers and good hedge funds continue to produce EXACTLY what they promised - uncorrelated absolute returns with capital preservation. Portable alpha redistributes from the unskilled to those with an edge. Back in 1970, 2 out of 3 "hedge funds" shut down but the following 40 years saw a LOT of growth. 1994 and 1998 were also supposedly the "end" of hedge funds. The current blip is another temporary timeout in the ongoing expansion of the hedge fund industry. Any money withdrawn creates more space for smarter investors.

The ONLY hedge for a long is a short. Why should bull markets or bear markets affect the capital growth of a truly diversified portfolio? Asset allocation has not met the expectations of investors. As this decade showed, if you own lots of stocks, bonds, real estate, private equity and commodities you are NOT sufficiently diversified. Long only risky assets are correlated, particularly in bear markets. A robust portfolio requires substantial investment in orthogonal skill-based strategies that do not depend on rising markets or a strong economy for performance. Diversification with lots of different strategies is critical to optimal portfolio construction for the long term.

Not investing in any stock or corporate bond because of Bernie Ebbers would be dumb so why are some arguing for avoiding absolute return strategies because of a fraudulent stockbroker called Bernie Madoff? That would be almost as silly as eschewing honest funds of funds that actually conduct due diligence because of Bernie Cornfeld. One of the best hedge fund managers was Bernie Baruch. If only we had access to his perspicacity today like President Roosevelt did during the 1930s depression. It is hazardous to rely on economists to advise on the economy and we shall see if the PPIP succeeds. Is government leverage the solution to ineffective use of leverage?

Long only funds are not for those who dislike riding the stock market rollercoaster. Long term absolute returns are the raison d'etre and why anyone would invest in an AVERAGE hedge fund is incomprehensible to me. It's almost as weird as wasting time and money in an "average" stock. With the right evaluation techniques, investors can do a LOT better than "alternative beta" just as they can with market beta. Traditional 60/40 stocks and bonds just doesn't work. Keep it simple - overweight alpha in your portfolio. It's safer and more reliable. Don't bet on beta and avoid any "hedge funds" or "mutual" funds that depend on it.

The redemption of hot money creates more room for investors who understand that smaller AUMs lead to larger alphas. Poor quality "hedge funds" that shut down will simply be replaced by better new ones. The "free lunch" of "passive" index funds has cost investors too much money for far too long. The CULT of equity and the credit cataclysm have devastated beta-centric portfolios. The CURE is to rebalance in favor of investment skill. Not long from now hedge funds will be a CORE component of all investment portfolios. Risky asset classes are too volatile and need to be hedged.

Good hedge funds continue to generate the performance that investors need and have done that throughout the equity tumult and credit induced economic turmoil. There is a terrific pipeline of NEW strategies and hedge funds coming. Did the dot.com implosion end internet usage? For each Netscape, Excite and Pets.com along came a Google, Facebook and Twitter. Creative destruction and innovation drives investment technology too. Good riddance to the dinosaurs; welcome to evolving ways of making money. Many investors are aligning their interests with talented and incentivized fund managers that focus on risk-adjusted returns.

The stigma of high sigma renders unhedged equity funds unsuitable for those who seek reliable performance at low volatility. The blandiloquence of the index fund aficionados with their "cheap" fees but expensive losses has not helped investors. The FACT that equities have underperformed bonds over such long periods refutes the "Nobel" prize winning dogma. Stocks constitute an opportunity set of securities to buy and short sell. The mythical equity risk premium doesn't exist. For persistent alpha generation, you need a better data set and better ways of extracting information from that data set. Hedge funds are NOT an asset class; they are skilled strategies applied within and between asset classes.

Redemptions? Sure some cash is being transitioned since manager mixes are being upgraded. You must redeem from the underperformers before you can reinvest in the better hedge funds. It is also great news for the new money that will be coming in. The removal of the beta repackagers, that pretended to be "hedge funds" but got blown away by the market meltdown, improves the quality of the industry. Isn't that how capitalism is supposed to work? Doesn't the cull of the bottom quartiles IMPROVE the overall standard? Some people are redeeming for liquidity reasons due to losses in public and private equity. When "hot money" is taken from good hedge funds for ATM purposes, it creates more room for stable long term money.

Investors care about performance, not asset gathering accolades, so why is a reduced AUM a "bad" thing given that it is likely to lead to INCREASED performance? Smaller sized hedge funds and a superior manager universe means HIGHER returns and less crowded trades. There are MORE arbitrages, dislocations, anomalies and mispricings around for those with the ability to find them than ever before. As we saw with previous "death of hedge fund" predictions, shaking out the losers is good for the absolute return industry and even better for investors.

Public scrutiny of "secretive", "swashbuckling", "unregulated" hedge funds is fine as long as it also brings public availability. Some countries' regulators have not permitted those who they deem "unsophisticated" to invest in hedge funds. Rarely have the FORWARD-LOOKING alpha opportunities been brighter and who can afford to endure the damage of "passive" beta again? The volatility has eliminated funds with poor risk management processes while the departure of short term money has expanded the capacity available for investors that understand the diversification value of good hedge funds. The shakeout is a POSITIVE for those seeking alpha.

The more unsophisticated money that departs creates more room for people that appreciate the RISK REDUCTION properties of good hedge funds. Alpha-centric portfolios require skilled security selection and risk management. Since skill is rare and performance dispersion wide, strategy analysis, manager evaluation and portfolio optimization adds more alpha. No-one claims investing in hedge funds is simple. Index funds are easy to understand but "passive" performance has been poor.

Aggregate returns when the hedge fund industry was smaller were higher. Robust strategies have capacity and implementation constraints so a lower AUM is good for performance. Changes in the financial markets? Sure but the best managers adapt to any conditions. Variant perception and negative sentiment creates opportunities for those who do the hard work and analytical heavy lifting to find the value through the blind hysteria and non-expert opinion. The wisdom of crowds often results in wealth destruction. As last year showed, the zero sum alpha game means lots of people will be wrong. The animal spirit of the markets inevitably results in some winners but more losers. If "everyone" is making money then something is broken.

Time is worth more than money so I shall not be waiting around for stock markets to recover when so many talented managers are at or near their high water marks NOW. With better solutions available, why endure the deadly drawdowns, vicious volatility and ridiculous risk of the stock market? Life is short and liabilities grow so who has decades available to await the alleged upward drift of the index? Reliable long term returns requires attention to short term risk.

In the worst bear markets there are always good stocks and there are plenty of short sell candidates during bull markets. Long only index based investing guarantees too much money flows to bad stocks. Tracking a benchmark means the same HIGH risk as the benchmark is taken. Equity capital should flow to good companies; not ones that "have to be bought" because someone else actively decided to include them in their "passive" benchmark.

By replacing market risk with manager risk, investors get reliable growth with capital preservation irrespective of underlying market direction. If they diversify, do their homework and are advised properly, investors DO get compensated for taking good hedge fund manager risk but they have NOT been paid for taking stock market risk. Individual investors need absolute returns in reasonable time frames. Whether you have $1,000 or $1 trillion to put to work, a substantial allocation to absolute return strategies is ESSENTIAL. Investors need performance whatever the economic situation. In fact they need it even more in tough economic times.

Some believe that by holding on long enough, traditional portfolios will be fine. Economists rarely let the facts get in the way of their assumptions. The long only crowd claim that by staying in for the "long haul", UNHEDGED funds are all your portfolio needs. Conversely anyone who studies PROPER hedge funds sees their overwhelming superiority and safety. The critics know little about hedge funds and have usually never invested in one themselves but still think their views are valid. Finance has changed; the dubious mantra of buy and hold ended last century.

No place to hide? Actually there have been plenty of places to hide during the market turbulence. For managed futures CTAs, options traders and short biased strategies, 2008 was an outstanding year. Cash isn't king when it yields zero. Traditional asset allocation simply hasn't worked very well; skill based security selection with strategies that DIVERSIFY are what work. If an investor wants RELIABLE growth at limited risk in any forward looking market scenario, a well constructed portfolio of bona fide hedge funds running DIFFERENT strategies is the way to achieve it.

Stay the course? But what course is the economy on in the long term? How should one invest given that we do NOT know future market conditions? Why the stoic indifference to portfolio pain when proven antidotes are available? The answer is with the absolute return managers that have the talent and incentives to make money irrespective of market direction. Modern portfolio theory doesn't need a tweak; it needs an extreme makeover. Any manager that loses -50% TWICE in a decade does not merit a place in any risk averse portfolio so sayonara to long only "passive" funds. Speculating on the noxious notion that stock markets "rise over time" isn't suitable for those who need performance in sensible time frames. Even in bull markets the RETURN ON RISK of index funds is very low.

Bull market? Yes it's always a bull market for investment EXPERTISE. Traditional investors need to access that talent. A SUBSTANTIAL allocation to diversified skill based absolute return strategies is necessary for risk averse investors.

Bernie Madoff?

2008-12-26T22:08:00.184+09:00

Bernie Madoff did NOT run a hedge fund. He was a broker-dealer "managing" customer accounts. His firm was "regulated" and fraud is already illegal. REAL due diligence itself is an alpha source and Madoff failed the most basic checks. PROPER manager diversification with GENUINELY uncorrelated strategies is essential for risk averse investors.

It was always odd that Bernie didn't set up a hedge fund if he was so good. No incentive fees, no prime broker, no proper auditor and no independent administrator? Despite his "performance", Bernie wasn't a billionaire. With those "returns" on that AUM he should have been a stalwart of the Forbes 400. Why did so few question his absence from the list?

The chart is Madoff feeder, Fairfield Sentry, versus Gateway GATEX, a fund running the "same" strategy. Suspicious numbers and autocorrelation in the 1990s got worse in 2001.

Split strike conversion is a BASIC strategy for options traders. It is too simple and well-known to be an edge and does NOT protect against major stock market falls. It looks like Madoff was subsidizing losing months with brokerage commissions from early on. Then a watershed event occurred in 2001 from the potent combination of a sustained bear market, reduced payment for order flow and decimalization. The broking income became insufficient to smooth away drawdowns. The divergence between the feeder fund and Gateway became startlingly wider than the previous merely dubious disparity. The abnormal returns were noticed by those who pay attention and two skeptical media articles appeared that year.

I was lucky. It took five minutes 14 years ago to decide I had no interest in the Madoff "strategy". Since then many feeders wholly or partially invested with him have crossed my desk, often without disclosure as to who the underlying manager was. A few weeks ago two marketers approached me at separate institutional investor conferences with "15 years of double digit returns at under 3% vol, daily liquidity" pitches. Both times I replied "No Madoff" before I heard the manager's name. I look at actual hedge funds and don't have time to study obviously unsuitable investments.

Bernie did not make the first cut with most professional investors. I didn't know for sure that Madoff was a fraud until now. But I do know a bit about options and stay away from funds with a big difference between what they should have made and what they did make. Back in Christmas 1994 I was simply looking around for some good funds that had navigated that challenging year successfully.

"It's a proprietary strategy"? The trouble with Madoff was that he performed too well for the split strike conversion strategy on the S&P 100 OEX he was supposedly running. I like good black box trading strategies but this was no black box. I've designed options pricing and trading models and volatility arbitrage systems and it takes much heavier quantitative weaponry to generate consistent returns out of the options markets.

Going long some large cap equities, sell calls and buy puts for the collar does not protect capital in sharply down markets. Contrary to its "market neutral" claims, split strike conversion performs better in bullish conditions. 1994 was a flat year for the S&P 100 with several negative months but Madoff reported 12%. Gateway, returned 5.5% which is approximately what would be expected. Madoff should have had similar numbers to the mutual fund but somehow "made" double digits. That was impossible for his "claimed" strategy in 1994.

You can detect a lot by focusing on difficult periods. When Long-Term Capital Management imploded in summer 1998, volatility was itself very volatile and stocks dropped sharply. But Bernie produced a similar return as in quieter months despite the mayhem. In September 2001, 9/11, stocks gapped down and volatility gapped higher but no problem for Madoff. Almost every real hedge fund either lost or made a lot in that terrible month. More recently Bernie Madoff seemed remarkably immune to the market meltdown that has unfolded. The crash of October 2008 was the end. His undoing was that even products that were up for the year were suffering redemptions.

Isn't a media search an important part of Due Diligence 101? Not many investors would want their money with Madoff after some good reporters looked into the story seven years ago. Barrons and MAR Hedge carried some heavy hints on Bernie Madoff with well researched articles. An actual hedge fund would normally be delighted to be profiled by Barrons. Free advertising and read by many high net worth investors. But the curiously defensive response of Fairfield Greenwich concerning its "sought after" Madoff feeder, Fairfield Sentry, was "Why Barrons would have any interest in this fund I don't know". Rarely do investors get such a STRONG indication that things would not have stood up to close scrutiny. Kudos to Harry Markopolos who did reveal the problems and attempted to alert regulators. How could intermediary allocators ignore such obvious RED FLAGS?

Anyone with similar LEGITIMATE numbers could impose higher fees than the industry standard. Why was he trying to raise new money recently when every proper fund has capacity issues long before they reach $50 billion? Of course he needed incoming cash to keep the Ponzi scheme functioning. If the numbers were real he would have needed to hard close to all investors long ago. And why was such a high proportion of money from overseas? I was skeptical years before the earlier Princeton Economics pyramid scheme of "star managers" who don't (or can't!) raise most of their capital from local investors. Why did so few US university endowments and pension plans queue up at 53rd and 3rd in New York to follow the master?

Bernard Madoff may not have been a skilled investor but he was a brilliant salesman. There is a reliable rule with any fund when a manager says they can make a "special case" to get you in their "closed" fund. UNDER NO CIRCUMSTANCES INVEST. Run, don't walk, away. Creating FALSE scarcity shouldn't get a fund past competent gatekeepers. That exclusive "access" or "capacity" with "super" managers is a ruse. Most large investors can get direct access to quality managers. Yes there are some genuinely closed funds as talented traders know the AUM limit for their strategy. Why would anyone want to invest in a fund beyond its optimal size? AUM and returns tend to be negatively correlated. Too many funds, like stocks, are driven by sales tactics. Decide whether to buy into a fund, don't get sold into it.

It is sad to hear of investors who were told their money was in a diversified portfolio, only to be wiped out by one fraud. It confirms the essential need for informed advice and a very wide spread of manager bets. I wonder whether Fairfield, Kingate, M-Invest, Rye, Herald, Gabriel, Frontbridge, Fix or Ascot really understood options collar strategies or questioned the positive performance in periods when it SHOULD have done poorly. Due diligence is important but diversification even more so, in case you are wrong. There was too much trusting and not enough verification going on.

Diversification by strategy and manager is the first and unbreakable rule for any portfolio. The most I would ever put with any one manager would be 5%, no matter how good and only after passing rigorous operational due diligence. If Munehisa Honma, the best hedge fund manager in world history, came back to life the most even he would get from me would be 5%. If Renaissance Technologies re-opened their Medallion Fund, the world's best currently operating hedge fund (over +80% 2008 return, after those "high" fees), the most I would invest is 5%. It is simply prudent protection. Concentrated strategy or manager bets are for bolder and smarter investors than me. The ONLY people who should have 100% in any one fund are the manager and employees themselves. It is an ESSENTIAL alignment with clients to ensure shared downside.

The world's best fundamental stock picker is perhaps Warren Buffett, manager of the hedge fund Berkshire Hathaway BRK-B, which is available to anyone with $3,000 to put to work. Unfortunately I had to redeem in early 2008 when I found out about his weird options speculation. Naked short selling index puts to collect "high" premium was a rookie mistake, far removed from his edge. The "margin of safety" skews to his counterparty not the short seller and the risk/reward scenario is OPPOSITE to almost every other transaction he has ever done. Warren Buffett, the well-known derivatives trader, should unwind those disasterous deals which have lost so many billions, so far. WHEN he does, BRK-A might be worth considering again for a new 5% allocation.

In my case I also only allocate 5% to myself to manage in certain special situations and frontier markets where I have a long established edge. My favorite investment this year was actually executed in 2007; short selling private equity by way of Fortress FIG, Blackstone BX and KKR KFN. Not often do such absolute returns offer themselves up so easily and generously. The implosion of big private equity was a rare example of an apodictic certainty in finance. The short positions are now so small they are hardly worth covering. That's the trouble with successful shorts but I will buy to cover before 2009 begins. Some specific emerging markets are looking VERY good for next year.

Most funds may not be worth investing in but a tiny few are frauds and with proper checks and balances they are ALWAYS avoidable. Don't invest in any fund managers because of Bernie Madoff? Some funds of funds invested with Madoff so avoid all of them? Enron, WorldCom and thousands of other equities went to zero, including some "blue chips" in 2008, so avoid every stock? Ecuador, Iceland and Seychelles are bankrupt so avoid ALL government bonds? House prices are falling and real estate scams have been around for centuries so avoid all real estate? One bad apple or even 100 hundred bad apples does not mean ALL apples are bad! You can't apply homogenous generalization to a heterogenous universe. Fund managers range from the vast majority that are honest to the rare swindler.

Skilled strategy diversification, manager selection, DEEP due diligence and portfolio optimization is the key to REAL double digit returns EVERY year at LOW risk. Most days I look at many investment products purporting to offer a consistent absolute return. The first question I ask myself is whether it actually is a hedge fund. That doesn't take long and eliminates many. The second question is whether it is a GOOD hedge fund. That is more difficult, takes much longer and removes many more. The third question is whether I would actually invest or advise anyone else to. That process takes months. In general for every 100 hedge funds or funds of hedge funds that I analyze, only a few make it to selection.

The Bernard L. Madoff Investment Securities scandal has NOTHING to do with the value to portfolios of good hedge funds. However it does emphasize the need for due diligence and BROAD manager AND strategy diversification.

Hedge fund drawdown?

2008-10-28T21:08:00.169+09:00

Hedge fund drawdown? Risk management rule No.1 - if it CAN happen then it WILL happen. Hope for the best but hedge for the worst. 2008 provided EXCELLENT returns from many hedge funds, hard times for other hedge funds but far worse from long only equity. Skilled absolute return managers don't always make money but they do have fewer, milder and shorter drawdowns than traditional funds that don't even attempt to manage risk, go to cash, reduce exposures or preserve capital. I'll stick with hedge funds. It's safer.

I wrote in January 2008, when both were well above 13,000, that the Dow and Nikkei would collapse below 10,000 as a result of the credit crisis and, as predicted, negatively correlated strategies and owning option puts have indeed been helpful in achieving good absolute returns. Contrary to conventional "wisdom", the recent performance of risky asset classes proves the need for investors to have LARGE allocations to skill-based return sources and PROPER strategy diversification. The crisis is more damaging for mutual funds than true hedge funds. Losses of 40% are unacceptable so why endure the RISK of "low cost" long only?

Several ALTERNATIVE investment strategies have NOT been affected by imploding prime brokers, changes in short selling rules or the leverage lockup. The BEST managed futures CTAs, global macro, high frequency trading and volatility arbitrage hedge funds have been generating absolute returns throughout the equity and credit meltdown. The outlook for distressed debt strategies is positive for the few, focused managers with the necessary expertise. Short biased equity, credit and commodity strategies have delivered that so important negative correlation to portfolios. Strategy and manager diversification is crucial since forecasting is difficult - especially about the future.

Crash or capitulation? For those predicting a Great Depression, it is worth recalling that hedge fund managers like Benjamin Graham, John Maynard Keynes, Karl Karsten, Philip Fisher and Gerald Loeb performed very well during the 1930s. And when the 1960s boom ended, even the Buffett Partnership closed down despite good returns but Warren has extracted plenty of alpha subsequently. Dislocated markets create inefficiencies for traders with the rare expertise to exploit them. If the world really is entering depression and deflation, investors need to rapidly move MORE of their money into quality hedge funds. Government bonds and cash will NOT be yielding enough.

Hedge funds are dead? Long live hedge funds. I am long/short optimistic/pessimistic for different strategies. Even in ideal conditions only 20% of hedge funds are "buys" and 80% are "sells". If we lose the bottom quartile, it is POSITIVE for the industry. It is survival of the fittest, not biggest, so good riddance to the growing economy dependent, beta bundling asset gatherers. The crowd is usually wrong and seeking alpha requires going against the crowd.

Severe losses for stock markets have occurred many times in the past. Plenty of "hedge funds" unable to manage risk or cope with chaos disappeared in 1970, 1974, 1994 and 1998. The more hedge funds that shut down, the better the opportunity set for talented managers. Redemptions? Sure but the money will simply be reinvested with firms that know how to generate alpha INSTEAD of the many weaker funds that were just repackaging beta.

There is NOTHING unprecedented about recent volatility. Many long biased "hedge funds" closed as a result of the hard times for hedge funds back in 1969 but that had no impact on REAL hedge funds that didn't need a bull market to make money. The current problems are impacting the unhedged funds rather than the hedged ones. Economists forecasting the end for hedge funds (yet again!) should check into how much money was made by investors that INCREASED allocations to GOOD hedge funds at the end of 1998. Or invested with George Soros and Michael Steinhardt, among others, at the end of 1969. Meanwhile the experts' beloved "passive" funds are still in a drawdown over a DECADE later. Some never let the FACTS get in the way of their delusional THEORIES. Long only equity funds are much too risky for conservative investors like me. Hedge away that systemic risk.

Flight to quality? I focus on managers that preserve capital, control drawdowns and can generate alpha no matter what. Many quality hedge funds are POSITIVE for the year even when the aggregate returns for the industry are negative. Performance dispersion is enormous in such a diverse universe especially when all it takes to be considered a "hedge fund" is to claim to be one! While OVER 2,000 hedge funds are up for the year, 100% of long only equity funds are down. Many unleveraged, heavily "regulated" but unhedged funds have lost trillions in 2008 by speculating on rising stock markets. During this decade those who saw the value of bona fide hedged funds have more than doubled their money unlike long only equity products which have underperformed T-bills. What compensation for risk?

Creative destruction is the inevitable result of free markets and there have been several hedge fund shake outs previously. I don't know the etiology of the market meltdown and credit crisis or intend to guess government policy initiatives or regulatory solutions. I do know good hedge fund managers are able to evolve in WHATEVER market conditions occur. When business magazines use words like hedge fund extinction, absolute return armageddon or hedge fund apocalypse then capitulation is near. All I can say in response is that out of the hedge funds that I follow or invest in, they range from UP a lot to DOWN but much less than long only equity, credit or commodity funds.

The FUTURE prospects may be negative for some strategies BUT the outlook is attractive for many other strategies. The manager universe is so varied and investment skill so wide ranging that the "average" return is not informative. Of course the "typical" manager will be down especially with the largest hedge fund category being long biased equity. The independence of a return source and the low covariance of that performance with underlying risk factors is what separates the alpha managers from the beta repackagers. Keep the powder dry since buying good securities and good hedge funds in a drawdown can turn out to be a good decision.

Turbulence and turmoil permit talented traders to make money. The PURPOSE of REAL hedge funds is to REDUCE total portfolio volatility. The previous bear period a few years ago when stock markets also dropped 50%, money flowed INTO hedge funds for that very reason. Quality hedge funds offer a SMOOTHER ride, lower volatility and less severe drawdowns than long only. Despite the current hysteria on redemptions, the percentage asset allocation to absolute return strategies actually ROSE recently because so MUCH more was lost gambling on the stock market. When a strategy gets crowded and AUM too large, it makes sense to do the OPPOSITE. The negative carry trade that worked best in 2008: borrow Icelandic króna to BUY the Japanese yen. Shorting the mythical "upward drift" of equities and REVERSE arbitrage of popular "market neutral" strategies also did well.

Markets fluctuate. The revenge of the pessimists has triumphed over the optimists for 12 years in many major markets and 26 years in Japan. How many decades are investors supposed to wait for the alleged "stocks go up over time" wish to come true? Long only has provided no growth for so long UNLIKE the capital appreciation that good hedge funds have delivered. Hedging means expecting and preparing for the unexpected. Reducing risk and PROPERLY diversifying BEFORE bad times occur. The beta bubble has burst so the need INCREASES for absolute return strategies that can make money or preserve capital.

Some might have the patience and fortitude to grow old riding out ANOTHER damaging stock market drawdown but I don't bet on beta myself. I realise some still think stocks will go up over time but I have yet to be shown ANY evidence for that dubious assertion. Instead of waiting decades hoping for some stock market magic to eventually show up, I prefer receiving absolute returns in time horizons that match my requirements and conservative risk tolerance. So I find managers with genuine skills in risk management and security selection. Then I overlay that with my own edges in strategy allocation and portfolio construction. Consistent portfolio returns requires identifying managers with rare talent and a robust strategy.

Neither hedge funds nor capitalism are facing judgment day. Overly pessimistic economic eschatology has been misinformed and counterproductive. The pundits could note that some very SOPHISTICATED investors are planning to INCREASE hedge fund allocation in 2009 because they recognize the alpha opportunities that will be available. Most redemptions from losing hedge funds will simply be reinvested in better strategies run by superior managers. If anything the equity and debt meltdown CONFIRMS the case for genuine alpha generators. Beta is simply too unreliable. That's traditional beta AND alternative beta.

Many equity or credit risk premium managers masquerading as hedge funds have been revealed in the past 15 months. Thorough due diligence can detect such bull market reliance in advance. If a fund needs fine conditions to make money there is little point in having it in a portfolio. We can get "good economy" return sources from traditional funds. A TRUE hedge fund should offer something different. That's why they are called ALTERNATIVE investments. If it is dependent on underlying risk factors it is NOT a hedge fund.

Capital should flow to quality strategies as much as quality assets. A PROPERLY diversified portfolio can eliminate major drawdowns. Volatility is vicious if a manager is not nimble or too constrained by mandate or large AUM to capture the market anomalies it creates. Commentators try to impose a homogeneity on hedge funds but it is the heterogeneity of strategies and managers that is the value proposition. A good fund below its high water mark is an investment opportunity but a good manager up for the year is even better. Natural selection and thorough research reveals who those funds will be.

I've never found empirical support for the so-called "equity risk premium" despite analyzing 100 countries and 300 years of history but "skill-based alpha" is persistent in the REAL hedge fund performance data. The "average" hedge fund has lost money but would anyone seriously expect an AVERAGE fund manager to have made money in 2008? Recent events simply emphasize the rarity of skill and the MANDATORY need for portfolio strategies that are able protect capital in DOWN markets. Alpha is the ability to extract absolute returns out of other market participants. 2 and 20 is worth paying for uncorrelated sources of return but NOT to funds that need conducive markets and risk premia to make money.

Great Depression - no, Great Delusion - yes. In bull markets the best trade is to short sell arrogance and ignorance of risk but in bear markets it can be optimal to buy into pessimism and negativity. With the widespread predictions of an economic cataclysm, we are likely nearing the end of the panic. Ironically my own long term macro model switched to bullish this week after over 18 months of bearishness. The beauty of computational intelligence is that it is the complete opposite of computational finance. Those looking to apportion "blame" for current economic woes might like to check out the demented credit pricing and rating "models" the computational finance crowd cooked up.

My own highly unorthodox black box is often early and the stock markets could still fall much further. An edge does not mean correct all the time. But since it has been short stocks and long volatility for such an extended period the risk/reward MIGHT now favor the bull case in the short term. Not that I have ever put money in a long only fund; there are so many arbitrages and mispricings available that it is BETTER to invest with hedge funds running LOWER risk strategies.

I have no doubt managers with genuine edges will be back at high water marks MANY years before major equity benchmarks. Sure there are issues affecting particular strategies but the best investors and traders adapt and ultimately thrive in new economic paradigms. Transitions from one market regime to another usually requires a financial revolution.

Why are so few aware that those who invested in the stock market in the late 1890s were still losing money over 30 years later? Or that fixed-income outperformed equities from the late 1790s to 1870s. Could the late 1990s be similarly prescient? Over what aeon-like time frame are stock markets supposed to deliver a real return? I'd rather keep the PROFITS that talented, unconstrained managers make for me than worry about antiquated asset allocation. 2 and 20 for reliable absolute returns is a bargain. Long only "passive" and closet index active funds have steep drawdowns and have an egregiously expensive negative effect on portfolios. "Cheap" fees beget cheap risk-adjusted "performance". Unhedged equity has been an underperforming asset class for a long time.

Some good hedge funds have made money while others have had limited drawdowns in the market meltdown. Many have reduced exposures and moved substantially to cash. Good defence is more important than good offence. A bear market for stocks and credit is the SCENARIO that proves the need for strategy diversification. Of course beta dependent unskilled managers are shutting down and being redeemed but that is the Darwinian nature of the business. It is excellent news for the industry.

REAL hedge funds have CORRECTLY functioned as a portfolio hedge during difficult times for traditional risky assets. Despite temporary problems for some strategies, GOOD hedge funds offer outstanding long term prospects for consistent risk-adjusted absolute returns. That was true 1929-2008 and WILL definitely be the case for 2009-2088. The best product for long term conservative investors are good absolute return funds. Begin due diligence NOW as 2009 is going to be a fantastic year for hedge fund performance, just like 1999.

Best hedge fund?

2008-04-15T03:08:00.238+09:00

Best hedge fund? Recently I visited the best ever hedge fund's offices. On the way I saw some black swans and ate at a restaurant that had run out of rice. Sometimes minor events can signal major investment opportunities. Many commodities have risen but wide fluctuations do not bode well for financial stability. Economic decoupling was always a crazy concept; volatility is never "contained" and reverberates across every asset class.

How to define "top fund manager"? Best past performance? Highest risk-adjusted returns? Below is the chart of a very popular fund I analyzed a while back.

Seems good. Over 20% compound annual return after fees. The fund is still open and you could, if you want, invest in it. The returns have been independently verified many times. Heavily regulated and available to all investors globally. Zero leverage, no lockup and no valuation issues. The manager keeps it simple by investing in equities listed on the world's highest market value stock exchange. No arcane assets, malicious models, specious SPACs or dubious derivatives so it must be "safe"?

But after thorough analysis I concluded the fund was not a suitable candidate for investment. Too risky. I decided to figure out who was the best manager ever. The criteria for an investable fund are complex but necessary to identify the "best". If we define the top hedge fund as that which achieved the best returns over several decades, the wealth accumulated by the manager from his trading acumen, the consistency and repeatability of that performance from protectable edges and a legacy of investment thought-leadership then the world's best EVER hedge fund manager is obvious.

That person was of course the legendary Munehisa Honma, the “god of the markets”, who ran a managed futures CTA hedge fund in 18th century Japan. He generated outstanding amounts of alpha for over 50 years. His main book, the "Fountain of Gold", is brilliant. Probably the best investment book ever written. His trading ability enabled the Honma family to go on to be the largest land owner in Japan. They later diversified into the Honma golf business which makes sense if you own vast tracts of flat land in a mostly mountainous country. There is a fountain in the main garden of the house as a reminder of the initial source of wealth - Honma's trading profits. As befits many successful hedge fund managers, Honma-sama was also an avid art collector. He also advised the world's first sovereign wealth fund.

In today's money, Honma's net worth was over $100 billion. Some years he "took home" more than the equivalent of $10 billion so it is curious those pundits excited about the "news" that John Paulson received "record" pay of $3.7 billion; fair "salary" for the over $12 billion he and his team generated for clients that they would not OTHERWISE have. REAL hedge fund managers focus on achieving good performance to monetize their talents and build wealth. Shorting subprime was NOT the greatest trade ever. Good but not greatest. "All time" means since 2002? Recency bias...again. Honma's short sale of rice futures in 1789 was far more profitable than Paulson's trade in 2007.

AW Jones did not "invent" hedge funds. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that it was psychology and the IRRATIONAL actions of participants NOT economic logic that drove markets. Behavioral finance isn't new, it's 253 years old. He didn't buy and hold rice and wait around to be compensated for its higher risk. He did not "expect" a risk premium or "assume" that rice would go up over time.

And though rice was heavily traded and followed even in those days, such liquidity did NOT produce an efficient market. Like most good traders, he figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether rice prices themselves were rising or falling. That is a TRUE hedge fund.

Munehisa Honma paved the way for the absolute return managers of today. Translated adages from his main book: - "Market action is more important than news". "Prices do not reflect actual value". "Buys and sells are decided on emotion not logic". He discovered the truth all that time ago and without the computers, analytics and communication systems we have today. He also knew the dangers of transparency: "Never tell others your positions or strategies". His performance speaks for itself. They should retrospectively award him one of those "Nobel" prizes that the efficient, equilibrium economists still hold onto as they continue their futile search for a rational, perfectly priced market.

Since Honma's era there have been many hedge fund obituaries. We are on yet another iteration right now because a few beta dependent speculators masquerading as hedge funds recently blew up. That SOME hedge fund strategies are short volatility and can be modeled as effectively short sellers of options and hoping a black swan won't show up to reveal their fund as a lemon is very OLD news.

Ten years ago Long-Term Capital Management short sold options and bet the house on convergence and then got taken out by the "never happened before" Russia default. Fortunately there are many quality hedge funds run by managers who are fully aware of the dangers of being short gamma and convexity, potential "rare" event fat-tail risks, carefully hedge for those exposures or maintain a long volatility profile. Sure plenty of "hedge funds" are no good but there are many skilled hedge funds that DO manage such risks.

Honma wrote of the returns to be made buying when most are selling and shorting when everyone else is buying. Consult the market about the market! Even today many prognosticators spend valuable time on Bank of Japan and Fed watching when they could INSTEAD be listening to what the MARKET is saying. The Market told us we were entering a recession several months ago and the credit crisis was NOT "contained". The Market is not efficient but it forecasts better than any economist. As befits the samurai trader he was, the time between making a decision and implementing that decision MUST be minimized. Delayed execution and transparency are the enemies of performance.

Though primarily a statistical trader, Honma also spent time on fundamental analysis, talking to farmers and consumers about what moved rice prices, who was buying or selling and why. He had detailed historical weather data and analyzed it to predict a key factor driving rice crop yields. His strategies required low latency trading so, despite the pre-electronic era, he established a signaling system all the way from Sakata to the Dojima Exchange in Osaka to get orders done and price data as quickly as possible. He developed many quantitative techniques to maintain his competitive advantage; some simple ones, like candlestick analysis, have entered the public domain but other more sophisticated methods he rightly kept to himself.

Honma was the original black box algorithmic trader. As his impact on the markets grew he evolved from market-taker to market-maker. He leveraged his informational advantages and adapted to the situation as needed. Those quants who download the previous decade of security prices and then overoptimize and curve-fit to the patterns of recent history might remind themselves that Honma analyzed 1,500 years of rice data BEFORE doing a single trade. He focused on finding robust and persistent phenomena NOT spurious patterns containing zero PREDICTIVE information.

Feedback fuels future fluctuations. Honma would have scorned those economists that assert that markets have no memory. Securities are traded by humans and computers programmed by humans, both of whom DO have memory. If the input has memory then surely the output has memory. If no memory is assumed, prices might indeed follow a random walk. Professor Paul Samuelson supposedly "proved" that "Properly anticipated prices fluctuate randomly" which MIGHT have been relevant except for the INCONVENIENT TRUTH that prices are NEVER "properly" anticipated.

Since stock, bond, currency, real estate and commodities prices are determined by participants with memory, prices MUST themselves also have memory. Honma ALONE accumulated more personal wealth exploiting security price memory than all the economists TOGETHER who have ever believed in memoryless markets. Not only is there NO efficiently priced security; it is impossible for an efficient market to exist in the real world. Amnesiac assets? Absurd. Rational agents? Really. The future state has no dependence on the present or past states? Preposterous.

Many trading techniques can be traced back to Honma. It is interesting how often Western investors get caught out trying to trade Japan. I've seen more than a few "star" bund or treasury traders get blown up by JGB futures. Some fixed-income arbitrage hedge funds got hurt by cash Japanese bonds recently. The yen carry trade has damaged many that didn't realise that a low interest rate does NOT imply a weak currency. And of course there are "strategists" and some Japan long/short equity focused "hedge funds" have been claiming "Japan is cheap" since the Nikkei was at 17,000. As Honma wrote, the cheap can get MUCH cheaper. Value traps many value investors.

Some might be skeptical of technical analysis and know nothing about Japanese-style technical analysis. Fair enough. There are plenty of fundamental ways to make money. But if a bigger investor with a few trillion yen to put to work DOES believe in such things as Doji, Harami, Kagi, Renko and ichimoku kinko hyo then that trading may impact the Japanese markets and lose money for those who do not keep up with such methods. If you don't know your edge then you don't have an edge but also that edge must be enough to overcome other traders' edges. I haven't come across many people able to consistently make money trading the yen, JGBs or Japan equities without a thorough understanding of Japanese charting interpretation.

As Honma knew and John Maynard Keynes succinctly implied, the key is working out what others will do and how they value securities NOT necessarily one's own estimate. The market may NEVER value an asset "correctly" as some activist and value investors in Japan have recently found out to their and their unfortunate clients heavy cost. Equity analysts visiting companies may be useful in some countries but I have seen zero evidence of its utility in Japan.

Honma was the first successful quantitative trader. Isaac Newton's earlier trading forays weren't successful but then gravitational modeling is easier than financial modeling. The sun WILL rise tomorrow but the motion of the markets is somewhat less predictable. It is interesting how today more scientific method and new math are being applied to the markets. But, to put it mildly, OLD math and dubious "theory" have not coped well with modeling REALITY. Assets classes affect each other but the ways they interact change over time. Since no traded security moves randomly, the math of randomness is not very useful in finance but even today many still use it because stochastic calculus is easy, unlike the quant methods that actually work.

ALL assets are connected. The equity long/short crowd will be keeping a close eye on credit traders from now on and vice versa but they should have been doing that all along. You also have little hope of picking the right stocks or bonds without closely following the commodity and currency markets. Honma monitored many things even if they had no apparent connection to rice prices. Everything is related and NOTHING is independent. Beware of ANY financial "model" that assumes independent, identically distributed prices. We have seen the dire results though it does allow alpha to be transported from those that use them to those who employ more sophisticated methods to win the zero-sum game. The Central Limit Theorem has little applicability to the REAL statistical distribution of prices.

Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic was a popular trend in Japan for a while though it was first developed in the USA. It is routinely disdained by those who think we live in an orderly, bivalent world of true/false, right/wrong, yes/no and 0/1. Many years ago I developed a fuzzy model to calibrate the bullishness or bearishness of the Japanese market. It provided nice projections for the daily ranges for the JGB, Nikkei and yen fx. Given the inappropriate Ito stochastic integral for pricing derivatives, I also tried adapting the Sugeno fuzzy integral to derive a more accurate option replication and hedging model. Isn't the world itself FUZZY so fuzzy logic could be of use? The market looks vague to me even at the best of times. The market is NEVER in a 1 or 0 bull or bear state; it is always somewhere between 0 and 1.

Japan therefore had the world's best ever hedge fund - Honma's long/short rice trading strategies managed from the 1740s to the 1790s - but also, and quite surprisingly, the world's best performing stock market index over the LONG TERM remains Japan. The chart above is a Japan "passive" index fund's performance from 1980-1989 but below is the ENTIRE performance chart from 1980-2008. Past perfomance was not indicative for future performance.

The risk and volatility since 1990 have failed to compensated investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy and ~~hold~~ hope. A good heuristic for assessing investment strategies - if it is simple then it likely won't work. Easy "solutions" cause difficult problems, as we have seen this year.

Returns have not been good for the TOPIX since the high water mark set so long ago. The 1980s were NOT even the best decade; the 1950s compounded at a 25% CAGR and returned 10x investors' money. Even now, 18 years into the bear market, the TOPIX remains the BEST returning stock index in the post war period. Would I therefore invest in it? Absolutely not. I want funds that WILL perform in the future not rely on a magnificant past. But for those who like the "cheapness" of long only equity funds and historical data dredging, it is interesting they don't overweight Japan considering its enormous HISTORICAL outperformance of ALL other stock markets! As for me I am staying long yen, long JGBs and short the Nikkei.

I prefer the manager risk of TODAY's superstar traders and investors NOT the risk of equities. Honma-sensei would have thrived in current market conditions. Recession will make the absolute returns generated by quality hedge fund managers important and they have the best ever, Munehisa Honma, also known as Sokyu Homma (本間宗久) and born Kosaku Kato, for inspiration.

Absolute return?

2008-03-12T08:16:00.142+09:00

Absolute return? Investors need alpha because beta isn't reliable. The traditional portfolio of 60/40 stocks and bonds can lose money over long periods and is too risky anyway. Fortunately there is a solution - alpha from the strategies and skills of the world's best absolute return managers. It would be good if beta does eventually perform but we need the "hedge" of alpha. Diversify away SYSTEMIC risk with return sources that do NOT depend on a good economy to make money.

History is a great persuader but terrible predictor. The 20th century was ultimately the "triumph of the optimists" aided and abetted by the highly anomalous bubble of the 1980s/1990s. Past returns do not guarantee that the 21st century won't be the "revenge of the pessimists". There is no FORWARD-LOOKING evidence that "buy and hold" still works. Just historical data erroneously extrapolated into that "fabulous" future the long only crowd expect. Some even have the effrontery to say we can ignore volatility along the way due to the economic utopia that we can apparently look forward to...eventually!

It is fascinating how financial advisors and tenured economics professors just seem to "know" everything will turn out fine many DECADES from now. Optimism is good but overoptimism is dangerous, as we have seen recently in the real estate, credit and stock markets. Hindsight driven "buy and hope" is the biggest risk most investors take. Reduce large bets on "passive" index funds and traditional long only equity strategies. Too risky and very EXPENSIVE considering the lack of skill on offer. And unnecessary now that financial innovation has delivered LOWER risk investment products that people actually need - absolute return funds.

Performance attribution between market and skill-based returns is the idea behind alpha and beta separation but there is less attention to the fact that beta itself splits into PRICE beta and DIVIDEND beta. Alpha comes from the RELATIVE alpha of good traditional funds and the more valuable ABSOLUTE alpha produced by quality hedge funds running GENUINE absolute return strategies. Equity beta ALONE is unlikely to provide us the performance of the past. Perhaps some day in the future, beta may again contribute but in the meantime investors need SUBSTANTIAL allocations to managers who can reliably deliver at least one of the three absolute alphas.

Alpha 1) buy securities that go up and know when to book those gains
Alpha 2) short sell securities that go down and know when to book those gains
Alpha 3) figure out which fund managers WILL do 1) and/or 2) consistently

An example of Alpha 1) is the well-known listed hedge fund Berkshire Hathaway BRKA. It's annual letter to shareholders is written by Warren Buffett and this year's was as insightful as ever. The most salient quote was "You can occasionally find markets that are ridiculously inefficient or at least you can find them anywhere except the finance departments of some leading business schools". There are even some who think Warren's returns are from luck or the "reward" for taking higher risk. The FACT is that he takes LESS risk than "the market" and his investment skill is the reason why he has produced such a large amount of alpha.

Warren says to avoid the 2 and 20 crowd. He's right. It is the 2 and 20 stars AHEAD of the crowd we need. The rare few who can generate alpha from security, strategy and manager selection are essential in any portfolio. "Beware the glib helper who fills your head with fantasies while he fills his pockets with fees." Absolutely correct. Only pay fees for alpha since beta is effectively free or should be. Warren may be an outlier but he is certainly NOT alone in the fat-tails of alpha seeking acumen. Absolute returns are of REAL use to investors but sadly not relative returns, especially in the coming severe bear market.

Warren Buffett, the junk bond and derivatives trader - "derivative contracts that I manage" - runs a multistrategy hedge fund that has adapted to the fluctuating opportunities in the markets for several decades. The "Oracle of Omaha" goes long the Brazilian Real, various commodities, trades Chinese oil stocks and short sells stock index options. Naked put selling seems at odds with his core value investing ethos and similar trades have sent quite a few speculators to the poorhouse. His bizarre long date options gamble is a nasty case of style drift for which he and his clients will pay dearly but the rest of his portfolio looks to be in line with his "margin of safety" moat philosophy.

Just like Benjamin Graham and several Nebraskan doctors spotted Warren's talents BEFORE he went on to great things, it is possible to identify other good fund managers with the skills to perform over the long term, even if their investment strategy itself is short term. Fees are irrelevant if the AFTER fee performance meets required reward/risk targets. Those 1950s Nebraskans have had no complaints about Warren keeping 25% of "their" profits because he worked hard to find absolute alpha for them and charged a fair fee for his abilities.

The Economist magazine recently ran another advertorial for "passive" funds, emphasizing the "high" fees of active management. Beating the market is difficult, requires rare aptitude and expensive expertise. Most fund managers will fail at such a task as a skill MUST be scarce, by definition. But why try to beat the market when finding a NEW source of absolute alpha is so much more important for portfolio diversification? Investors would be better off with reliable ABSOLUTE returns that outpace inflation EVERY year rather than just relative outperformance of some equity index. What is the purpose of relative alpha in a bear market? Why have beta swamp the alpha? You can ONLY eat absolute returns.

The article predictably quotes John Bogle saying that the S&P 500 returned 12.3% annually from 1980-2005 but makes no mention of the MINUS 70% after inflation that investors "received" prior to that from 1965-1980. And it writes of a hedge fund that dares to charge 5% and 44% fees but ignores the 38% a year since 1990 AFTER fees that the fund generated. Such data snooping is typical of the long only beta brigade. John Bogle assumes that the world's best stock pickers must work at index construction firms while Buffett is a fluke since the market "cannot" be beaten. Curious considering the number of other "lucky" absolute return managers around. Investment skill does not exist?

Professor Kenneth French has even made the FUTILE attempt to count the cost of active investing but fails to note the obnoxious opportunity costs, vicious volatility and ludicrous losses exhibited by the pathetic "passive" funds that he adores. 2 and 20 for hedged absolute alpha is a great deal compared to 0.20 for unhedged beta. Penny wise but dollar foolish capital "preservation".

Doesn't economic theory require investment capital to flow to where it can best be put to work rather than into every company in an index regardless of fundamental outlook? Perhaps in his next paper Ken French should try to calculate the absolute alpha that hedge funds generate out of index reconstitutions. Yes index funds "passively" tracking a beta benchmark can generate alpha...for good active funds. Either way his advocacy of worthless "passive" products that sit idly by while bear markets decimate client capital is mistaken and WILL cost investors a lot more.

There are low cost goods in any industry but that does not cause the highest quality manufacturers to lower their fees. Did Lamborghini panic about their pricing structure because Tata Motors TTM just launched a $2,500 car? Of course not. Performance comes at a price. I shall watch out for an academic paper on the money we apparently "waste" on cars just like all the cash investors supposedly squander on active fees. Buy the Tata Nano because it is irrational to drive any car that costs more? No proper hedge fund manager worries about "cheaper" unskilled funds. I'll happily pay 2 and 20 for consistent performance from a blend of skilled investment strategies than endure decades wasting time and losing money with "bargain" beta.

Some say alpha can't even exist. But a zero sum game does not mean zero gains for every participant. Some win, some lose and talent is the differentiator. Profits migrate from bad fund managers to good fund managers. Index growth will NOT be like the previous "wonderful" century; beta is not going to be sufficient to meet assumed target returns. Yet despite the 10% returns at 20% volatility - only half the reward for the risk! - many years spent below high water marks, a 90% implosion and several 50% drawdowns, we are STILL urged by the random walkers and efficient market hypothesizers to risk so much of our hard earned cash on equity beta!! Even with the performance of the PAST what kind of return-on-risk was that? Good hedge funds would be laughed out of the room with such dire risk-adjusted returns but not the beta bandits.

In aggregate the entire group of active managers WILL underperform their benchmarks. "Hedge funds" consisting of the whole set of fund products that say they are hedge funds won't, on average, be any good. I can't think of any reason why an investor would want to invest in a hedge fund index of "all" funds any more than an "all" stock index. Why tie up capital in sinking securities, archaic assets or mediocre managers? Seems VERY inefficient to me. Risk tolerance? I am too risk averse and conservative to tolerate the absolute risk of an long only equity. That particular "free" lunch is looking pretty expensive.

The long only luddites conveniently choose examples biased by their biased frame of reference. Instead of relying on their questionable conjectures I have looked at the full data set and the FACT is that SECURITY, STRATEGY and MANAGER SELECTION not ASSET ALLOCATION have done AND will continue to drive portfolio performance. Most hedge funds are run by unskilled wannabes but some in the top decile provide great value to investors. EVERY hedge fund manager can have losing periods, even Warren Buffett and James Simons, but when alpha returns drop below their high water marks they are shallower and shorter than the deep and extended drawdowns exhibited by beta. Of course proper manager due diligence, portfolio construction and diversification are ESSENTIAL for identifying investment skill.

Stock market PAST returns provide little indication of FUTURE performance. Now we are8.20 years into the new century and a negative TOTAL return from many developed market betas. How long should we wait and how poor must investors become before the "equity markets go up over time" or "stocks outperform bonds" mantra materialises? No-one I know is prepared to wait around to find out if "stocks" WILL rise. Despite his buy and hold persona Warren Buffett expects his holdings to perform in a REASONABLE time frame or he dumps them and rightly so. Many investors can't afford to tie up capital in steeply declining asset classes and why should they endure such drawdowns in the first place? Be impatient for absolute returns from ANY fund manager.

From 1900-1949 the Dow rose from 66 to 200 for a 2.25% annual return from price appreciation. Dividends added a lot in those days. From 1950-1999 the rise from 200-11,497 equated to a much higher 8.45% annually. Index appreciation over even very long periods is not stable and very temporally dependent. This century the Dow has "grown" a little from 11,497 but dividends are much lower nowadays. If there were some inherent "expected" price appreciation in stock markets would not the two fifty year periods' price appreciation be more similar? Shouldn't we have already seen more sustained gains this century by now? With such long term variability and derisory dividends beta does not look good going forward. Seek absolute alpha because beta might not be there for us. Performance is what you keep NOT what you make and then give back.

Let's look closer at this alleged "expected return" from "stocks". Warren calculates that the Dow only grew 5.3% per year in price appreciation last century. We have been treading water since so I updated Warren's numbers to include the "growth" this century. The Dow closed at 65.73 on 29 Dec 1899 and 12,266.39 on 29 Feb 2008 so we are down to a miserable 4.95% annually over the last 1,298 months. The Dow does not include dividends which is unfortunate considering dividends WERE such an important contributor to the total return.

AVERAGE dividends over the 108 1/6 year period were as high as 5% which gets us to a 10% total return CAGR so the Dow is NOW around 2,000,000 if it had included dividends. So for those "shocked" by 100-200 point swings, the total return Dow is ACTUALLY experiencing 25,000 to 50,000 point fluctuations each day. Just type 65.73*1.10^108.20 into Google GOOG to see what 65.73 invested at 10% compounds to over the period. But that figure contains no information on what $65.73 TODAY will be in 108.20 years if you were to invest it in the stock market index NOW. We don't know THAT data point YET.

Did anyone actually put $65.73 into the Dow on the last trading day of 1899 and now has $2 million? Of course not. It is just a historical artifact and TOO long term to be useful. Most investors need real returns quicker than beta alone can be assumed to deliver. 39,510 days ago there were no economists ranting on about "expected returns from risky asset classes" - a classic case of outcome bias and hindsight hype. Those who claim "stocks" rise over time only "know" that because they are looking at the result. No-one in 1900 recommended buying and holding the DJIA because they had no idea it would perform so well. Knowing the past doesn't mean you know the future. All I KNOW is that some stocks go up and some go down.

HISTORICAL performance was indeed quite good assuming someone endured or could afford the non-growth from 1900-1932, 1929-1954, 1965-1982 and 2000-...? Of course that is also restricting analysis to stock markets that DID survive the entire period. Just like many individual equities go to zero, several large countries' stock AND bond markets went to what was effectively zero during last century. I am not being apocalyptic, just reiterating that risk management, diversification and hedging for ANY scenario are necessary. Let's hope world wars and depressions are gone forever. A year ago some said inflation and real estate crashes were gone "forever". The credit crisis was also "contained". No-one knows the long term but the short term is sometimes partially predictable if you have the right fundamental and technical tools.

If you had invested in 1900 then 33 years later you would STILL have been waiting for that fabled equity risk premium to kick in. High dividends and the post war baby-boom bull market meant that by the 1960s it seemed like "stocks" had an inherent upward drift especially if you only used data starting from 1926 which led to the fallible financial theories of the mid-late 60s and early 70s. Forget about alpha(!) because the market is efficiently random and beta will arbitrage away any incoming information! Get that strategic asset allocation right, sit back and watch those absolute returns roll in over time?

Later the 1980s/1990s mega bull market "confirmed" the 10% from beta baloney and "justified" larger equity allocations back then but which now suffer from the ongoing bear market that BEGAN in 2000. Few real scientists would have fallen for such a spurious conclusion or make such a non-predictive data mining error but many orthodox economists still believe it. The "expected" return from stock markets is lower than they would have you believe. The Dow price return from 1900-1982 was 3.20% but inflation from 1900-1982 was also 3.20%. The real return over those 82 years came from DIVIDENDS which were high THEN but are now very low. Listen to what Warren is saying NOT the Nobel prize "winners".

Warren Buffett says buy SOME "foreign" equities? Bottom up stock picking may be a fine strategy but geopolitics and the macro situation can NEVER be ignored. Since history is supposedly helpful let's not forget what happened to investments in several major countries in the first half of last century. Some markets suffered a 100% drawdown while the USA "only" lost 90% in the 1930s but earlier had to shut down for several months in 1914. Perhaps things are different(!) today but a simple ukase to "buy foreign" is wrong. It is ALWAYS time to buy good foreign securities and short sell bad foreign securities. Ditto for domestic securities.

Recently some have even started saying "commodities" or "currencies" have an expected return. An asset class that deserves an asset allocation. UNLIKE stocks or bonds, commodities cannot go to zero and everyone needs them. Gold, silver, wheat and corn have a track record since 10,000BC unlike those new fangled financial products called equities. Stocks for the long run or commodities for the REALLY long run? But the opportunities in commodities are long/short tactical trading and very cyclical. The return comes from knowing WHAT to buy and WHEN to sell and vice versa. Commodities are an alpha source NOT beta.

Many commodities have been in a bull market in recent years so the long term return NOW does indeed look good but there is no "expected return" from "commodities" any more than "equities". Successfully trading oil or natural gas is an alpha process that requires high skill, an informational advantage and domain expertise. With "currencies" the returns are relative to WHERE you are. Risky asset classes like equities, credit, commodities and currencies are for security selection NOT buy and hold. Choose managers who can figure out what and when to trade and best leverage the opportunities.

Investors need REAL returns AFTER inflation. Inflation rates vary but inevitably take their toll so most portfolios CANNOT afford a deep drawdown especially during stagflation. The CPI is underestimating REAL inflation, that is the inflation you and I observe at the supermarket and gas station. TIPS won't help as much as expected since they track what the CPI says inflation is NOT what it actually is so there is significant basis risk with TIPS. Investors cannot be expected to ride out an extended bear market WHILE inflation erodes their purchasing power. Inflation-linkled derivatives like inflation caps also suffer from how "inflation" is measured; what the index says it is or what people are REALLY experiencing. The absolute returns from good hedge funds are a better inflation hedge.

Markets, risks and liabilities change so return sources and portfolio construction must also change. Why are investors urged to keep to a static asset class split when markets and economies fluctuate so widely? Don't the opportunities and dangers move over time? Trying to apply a static "solution" to a dynamic system must lead to errors? Warren is right that 8% probably can't be achieved with traditional beta but it IS possible with a properly constructed portfolio of beta AND absolute alpha that adapts as conditions require. Derivatives are indeed weapons of financial destruction in the wrong hands but there are many risk reduction benefits from the competent use of derivatives. Hedging and strategy diversification is the safer more risk averse route to the minimum acceptable return.

Worrying for shareholders in Berkshire Hathaway is the short sales of credit default options and long dated puts on various stock market indices. Warren is hoping that investing the premiums will exceed any potential liabilities at expiration. He says Dexter shoes was a bad trade but the option trades are potentially MUCH worse. Surely Warren is aware that 33 years into last century on 29 Dec 1932 the Dow closed at 59.12. No gain in the bellwether index for a third of a century but don't worry because equities will EVENTUALLY compensate you for their risk! Could you wait until after 2032 for beta to start working its "magic"? BRKA might end up owing plenty of cash to those who purchased the options.

High downside but limited upside doesn't look like a typical BRKA trade. Has Warren stress tested or Monte Carlo simulated for the S&P 500 being below 500 at expiration? AIG also short sold credit default options on securities that someone thought deserved to be "rated" AAA and recently had to mark them to what there currently is of a market. Japanese insurance companies short sold similar derivatives in the 1990s and also thought they could invest the premium and wouldn't have to pay out. They were wrong. There is much to learn from the Japan experience. It was driven by an internecine network of credit crossholdings backed by wrongly priced real estate "collateral". Mark to market is a cruel BUT necessary discipline.

The performance of ALL alpha seekers will sum to zero as fees and execution costs undermine the neophyte's attempt at something that is so difficult. An index of "all" hedge funds is like an index of "all" stocks; why invest when they are CERTAIN to include so many underperformers? Some securities are good but others are bad. Some fund managers are good but investment talent is rare. Equity indices are unhedged, have no skill, lose money too often for long periods with unacceptable volatility. Reinvestment of the relatively high dividends paid in earlier decades were a key contributor to long term compounded returns. Prior to 1982 dividends were the largest component of the total return in many stock markets. You can do a dividend swap to bet on rising or falling dividends. Portable dividend beta to overlay on the absolute alpha.

Invest in the leaders not the followers. Pick the good funds or hire someone with the experience and analytical resources to identify alpha generators whose FUTURE risk adjusted returns will make any management and incentive fees trivial. I too wish it were still possible to achieve 8% per annum with a simple portfolio of "stocks" and "bonds" but unfortunately it isn't. Risky securities may indeed go up over time but I just don't want to take the chance MIGHT not. Every investor should be activist with their portfolio. Security and strategy triage are essential. The only things investment grade are those where the returns are higher than the risks. Conservative investors need their capital protected with hedging instruments AND hedge funds.

It is not so much the unknown unknowns that worry me as much as the known "knowns" that are in fact wrong. We don't need two quarters of negative "growth" to know we have entered a recession. Real estate and credit prices are stronger indicators of economic strength and have more effect on consumer sentiment than stock markets. Ben Bernanke is correct that there is no danger of 1970s stagflation. Instead we have 2000s style stagflation and the remedy won't be easy to find. Banks continue to report VaR as if such numbers were indicative of the risks and exposures they have on. You can have low Var but enormous risk and vice versa.

There will always be hedge funds that lose money and a few that implode. Some stocks go bankrupt so avoid ALL stocks? A house once burnt down somewhere so NEVER buy real estate? Cuba and North Korea defaulted on their government debt so don't buy treasuries and JGBs? Sounds facetious but that is what we hear whenever one specific hedge fund implodes. Avoid good hedge funds because a few bad ones lost 100%? Everyone accepts that a single security blowing up does not mean ignore all the opportunities available in the asset class. But skepticism of any investment strategy other than long only still reigns. In any economic scenario there are ALWAYS opportunities for alpha especially when beta disappoints.

An investment strategy should be robust to structural changes in the market and financial regime shifts. I am tired of fundamental stock pickers who claim reg FD or the recent change in the uptick rule made things more difficult or quant types who complain about decimalization or execution algorithm copycats. Good investors evolve to what the current conditions are and innovate their strategies. Market cycles are certain so an investment process must be fortified and robust. There will be many more changes in the future. The current situation provides an ideal environment to show who has skill and who was lucky.

Hedge fund blow ups and large losses from speculators marketing themselves as "hedge funds" are portayed as negatives when in fact shaking out the weak STRENGTHENS the industry and confirms the case for investing in the proper hedge funds. Lots of poor quality hedge funds shut down in the first oil crisis of the mid 70s but the quality ones thrived. Plenty of low standard funds closed or crashed and burnt in 1994 and 1998. It just emphasizes that skill is rare while thorough due diligence and manager AND strategy diversification is essential.

The hedge fund bubble is bursting? No. January was bad but February was good on "average". Trouble in a few specific areas of hedge fund land? Sure. Overdue volatility and a bear market were bound to catch out some overleveraged players. Carlyle Capital Corporation CCC craters, DB Zwirn has difficulties, Drake Management drowns, Sailfish implodes, Richmond Capital loses 50% and AQR suffers from the same model development DNA malaise as Goldman Sachs' Global Alpha. Losses and meltdowns for some poor funds transports alpha to the good funds. That is the great thing about real "portable alpha"; the weak funds and risk premium products package their negative alpha up and "port" it over as positive alpha to properly hedged funds.

Invest in the breakaway leadership group NOT the the peloton. The Peloton hedge fund founders apparently couldn't keep an eye on their own millions in a simple bank account so could never have been expected to be able to manage client billions. The trouble with a cycling peloton is that if the riders at the front of the pack fall they also trip up the followers. It's those superstars way out in front, the yellow jersey winners and kings of the mountains to invest your money with.

It is curious how when "hedge funds" have a generally rough month some say redeem and the "bubble" is over but when long only funds lose a few trillion those same experts urge investors to "stay in for the long haul". They disdain technical analysis but then draw a trendline on a long term chart and extrapolate it into the future! Some even have the effrontery to say don't pay attention to market declines! Just "ride out that volatility" and hope the market will make it back in the dim and distant future. Even if you hate derivatives and hedge funds I don't think anyone could say they haven't changed financial markets and consequently the assumptions that underlie many portfolio postulates and economic phenomena.

That stock markets can be relied on to go up over time is a classic Type 1 statistical error. A false positive. Stocks generally went up therefore they will? History offers quite weak corroborative evidence. Investors need time in the market since "no-one" can time the market! A rare few can market time and those fund managers can often be identified in advance. Claiming the market can't be consistently timed is like saying no-one can run the hundred in under ten seconds, can't hit basketball three pointers or shoot under par on the golf course. Warren Buffett has been successfully seeking alpha for a long time and the 1,000-2,000 bona fide hedge funds will also be delivering for their clients as will the many good ones yet to be established.

There are many dilettantes in investing and, as in most industries, hedge funds obey the 80/20 rule. At least 8,000 of the products that say they are "hedge funds" are no good. Quantitative finance isn't rocket science; it is MUCH more complicated than that. Too many employ hubristic heuristics to make their miserable models tractable. Some solve PDEs or Pathetic Delusional Equations that allegedly "fully" describe market phenomena. These silly simplifications cause the problems in the first place. A complex question needs a complex answer. The trouble with so much investment "advice" to individual investors is that it is too simple to work. Reliable rule of thumb; if the math is easy then the model is wrong.

Proving a hypothesis is very difficult but disproving it requires just a single counterexample. Warren Buffett exists therefore financial markets are neither efficient nor random. Quod erat demonstrandum. Or was he just lucky like all the other successful hedge fund managers? A "bum on the street" that fluked the last 50 years? Economists set great store in the anatocism of the past. Compounded returns that were not anticipated in advance. Practitioners like Warren Buffett are pragmatists and adapt to current financial conditions as they see fit.

I realise many investors hope they will eventually be compensated for the risk of equities. And I sincerely hope they are right but I can't afford to hope. I might trust but I need to verify as well. I HAVE verified that alpha - investment skill - exists AND persists INTO the future beyond any statistical, reasonable or practical doubt. I HAVE not been able to verify the same for market beta. Stock market price appreciation AND dividends are unstable so we need alpha too, just in case. It is THE hedge.

Asset allocation is unlikely to be the main driver of performance over time. The primary factor will be security, strategy and manager selection. Fund managers that work hard to find securities that will go up and those that will go down and managing risk in case they are wrong. The VARIABILITY of portfolio performance is reduced by hedging, risk management and the appropriate use of derivatives. The path DOES matter for the long term achievement of investment objectives at the LOWEST volatility. As Benjamin Graham wrote many years ago "The essence of investment management is the management of risks". So choose managers who are trying to manage their absolute risk not just their active risk.

Diversification by holding many securities is not hedging. You can own 10,000 stocks and bonds and not be properly diversified. Alpha seeking strategies need to be FRONT and CENTER in EVERY portfolio. I don't know whether the Dow will be at 24 million or back down to 65.73 in 2099 but I can tell you for certain that a lot of absolute alpha will have been created along the way. Alpha returns are complementary to beta returns. I would rather chase skill than chase performance because investment talent is persistent.

Although I have been pessimistic about the markets for the past year or so, I am an optimist at least with respect to the ongoing existence of some humans with the ability to invest and trade successfully no matter how far the stock market drops. And they can charge whatever fees they want as long as they perform to demanding parameters. Produce 8% of absolute alpha above REAL inflation with careful control of risk will satisfy many investors' requirements.

There is $64 trillion in money management and ONLY $2 trillion in hedge funds. It is such a tiny little industry so far. The proportion is going to be a LOT higher and YES there will ALWAYS be a bottom decile that get into trouble. That does not change the optimistic outlook for the industry and a proper hedge fund manager should relish an equity or credit bear market. Even if you don't short sell much, it also creates long opportunities to buy value cheaper as Warren Buffett has done many times in his search for alpha.

It is a market of stocks NOT a stock market and some securities do go up and some go down. Why invest long only in them "all"? Warren doesn't and every investor would be wise to focus on security, strategy and manager selection NOT asset allocation. Future equity returns: lost decade...lost century? Buy and Hold has given way to Buy and Fold. Market timing outperforms buy and hold if you know what you are doing. The only thing to overweight in a portfolio is SKILL but most investors are underweight.

Active versus passive funds?

2008-02-15T08:58:00.135+09:00

Active versus passive? I've seen little evidence of "passive" in any investment strategy. Active is the only choice in the REAL world since "passive" requires active decisions by the index constructor as to which securities to include, the chosen securities come and go and what constitutes "long term" gets shorter all the time anyway. It is also an ACTIVE decision as to which "passive" benchmark to track. If you think the best active stockpickers work at Standard and Poor's, invest in a fund that tracks the stocks they CHOSE for the S&P 500. If you don't like that long only risk, avoid it.

The academic "experts" love of "low cost" index funds is VERY expensive for investors since there is no risk management, no hedging or even any attempt at capital preservation. Easy to be so wrong when you have tenure and the endowment that pays you conspicuously avoids "passive" investments. A fund manager that sits idly by watching bear markets destroy CLIENT wealth is unsuitable for any portfolio. DO NOT INVEST IN INDEX FUNDS. They cost far too much and your money deserves better treatment. People outside the ivory tower DO need to watch the downside and ACTIVELY reduce risk.

With skilled based strategies, no risk averse investor needs to leave their cash in harm's way HOPING for a bull market over the infamous "long haul". "Passive" funds are too volatile for conservative investors like me with a very low risk tolerance. Quasi-active "index" funds market themselves as passive because it sells, backed up by "Nobel" prize economics nonsense. Salespeople fail to point out that passive funds' risk-adjusted returns have been abysmal even in bull markets. The deadly drawdowns and vicious volatility of index funds are a disgrace. Long only is wrong only.

Alpha is partly about knowing WHEN and HOW to change your beta exposures. Stagflation, volatility and uncertainty mean portfolio management will require ACTIVELY searching for ACTIVE investment strategies able to make absolute returns in such times. Navigating the FUTURE financial landscape will depend on finding optimal ways to analyze data, deploy capital and hedge away systemic risk. We CANNOT depend on beta so it is alpha we need for RELIABLE performance. There aren't many "sizeable rate cuts" remaining when interest rates are already so low.

To reduce risk and long only equity speculation it is necessary to move beyond asset allocation. How different strategies are combined and applied to asset classes is what matters. The active versus passive debate comes down to whether to hire professional portfolio managers to pick stocks or have index constructors pick stocks. It is all stock picking in the end. "Active" ETFs just got authorised which is interesting considering that non-passive ETFs have been around for over 15 years. Plus ça change, plus c’est la même chose. There is nothing remotely "passive" about the S&P, Nikkei or FTSE indices. The editor of the Wall Street Journal actively picks and replaces the Dow components.

The credit crisis malaise continues and will NOT be over soon. Those hedge funds that already bought distressed assets have yet find out that vulture investing works best when the carcass has been dead for a while. The Fed could reduce rates to zero today but it won't have much effect on the depth and longevity of the bear market. The latest problems to emerge are in auction-rate securities and the VRDO market where investors were not made aware that buying these "safe" things effectively meant being short liquidity and exposed to the credit risk of the bonds' insurers. The "extra" yield was not high enough to compensate for the liquidity trap. That's the trouble with auctions - buyers need to show up.

Warren Buffett has been a successful hedge fund manager for decades and recently spotted an opportunity to try to make some money reinsuring the municipal bonds insured by MBIA MBI, Ambac ABK and FGIC partly owned by PMI and BX. It is unlikely the offer will be taken up and it does not change the dire outlook for those firms' exposure to structured credit and CDO toxic waste. The stock market is STILL not recognizing the growing problems in the CLO, CDS and LBO debt markets either. How many "secured" loans were genuinely secured? How much "security" was there in securitization? Asset-backed securities need the underlying assets to be somewhere close to their ASSUMED value.

Buffett's offer may sound like a positive development but it is a negative for the monoline insurers. It just signals his interest in stepping in should those firms go under or get split up due to their more exotic liabilities. Out of crisis there is always opportunity and he has been generating alpha out of special situations and distressed credit for a long time. Buying and holding large value stocks is just ONE strategy within Warren's multistrategy hedge fund.

This is not the end of the credit crisis. High credit correlation implies more volatility going forward. The stock market seems to be ignoring the chaos in the leveraged loan markets. The Blackstone BX led Alliance Data Systems ADS problems grow but that is just the canary in the coal mine for other deals. Probably the most seemingly sensible large private equity LBO last year was the Harrahs HET acquisition. On the left side of the Vegas strip after the Venetian there are several older casinos in prime locations all owned by Harrahs and all of which would best be demolished and replaced with a modern mega resort. Harrahs needed to go private for a few years and eliminate quarterly earnings scrutiny as it forgoes gaming revenue from those properties and rebuilds for the future. That an LBO with a solid business case could not raise sufficient debt shows how bad things are.

Elsewhere in the markets, Microsoft MSFT would like to buy Yahoo YHOO. Both ARE great companies but WERE good stocks once. I doubt Google GOOG lost much sleep other than brainstorming deal delaying tactics; its search technology is superior and its "new" competition will take years to integrate their cultures. Industry and product lifecycles are born and die fast these days. Companies, just like investment strategies, have short half-lives and depend on ongoing innovation to keep performing.

Several years ago when AOL was added to the S&P 500 I used the opportunity to get heavily short, selling to the index trackers yet every broker I gave the order to said I was crazy as it was "obvious" AOL was going to "own" the internet and their analyst rated it a "strong buy". It turned out to be almost exactly the top and AOL did not end up controlling the web. There can be no buy and hold when the commercial and technological environment changes so quickly. Today's no brainer buy can be tomorrow's short sell.

Google is more likely worrying about tiny startups like some of the venture-backed new search technologies I saw last week, not Microsoft-Yahoo. Otherwise in 2018 people might be asking what was the name of that stock investors got so excited about back in the 00s? Goggle.com or was it Googol.com? When was the last time you searched on Excite or Altavista? Both were major players not so long ago. Netscape was once the hottest stock around. Ten years from now we will probably have trouble remembering that Facebook ever existed. It's so popular no-one goes there anymore! Facebook fatigue shows yet again how social networks are a very fickle business. Anyone still remember Myspace.com?

Investors CANNOT be passive when the investment opportunity set is so active. Buy a stock because it is in an index OR because it has good value and FUTURE business growth prospects? The Dow Jones Industrial Index just made the ACTIVE investment decision to bet on Bank of America BAC and Chevron CVX. The Dow is supposed to be representative of the broader US economy and banking and energy already had a fair weighting. It is often better to keep your winners so dumping last year's highest returning Honeywell HON seems a tad harsh. Altria MO has been the best Dow performer over several decades. Sad to see the traders that construct the Dow Jones suffer from the disposition effect and make the DISCRETIONARY decision to sell winners but keep some losers.

If HON and MO must go then I would have added Berkshire Hathaway and Google as both bring more diversification to the mega cap index. Dow Jones would probably argue that BRKA is too illiquid and GOOG too "new" but the real reason is that with the absurdity of price weighted indices GOOG would have comprised 27% while BRKA would be over 99% of the Dow at current prices! How silly to limit the world's best known market metric to only those stocks that agree to stock splits. Surely market capitalization or another fundamental metric would be more appropriate. And why should illiquidity be an exclusion criterion for what is supposed to be a long term benchmark?

There is a notion that equity indices are passive when each addition and subtraction is an active choice. I have very accurate point in time and dividend data going back to 1896 and just spent my time in Alaskan airspace looking at the Dow Industrial's worst ever TRADES. The forerunner of Chevron first got added back in 1924 and it might have been better to leave it alone. Back in the 1930s the Dow added Coca Cola KO and IBM, deleted them a few years later and then re-added them after MISSING several decades of exponential growth. If those two stocks had been in the DJIA throughout, as best I can figure, the Dow would be somewhere around 26,000 today.

But can you blame the Dow for deleting such obvious "losers" at the time? Selling overly sugared soda made from a black box recipe during the depression? Manufacturing international business machines when the future CEO estimates market demand for five computers and most of "international" are preparing for war? Not very persuasive business models at the time. Conversely it is not so long since "blue chips" like Bethlehem Steel and Woolworths FL were in the Dow and we know what happened to them. Long/short means buying good stocks and shorting bad stocks; is that so dangerous? Is long only really "safer" than long/short?

I would have thought that prudent investing would require funds to be managed by full time stock pickers with NO other duties. The recent changes in the Dow do NOT "fully reflect the market". Are BAC and CVX really better additions than BRKA and GOOG? I realise MO is basically a stub now but Honeywell are right to be miffed just like the bizaare dropping of International Paper IP last time. And is Cisco CSCO really "less" deserving to be in the index than American Express AXP? Far more money tracks the S&P and Russell but the index followed by most people is the DJIA so it ought be as representative as possible given its influence on sentiment and media headlines.

Even that Dow bellwether General Electric GE has been traded before. Whether it is the Dow, S&P, FTSE, Nikkei, Hang Seng they are all managed ACTIVELY, mostly by publishing companies. There is no "passive" as index components go bankrupt, fall by the wayside or get bought out and then a trading decision must be made as to what the replacement will be. As equity market barometers these indices have use to measure alpha production by managers but to actually invest in them? Index reconstitutions have long provided profitable pairs trades for those nimble enough to put them on. Who would have thought that beta players handing alpha over so easily? Stock picking is best left to those with an informational edge and vocation in doing that stock picking. Even in the best of times there are plenty of stocks that go down.

Since we live in an active world the only style that really exists is ACTIVE investing. It may be the decades outlook of Warren Buffett or the seconds of a high frequency statistical arbitrage trading strategy but regardless of holding period it is all active decision making. Equity indices that are quasi-passive are those that minimize stock picking discretion. The Nasdaq and TOPIX include EVERY stock on their respective exchanges; they are still active though since the equities change. Check out the Nasdaq components today compared to 2000. Lots of ACTIVE natural selection there driven by business success and failure.

Whether an equity index will go up is conjecture. That some stocks go up and others go down is a CERTAINTY. Given that active investing is the sole choice available it would seem to be the best course of action is to hire the managers with the most dedication, skill, talent and incentives to figure out which stocks to buy and which to short and REDUCE risk as much as possible. Economic conditions, products, consumer trends, corporate and human longevity and geopolitics changed rapidly last century and will even more so in this one. How can passive succeed in such an active environment?

Hedge funds outperformed in January and 35% made money unlike all the "passive" indices that lost $5 trillion of investors' hard earned cash. I don't know where people get the idea that January was "difficult and challenging" when it offered so much opportunity and volatility. Often missed by some about short selling is that as the price moves down you need to do more short selling just to maintain the same portfolio percentage weighting. Stock indices might or might not go up but many more individual stocks drop to zero than go to infinity. I wrote in early December how "short only" was probably going to be "the" strategy for 2008 though I reserve the right to change my mind. The only way to survive in finance is to adapt to the CURRENT and forward looking scenario.

There is no inherently reliable return from "stocks" OR "real estate" anymore than "hedge funds". Even dividends and rental incomes are pretty unstable. It is naive at best, dangerous at worst, to "expect" to be compensated with risk premium. So next time your real estate broker tells you houses "always" eventually hold their value or your stock broker/wealth manager/private banker/finance professor asserts that stocks "must" go up over very long holding periods, tell them to write you a 30 year at the money put option on any index of their choice, Dow, Dax, Shanghai Composite, BSE Sensex...whatever. For zero premium. Risky assets "will" go up therefore in their mind there "should" be no chance of the option expiring in the money. If they refuse ask them the reason for their caution.

If you were an animal, what animal would you be? As far as finding good fund managers is concerned, look for an alpha rat. Now it is the new year, why does the twelve year animal cycle in Chinese astrology BEGIN with the rat? Because the alpha rat was smart, small and nimble enough to win the race against the lumbering beta buffalo, goat, horse and others. A bona fide hedge fund manager is an investment rat; able to survive conditions that destroy others, exploit crevices of opportunity amid adversity and outperforming the slower financial fauna. They are often hated by others for their very existence or wrongly blamed for incubating any financial disease that hits the markets.

The investment jungle is still mostly inhabited with soon to be extinct beta brontosauruses strutting around unwilling or unable to do the dirty, hard work of seeking alpha. Rats figure it out earlier than most and take protective hedging action as soon as danger appears. Remember the rat scene after Titanic hits the iceberg in the movie. Military strategy says to advance or retreat; take risk aversion action because passively hoping things will turn out alright usually ends with defeat or worse.

Whether credit and recession strike the market and whatever the economic scenario there is ONLY active investing. Markets change so portfolios must adapt to them. It is staying agile and innovative and keeping up with new opportunities that separates the alphas from the betas. Markets morph, factors fluctuate and drivers deviate. As in any industry, the passive become obsolete while the active thrive.

Future of finance?

2008-01-31T08:48:00.048+09:00

Time is not money; technology is money. The best way to predict the future is to invest in it. The only certainty is change. Technology is affecting how we manage money and innovation impacts everything. Good hedge funds are inventing new ways to make money and disrupting the risky long only world. Successful investing REQUIRES flexibility so it makes sense to keep up with the trends. Safer strategies and financial products have changed OLD investment strategies.

Creative destruction doesn't only apply to business innovation it also applies to investment innovation. There has been plenty of Darwinian natural selection in fund performance and survival of the fittest recently. Past returns are not predictive for future returns and market evolution means reliance on HISTORICAL assumptions is NOT applicable going forward. Investment technology benefits people just like other technologies so why ignore NEW things and hope to rely on the OLD ways?

The World Economic Forum coverage in Davos seemed rather subdued this year but then the REAL action was elsewhere. Hedge fund managers were at their desks with no time to head for the Alps when there were mountainous trading opportunities and valleys of risks to negotiate. Sometimes the World Economic Forum yields an end-of-party short sale signal like private equity in 2007 or dot.com stocks in 2000 but little irrational exuberance this time. I was hoping there would be another "obvious, no-brainer, definitely going up, can't lose" theme so I could short sell it.

Monetary policy should also take account of how globalization and capital flows have CHANGED the game. Economics is about maximizing the use of scarce resources and that includes how best to put money to work. The optimal utilization and protection investors' of capital are key to maintaining economic well-being. People respond to economic incentives. Performance fees INCENTIVIZE good fund managers to do a good job, work to MINIMIZE losses and control risks.

High compensation attracts the best people to set up and join the best investment firms. Responsible investing requires having the most skilled portfolio managers and traders taking care of your money. The 2 and 20 versus 0.20 fee debate is an example of how incentives lead to better products that more closely match INVESTOR needs. Index funds and "cheap" long only funds cost investors TOO much in bear markets. Pay minimum wage to fund managers and receive back minimum performance.

More information, lower trading costs, more liquidity, more computer power, new geographies, asset classes and financial products have enabled proper diversification. One reason buy and hold looked good in the PAST, although quite poor on a risk-adjusted basis, is that in earlier decades the costs of trading and information gathering were high. There wasn't much else to invest in other than long only but the range of opportunities TODAY is much broader. Long term performance is MUCH more important than long term holding periods. Some stock indices WENT up but WILL they now that financial markets are so different?

Formerly, many informational edges could not exceed the trading costs involved in executing the strategy but NOW they can. Commissions are lower, higher trading volumes mean less slippage and competition from national and global market deregulation have benefited ALL investors. Data gathering using machines with superior information processing capabilities have helped their human masters make and execute investment decisions. Financial innovation in the form of derivatives, structured products and hybrid securities allows risks to be sliced, diced and hedged as required. New strategies and assets have let investors FORTUNATE to be permitted to use them to get more diversified.

These benefits come with complexity which creates the need for "expensive" expertise in trading and managing these risks. Derivatives are useful trading and hedging vehicles OR weapons of financial destruction DEPENDING on the competence of those using them. Osaka rice futures and Chicago soybean futures have allowed farmers to transfer risk for generations AND built many traders' fortunes but have also wiped out many more unskilled speculators. Equity, interest rate and credit derivatives have been hugely beneficial to end users and competent investors but do damage if used wrongly. Fire has been very important to human economic development but fire in the wrong hands can be disastrous. We still need fire though.

Societe Generale's derivatives trader Jérôme Kerviel played with fire and lost $7 billion. I wonder if it would have been revealed if his rogue dealings had brought in $7 billion PROFIT? Curious how heavily regulated banks seem more prone to rogue traders than "unregulated" hedge funds. When it is your OWN money and own firm's reputation at risk you are more likely to catch unauthorized trading by the troops or question numbers that are out of line with margin limits. There have been a few hedge fund frauds although the premier meltdowns like LTCM, Amaranth, Bear Stearns were due to inexperience and lack of skill NOT rogue traders. You can't eliminate the possibility of losses but with proper due diligence and monitoring you CAN eliminate the risk of fraud AND incompetence in hedge funds.

I've written several posts about LBOs and CDOs but the products themselves are not to blame for losses anymore than credit derivatives. LBOs, pioneered by KKR, were a brilliant financial innovation. The issues that bothered me in recent years was their dependence on cooperative credit buyers, the strategy NOW being too well-known and too much money in the "taking public firms private" arbitrage trade. Similarly CDOs are a great invention but it was executive arrogance, junk math, dubious pricing, mad modeling and ridiculous risk management that were the problems NOT the idea behind the products themselves.

The credit crisis is one factor that has led to the present economic situation. It looks like we are going to get some kind of stimulus package though whether it will be the catalyst for the necessary change in sentiment is anyone's guess. Rate cuts help banks with steeper positive carry, assuming credit worthy clients still exist and want to borrow, but the primary idea is that low rates spur spending and investors to move into riskier assets.

The possible flaw with this economic antidote is that when real estate and credit markets are performing even worse than stock markets then risk aversion can INCREASE. If your 401(k) statement shows a much lower number than the previous one and that house nearby just heavily reduced its asking price, a money market yield of 2% can START to look attractive compared with heading to the shopping mall or buying into the "stocks are cheap" sales pitch. Stocks can get MUCH cheaper but more importantly so can real estate.

Recession or not, stock markets ANTICIPATE problems and portfolio drawdowns change the economic outlook. Bear markets are "defined" as a drop of 20% but does it matter? A 20% fall is a huge loss already and needs a 25% rally just to get back to breakeven. So whatever economic scenario transpires, a fall of that magnitude for long only equity portfolios is not only unacceptable but also unnecessary. The appropriate use of hedging instruments and new investment strategies ought to have made such portfolio volatility obsolete by now.

Whether we are in a bear market or a recession is just semantic debate. Traditional equity, credit and real estate investors HAVE lost money and that WILL change behavior. The Fed has been criticised for "panicking" last week with a 75bp cut after heavy selloffs in Asia and Europe after the Societe Generale debacle but they probably had no choice given the circumstances. If Ben Bernanke had NOT cut, the US stock market would likely have lost 7-8% that day or 1,000 points on the Dow. Such a drop in a single day would have had a very negative impact on investor psychology. Central banks try to protect the economy and stock market fluctuations have a direct and immediate effect on economic well-being.

Doubly damaging is that not only have traditional strategies failed to preserve investors' capital but inflation is raising the cost of living. Reduced savings and less spending power are not a recipe for growth. Many analysts like to focus on a misleading metric called "core inflation" which EXCLUDES food and energy prices. So according to economists, as long as you don't eat, don't use any form of transportation and don't heat your home in the winter, insidious inflation is indeed "moderate"! For those of us outside the ivory tower in the harsh cold of the real world, let's hope stagflation is avoided. Six months ago some said credit contagion was "contained" and we know how that absurd assertion turned out.

Even if someone avoids new assets, structured products and hedge funds themselves I don't think anyone can dispute that such disruptive technologies have impacted market dynamics. You may dislike dark pools, derivatives, decimal point price increments, deregulated commissions and day traders as well but they have changed how securities fluctuate. A buy and hold investor is affected by new strategies and trading technologies whether they want to be or not. New ways of preserving wealth are like new ways of preserving health. But just as there are quacks and charlatans in medicine, there are plenty of good doctors in HEALTHCARE and talented fund managers in WEALTHCARE.

Financial and medical technology have other parallels. There was once a time when innovative surgeons were ridiculed for their "radical" ideas of washing hands and using anaesthesia before operating. Technological innovation in HEALTH management has benefited everyone. Why then in WEALTH management do many financial advisors remain in the stone age world of ~~prehistoric~~ "modern" portfolio theory? Hedge funds and derivatives are not fads and can assist in REDUCING market exposure BEFORE bad things happen. Portfolio immunization prevents economic diseases like recessions and inflation sickening investors.

"Hedge fund" is a loaded term these days so rebranding them simply as "diversifying skill-based strategies" would help. New investment technologies that seek, but do not guarantee, to produce absolute returns even if underlying asset classes fall apart. Some will deliver and many others won't but ALL investors need strategy diversification in their portfolios. As for "derivatives", they enable risk transfer from those that DON'T want an exposure to those that DO. Derivatives may be dangerous in the wrong hands but they are very useful and EVERY investor needs them.

Data-driven prediction and market anomaly detection are necessary for consistent returns. Systematic trading strategies like quant funds are in the news again because some weak models weren't properly tested for bearish conditions. Maybe it would be better to rebrand quantitative investing as carbon-based organisms outsourcing the more tedious aspects of security analysis, data gathering and trade execution to silicon-based organisms. Failing to make use of robust quantitative strategies and modeling techniques is a bit like refusing to use electricity or email. And why get one of those "unecessary" computer things when slide-rules are so useful for so long? Society moves on.

Artificial intelligence complements human intelligence. Alan Turing didn't have financial markets in mind when he did his work but computerized traders can mimic and often "think" better than many human traders, thereby satisfying the Turing Test as far as trading is concerned. It may be quite a while before computers can pass for a human in natural language processing or other endeavors but in finance the Singularity isn't near, it's already here.

Bear market?

2008-01-16T08:43:00.048+09:00

Bear markets for beta are bull markets for alpha. There are always OPPORTUNITY markets for absolute returns. Short selling is performing well and stock indices have erased ALL last year's gains. Investors have not received the alleged equity risk premium for so long but then stocks don't read economics textbooks. Not many people can afford to wait for REALITY to catch up with dubious THEORY. The "panic of 2007" will worsen significantly in 2008.

I would be very surprised if the Dow or Nikkei are still above 10,000 by the time this MAJOR crisis and deep recession are played out. Few investors can afford to wait long enough for beta bets to pay off and why should they when they can allocate to PERFORMANCE driven managers with the RARE skill to generate absolute returns AND preserve capital no matter what the economic conditions? Even more damaging is the double impact of lower interest rates at the same time as the stock market collapses.

The S&P 500 is now at 1,400 as it was 12 months ago AND 96 months ago(!) back in January 2000 but it could be worse; in January 1988 the Japanese Nikkei was at 24,000 and TWENTY years on the index has "grown" to 14,000. When will traditional investors belatedly realise there is NO inherent return from "the stock market". Just sell-side stupidity and historical hype based on faulty hypotheses. With equity benchmarks mostly flat for the decade investors can be grateful for alternative sources of return that have helped diversify portfolios and preserve capital. A stock and bond portfolio is TOO risky for conservative investors like me. Some stocks go up but most go down. Long/short is obviously SAFER than long only.

Strategies make money out of asset classes. In implementing a strategy the fund manager must either have a protective moat of a talent-based barrier to entry or keep it secret. Many things in the public domain do NOT work anymore but is that surprising? "Sell in May" timed the market brilliantly last year while "3rd year of Presidential cycle" didn't but then both are just statistical flukes. The Dogs of Dow, the January effect, the "Magic formula" are too well known to work anymore. Those anomalies, among others, are gone. I hope for the sake of the long only crowd that the "First 5 days in January" is not predictive but suspect it will be this year. Buy stock index puts.

Investing and trading have important roles in portfolio management but it is NO place for gambling on the supposed "upward drift" of equity benchmarks. Prudent investing surely requires acknowledging the possibility of an extended bear market and constructing a portfolio that can grow, if necessary, no matter what happens. Inflation bites, bills come due and liabilities grow regardless of what stock and credit markets do. But "risk free" yields are far below required actuarial return targets.

What is the difference between investing, trading and gambling? With the first two it is the holding period; seconds to months is trading and years is investing. Investing and gambling are quite similar at first look; putting money at risk in the hope of making more money. Decision making under uncertainty. But most investors would balk at the idea of being called a gambler even if the markets often resemble a casino.

Surely the difference is that investing is deploying capital when you DO have the edge while gambling is when you DON'T have the edge. To make consistent absolute returns it is necessary either to have an advantage or identify someone else with one. That does not eliminate the possibility of small, manageable losses but it does mean persistent and predictable performance. By definition there is no edge in beta and it is not very reliable over most relevant time frames.

There are reasons to be bullish but then there usually are. The mythical "private equity put" and "Greenspan put" evaporated to be replaced by the sell-side delusion called "global decoupling". Many economists are predicting a recession which, given their track record, means there is a chance there won't be one. Several large US banks will report earnings this week and with new CEOs and new stock options the temptation to write down doubtful CDOs, SIVs, CMBSs and real estate loans to very conservative levels and adopt a kitchen sink approach to disclosing bad news must be high. LAST quarter can be blamed on former management but not the NEXT quarter. Ben Bernanke promising rate cuts was clearly preparing the market for bad news.

Monetary policy isn't quite the economic rudder many would like to rely on. Some central banks think raising interest rates will curb inflation and lowering interest rates will avoid recession. Maybe but not necessarily anymore as global capital flows and new, non-obvious relationships between assets and geographies may have changed the rules of the game. High rates in Iceland or New Zealand or low rates in Japan or Taiwan haven't had quite the effect that central bankers anticipated.

Situations change; western investors helped out Asian banks and now Asian investors help out Western banks. Asset classes shouldn't be looked at in isolation as they all have varying effects on each other. Commodities move stocks, currencies impact bonds and vice versa. Last year showed how long-biased credit strategies could hurt everything from private equity LBO funding to some of the more crowded "market neutral" equity strategies.

One of the hedge funds that profited from the subprime CDO meltdown, Magnetar Capital, did NOT contribute to "astronomical" losses for the street; some counterparty banks simply didn't know how to price or hedge structured credit tranches properly. As with caveat emptor, caveat venditor or seller beware - if a sell-side firm can't manage the risk in a product, don't sell it to clients in the first place. You can dress the credit crisis up with the exotica of Klio and Norma CDOs but basically it was poor quality financial engineering and fictitious capital rearing its monstrous Cetus-like head.

Casinos are now using something called NORA or Non-Obvious Relationship Awareness in their surveillance work. Successful investing is now very dependent on monitoring non-obvious relationships between securities. It was the key to doing well in 2007 and will be more so in 2008. This is where many err; looking at a single stock, pair of securities or one asset class when it is the ENTIRE interrelated macro puzzle that needs analyzing as well. Sometimes a stock, bond, commodity, currency or any other security goes up and other times it goes down. Predicting those moves is difficult but some can do it. Their changing relationships opens up anomalies and inefficiencies that can be exploited if you work hard enough to identify them.

For New Year I spent a few days in that bastion of statistical arbitrage, Las Vegas, the only city in the world named after a volatility metric. The usual opinion on casinos is you can't beat the house just like conventional "wisdom" in finance is that you can't beat the market. In general that is true since the sweat equity, concentration and aptitude required to perform such a difficult task on a consistent basis is rare. Difficult yes, impossible no. Like others I've taken the time to try to find an edge in picking managers and picking securities. And some people have an edge in Vegas.

As in financial markets there are slight advantages that can be developed in a few casino games to change the negative expectation of gambling to the positive expectation of investing. But it requires dedication, insight and research. Many people are aware Blackjack can be beaten but disclosure of the techniques and changes in the rules have reduced that edge. The first time I visited Vegas I had mastered basic strategy and the probabilities almost as well as Ed Thorp and could memorize cards as well as Dustin Hoffman and I did reasonably well; nowadays I am content to break even. But others have greater skill and do better than that.

Despite the increased sophistication and monitoring at casinos there are still professional blackjack players making money from innovating their strategy and developing their talent. Just like a proper hedge fund keeps refining and adapting its edges and finding new ones. Perhaps even roulette and dice games can be "beaten" if beaten is defined as having a small probabilistic bias that reduces the house's advantage; it just takes high ability AND years of practice to do it. Skeptics can read the book Eudaemonic Pie or Google "dice control" for some basic tips though what works NOW is not going to be written about or easy to implement for obvious reasons.

Poker is a game of luck over one hand but skill over many hands. And when I looked up at the casino's sports book I saw potential mispricings and arbitrages on the board just like on a futures exchange or page of stock quotes; but it does take hard work, an informational advantage and domain knowledge of the teams, players and horses to identify them. I've written before that a sports gambling hedge fund would make sense although there are larger edges available in financial markets than in casinos.

Slot machines are interesting from a risk/reward perspective. The house has the edge but that does NOT imply they should never be played. The POSSIBILITY of an enormous payout for a very low capital outlay is a different value proposition. "Experts" say that the odds of hitting a +$10 million jackpot are so remote (1 in 100 million or so) as to make them a loser's game. But as with a national or state lottery, the probability that the jackpot will be won is 1.00, i.e. a certainty. Someone WILL win it. If you don't play you have ZERO chance of winning but if you DO play you have an unlikely but NON-ZERO chance. Since any number divided by zero is infinity the act of risking a few bucks RAISES the probability of winning by an infinite multiple! The optimal algorithm with a lottery or a Megabucks slot machine IS to play but with small cash. Similar to buying far out of money options; even if most expire worthless, you only need one to pay out.

By complete fluke I happened to put $20 into a machine one evening and won $1,000. Deducting "fees" of 5% and 50% that is a "return" of 2,400%. So now you know what the "best" performing "hedge fund" was last year - the Nevada Slots Opportunities Fund. A stupid statement of course but sadly such unrepeatable luck has been used to market many a real fund. Naturally that return was "pure alpha" as I had the "skill" to pick the right machine in the right casino at the right time. NOT. But I have seen even sillier contentions in some fund marketing materials. There will be plenty of mean reversion in certain stock markets this year.

Suppose I had then lent the $1,000 to someone who promised to pay back $2,000 if they won speculating on local real estate. What if I assigned an overly optimistic default probability to this "trade" and launched the Nevada Credit Opportunities Fund on the back of this "amazing" mark-to-model yield? Sounds ridiculous but that is what Merrill Lynch, Citigroup, Bear Stearns, Northern Rock, Sowood and Dillon Read among several others were effectively doing in their credit businesses. Subprime borrowers weren't "obeying" the Moody's KMV model any more than stock markets have been rewarding investors for their "risk".

The cold winter of the real world has not been kind to the warm summer of academic conjecture. Zero passive equity index growth century-to-date! I'll take different strategies applied to assets rather than the "reliability" of the asset classes themselves every time. That very long term security called Gold may be around $900 today but remains far below its inflation-adjusted high set nearly 600 years ago. Gold traders and gold miner pick and shovel makers - yes, long only gold - definitely not. Take the long view? On what?

What if in 2020 or 2030 major equity indices are LOWER than today? Lost year, lost decade, lost...? High yield only makes sense if it is higher than the risk. Volatility and extended drawdowns do NOT always compensate with performance. Whenever I hear the case for long term passive investing I wonder what temporal era is meant - geological or cosmological time. Over holding periods of importance to humans I'd rather invest in alpha than gamble on beta. It just snowed today in Baghdad and Maui; "unlikely" events can and do happen that risk "models" can't handle.

Hedge fund performance?

2007-12-21T00:11:00.027+09:00

Hedge fund returns ranged from -100% to +1,000% recently. A few blew up while some bet the farm and happened to be right. Most investors avoid short biased strategies so it is ironic that short only credit was the best performer. In 2008 shorting equities will likely be the best strategy. Some hedge funds that shorted subprime indices and the stocks of mortgage lenders and banks were very skilled. But the performance that matters is how much money was made from how much risk in a truly DIVERSIFYING way.

The "average" return includes many funds and strategies with different levels of risk and leverage and includes such a wide dispersion of performance that it is irrelevant. Hedge fund databases list many non "hedge funds" and miss lots of good and bad actual hedge funds. Because positive results are unbounded to the upside but losses are floored at -100% the skew from the effect of high outliers will upwardly distort the mean anyway. Also there is the much bigger issue of precisely what kind of returns investors are seeking.

There are more one hit wonders in fund management than the music industry. Every year there will inevitably be traders that make a big bet on some idea which proves to be right. Whether they can keep on finding ideas that work and can hedge risk in case their next idea is wrong is much rarer. Some good funds had a flat to slightly negative year while some lucky funds had enormous returns but one year counts for little. A manager that makes +15% CAGR over 15 years is more impressive than one that makes +1,000% in 1 year.

Alpha or beta? The purpose of a hedge fund is surely to offer a source of performance NOT obtainable from a traditional fund. This would imply that the "performance" to measure is the risk-adjusted true alpha that a manager extracted from their opportunity set. The idiosyncratic returns contributed over and above what the underlying factors added. If you do this you get a very different ranking of performance results than what the headlines suggest. It is the QUALITY of the returns that matters not only the QUANTITY.

Obviously I favor hedge funds but many of the concerns critics raise on general hedge fund industry issues ARE legitimate. For asset allocation unhedged traditional funds have lower fees, lower due diligence costs and more liquidity and transparency but they do little to mitigate risk. IF a return source can be accessed through a traditional product that is the way to go. The reason to invest in ANY hedge fund is if it can produce a risk-adjusted return that would NOT have been otherwise available.

Unfortunately many products purporting to be hedge funds are dependent on the underlying asset class going up. Credit, until very recently, and currently Asian/Latin American stock markets are examples. Many energy hedge funds have ridden energy beta this year. Too often leveraged beta gets disguised as alpha. It is also easy to appear uncorrelated but be beta dependent. Many of the basic high school linear statistical measures are useless. A high volatility equity can have zero beta. A low volatility fund can have enormous risk. A low correlated fund can be 100% dependent on the underlying but conversely a fund with a correlation of 1 can STILL be a valuable diversifier!

A high volatility hedge fund can be low risk and REDUCE the volatility in a portfolio. Some of the riskiest strategies in isolation have the opposite function in that they lessen total portfolio risk. This rather nullifies the performance statistics hedge funds and funds of hedge funds email out to investors each month. Mean variance optimization isn't very useful in hedge fund portfolio construction when averages, variances and covariances are either useless or, worse, misleading.

HOW the return was made can be more important than WHAT the return was. If you are SURE the stock market is going up next year you probably do NOT need any hedge funds in your portfolio. If you think oil, gold, Chinese real estate or anything else is going up there are better ways to implement that view than a hedge fund. But if you want exposure to the opportunities created by the mispricing and anomalies in and between asset classes, ESPECIALLY if the asset class goes down, then that is the main reason to invest in a hedge fund. Most investors already have enough exposure to economic growth and long only.

"Hedge funds" apparently outperformed "equities" in 2007. But hedge funds are supposed to offer an alternative source of return. How equities or any other asset class performs is irrelevant. Hedge funds are strategy classes. And which "equities" are we talking about? The MSCI World index is not very worldly anyway. Compared to Chinese indices "average" hedge fund returns have been pathetic; compared to Japanese indices "average" hedge fund returns have been brilliant. So what? Whether a hedge fund underperforms or outperforms any asset is of no importance; it is the DIFFERENT performance that matters.

I've written before that most of the -100% funds this year were not hedge funds anyway. That was clear to me years before they imploded. But non-hedge funds marketing themselves as hedge funds cuts both ways. Several of the funds that made +100% this year were also NOT hedge funds. What amounts to leveraged long only equities, commodities or other assets is not a hedge fund strategy even if there is supposedly a modicum of shorting or hedging going on. Making money when the underlying rises and losing money when the underlying falls is a closet INDEX fund not a hedge fund. Why pay hedge fund fees for performance obtainable elsewhere? No-one makes money all the time of course but losing money is better when other things in the portfolio are making money.

Emerging markets have been the best "performer" this year though comparatively few "hedge funds" operating in the space actually are hedge funds. Much of the returns have been driven by beta. If a manager can't make money in the absence of beta then it is not a hedge fund. If you think China, India or Brazil equities are going up buy ETFs like FXI, INP and EWZ or some other long only product. There is no logical reason to pay 2 and 20. I've met several Indian and Brazilian funds recently and usually ask them how they would have done if the BSE or BOVESPA were down 50%. The good ones would still make money or at least preserve capital in that scenario. Not the bad ones though...

At the moment everyone loves Chinese and Indian hedge funds and hates Japan focused hedge funds. Obviously the headline absolute performance is vastly higher with many of the former up over 100% while many of the latter are up less than 10% or even negative. But if you compare their alphas as I define alpha: observed return minus expected return generated from their security universe adjusted for exposure and risk so the "performance" of a +10% Japan hedge fund could be argued to be superior to a +100% China hedge fund.

Alpha is surely what has been generated from a particular opportunity set adjusted to reflect the risks. A USA fund that makes 20% picking S&P 500 stocks has probably done a better job than a fund that makes 30% picking obscure microcaps. A Germany long short fund that produces 20% has likely done better than a Russia fund up 40%. If a fund sets up to invest in art, violins or uranium then it must demonstrate how it will STILL make money when art, violins or uranium go down. The are many "niche" strategies knocking around these days that use the hedge fund label to be trendy and charge fees more than they are worth but have little to do with hedge funds.

There have also been lots of portable alpha mandates recently. But these are only of value if it really is alpha NOT with plenty of beta mixed in. Asset allocation overlayed with strategy allocation is impossible if it just adds more beta to the portfolio INSTEAD of adding alpha. Strategy allocation should be about strategies that can perform when long only does not.

Citigroup funds?

2007-12-03T21:38:00.035+09:00

In the hedge fund oasis of Dubai again. I bought some Dirhams at Citibank and then spent most of them down the road in Abu Dhabi. I was going to exchange the balance to US$ until I came to my senses and purchased some more - why does the United Arab Emirates STILL have a dollar peg? There has also been an ongoing debate on the "high" cost of funding that Citigroup raised from the Abu Dhabi Investment Authority.

The chart below shows the payoff of the Citi FORWARD sale of equity to ADIA, yield enhanced with an embedded options spread. It was NOT at junk rates.

The termsheet reveals a fairly plain vanilla mandatory convertible. But pundits said that Citibank paid MUCH higher than junk bond yields. This nicely illustrates how differences of opinion on the valuation of hybrid debt/equity financings and some people not even noticing embedded options are opportunities for alpha. The level of borrowing cost was surprisingly LOW for a bank facing major problems. Probably it was too cheap capital.

Financial engineering, model arbitrage and misunderstanding of what a sophisticated security really represents allow skilled investors to make money out of the unskilled. The fact that so many jumped on the "junk" 11% headline is a lesson in itself. That they missed the options is another. Subprime CDOs also paid a "high" yield but most buyers didn't realise or were not informed(!) about the credit default options they were implicitly SHORT SELLING, much too cheaply.

The structure looks like Citi purchased the right to put stock to ADIA at 31.83 and sold a 17% out-of-the money call so ADIA would participate in any upside above 37.24. Since large bank equity puts are massively bid by those seeking protection and therefore implied volatility is high, ADIA picks up plenty of skew by writing the at-the-money put and buying a higher strike call so was obviously owed SUBSTANTIAL premium on the collar. So the "shocking" 11% coupon is explained as compensation for ADIA forgoing the 7% dividend yield available from Citi common, the high embedded option spread that Citi bought from ADIA, the typical equity premium on a mandatory CB and the tax treatment. There are also other terms in the deal that offer Abu Dhabi some protective rights WHEN the stock goes much further down.

The 11% coupon convertible to a 4.9% stake were EXACTLY the same terms offered in the convertible preferred bought by Prince al Waleed bin Talal al Saud the last time Citi got itself into trouble. The credit cycle repeats but lessons are NOT learnt; SIVs and CDOs now, real estate loans and broken LBO debt in early 1990s(!), and subprime countries don't go bust(!) in early 1980s. Over 30 years nothing has changed with Citigroup's continued misunderstanding of credit risk.

Since billions and trillions get confusing, suppose an investor with a $90,000 portfolio decided to risk $750 on a major bank in distress and whose stock was far below its high. I don't think anyone would see that as particularly risky. ADIA has about 0.8% of its portfolio in the trade. Even ~~when~~ if Citi stock goes to zero it will NOT be a disaster for the ADIA. Abu Dhabi has written a put at a level they would presumably be content to own the stock and get paid a dividend plus the embedded option premium until they take formal equity ownership in 3 years or so. Panic is high, vol is high, vol skew is high, the current dividend yield seems high; why not bet a tiny proportion of their portfolio?

What other financing choices did Citigroup have? Why not a domestic investor like Berkshire Hathaway who DOES have the cash instead of a sovereign wealth fund? My guess is Warren Buffett did not want to tempt fate from a similar situation he had ages ago with Salomon, now part of ... Citigroup. In September 1987, as a "white knight" he bought a Salomon convertible preferred with a similar "high" dividend (9% then) and "low" conversion price. Interestingly the deal was done with the stock at 31 and convertible at 38, almost the same situation as now. A few weeks later came the October crash of that year obviously taking Salomon stock way down. The price subsequently climbed the next few years ALMOST to the strike. But then the Treasury Bond scandal erupted hurting the stock price again. Ultimately it was a fair trade for BRKA but I doubt they had appetite for a repeat.

Actually there might have been an even "cheaper" financing source for Citi. Hedge funds might have been interested. After all Citadel just poured $2.5 billion into E-Trade ETFC. And RAB Capital and SRM Global FAILED to catch that falling knife called Northern Rock NRK.L. Trading the optionality and mispricings in large bank mandatory convertibles has been quite lucrative over the years. When time ran out for the Japanese city banks, convertibles were issued for similar reasons and turned out to be both good investments and trading vehicles for volatility monetization.

We may yet see futher equity financing emerge for Citigroup and they will be glad to have got an initial $7.5 billion done with a stable investor who won't short sell the common stock as a hedge, which is what I would have done. The structure also offers ADIA improved terms if Citi needs more than another $5 billion which it probably does. With ordinary covertible bond issuance so much "pre-hedging", "pre-bookbuilding" and "wall-crossing" goes on that it would have forced the equity price down even more. Less negative effect on the stock price is a reason mandatory CBs are preferable for the issuer than ordinary CBs.

With some financial engineering and restructuring of cashflows the 11% coupon could probably have been as 0% or 20% by changing various preferential rights, the capital structure, optionality, convert strikes or other aspects of the deal. What would the headlines have said then? "0% - Massive vote of confidence in Citigroup as it borrows at 400bp less than the US government?" or "20% - Citigroup forced to pay far above subprime rates as bankruptcy looms?". The reality is that this was effectively a forward sale of equity with a yield enhancing option premium NOT debt finance.

Commentary ranges on the pricing from Citibank junk bond to the more accurate and remarkably cheap Libor+150bp. Academic John Bilson even thinks there weren't any hidden options at all which explains why he is a finance professor! Those who know, do; those who don't know, teach; those who haven't a clue become tenured economics professors.

While the "experts" say markets are becoming efficient and opportunities getting arbitraged out, it is reassuring to see disagreement on this, and in fact, every security. The more complex, interconnected and innovative global investment products get, the more skill is required to understand and value them. That is why it is worth paying 2 and 20 to those able to identify mispricings in the markets and capitalize upon them. And why alpha really is portable; it transports itself from the many market participants and financial geniuses that think they understand to the few that really do. Quality expertise costs.

It doesn't matter what country an investor is in or whether they are institutional, high net worth or low net worth; the requirements are basically the same. Reliable absolute returns with MINIMAL drawdowns and volatility, performance that MORE than compensates for the risk and fund managers who can tell at a glance if a security is ultimately debt or equity and have the models and experience to value it. Detecting embedded options in capital raising structures helps too.

Hedge fund IPO?

2007-11-27T18:16:00.017+09:00

Hedge fund IPO? Proper hedge funds work because of upside incentives AND downside checks and balances that align managers WITH client interests. The much criticised "heads I win - tails you lose" compensation scheme is a myth. Investors redeeming for weak performance, low pay if below the high water mark and the principals' wealth in the fund assures clients of SHARED downside and incentivizes managers to try to minimize losses.

Investing in a hedge fund should be about REPLACING market risk with manager risk. If, like me, you believe in alpha NOT beta then that trade makes sense as "the market" itself is unhedged and notoriously volatile. Hiring a hedge fund manager means you are paying 2 and 20 to someone who is incentivized to make money while hedging risk. Paying 10bp to an index fund "manager" is a VERY expensive way to compensate the asset gatherer to lose lots of YOUR money in a bear market.

Managers provide acumen, experience and their own capital and then investors provide more capital to LEVERAGE that skill to the MUTUAL benefit of BOTH parties. It is a business model that has proven a win-win for over 50 years despite criticism from those who, of course, have never invested in a hedge fund themselves but still think they are experts. "Mutual fund" is a misnomer. Hedge funds are much more MUTUAL than a mutual fund.

A NEW diversifying source of return and keeping 80% of alpha is good for investors provided the manager is motivated to keep on making money, managing risk, restricting AUM to the size they can perform well with. Redemption fears, high water marks, personal wealth in harm's way and non-permanent capital if you don't do your job well are protective covenants for investors though, of course, nothing is guaranteed. We have seen the dangers of covenant-lite loans and there are possibly similar issues with covenant-lite fund capital. Permanent capital REMOVES the incentive to perform.

The traditionalists still say we don't need hedge funds. Necessity is NOT the mother of invention. Motivation is the REAL mother of invention. Lots of things weren't considered necessary until long AFTER they were invented. Life existed before wheels, electricity, cars, computers, internet or mobile phones and few said beforehand that we needed any of them. And remember all that demand for blogs in the 80s and 90s? I don't.

Hedge funds got invented because some were motivated to find safer, better ways of growing capital than simply owning assets. Incentive fees ensure managers keep working hard and figuring out even more ways to make money for investors. If, and only if, clients make money then you make money. It was an outstanding innovation for ALL investors permitted to access them.

"Cheap" funds mostly result in index hugging and asset gathering often at the cost of performance. Actively managed mutual fund and other relative return products have fees that are often HIGHER than hedge fund fees. Most mutual fund returns are at least 90% driven by the beta of whatever asset class they are investing in. Since beta fees are effectively zero as the holdings can be lent out to cover the indexation cost, that means a mutual fund charging 1% could be considered to be charging 10%(!) since it is actively managing only a small part of the portfolio and indexing the rest. Mutual funds are paid that outrageous fee whether they make or LOSE money. In contrast good hedge funds that can make money whether the market is up OR down are a bargain.

Hedge funds mostly charge that infamous 2% to cover much higher fixed costs on a generally smaller AUM; usually they ONLY get paid if they produce NEW profits of which they get a 20%. But in some cases now the 2% is also becoming a profit center and some hedge funds are sadly morphing from hunter gatherers into asset gatherers. Permanent capital reduces the fear of redemptions, falling too far below your high water mark and the many alignment benefits of ALL senior managers having wealth at risk in the fund.

Recently I was asked by an investor whether they should automatically redeem from an alternative asset manager that tries to IPO. Good question. After all, the IPO process, before and after, is a major management distraction away from focusing on portfolio management while the monetization of what are effectively future management fees may reduce motivation in subsequent years and also the interests of public shareholders and fund investors are not necessarily the same. It tends to emphasize the 2 rather than the 20 leading to more marketing and AUM raising usually at the cost of performance.

Hedge fund managers have always been able to monetize their skills through the performance fee. The more INVESTORS make the more the manager gets paid. Jim Simons, George Soros, Michael Steinhardt, Julian Robertson or Bruce Kovner among many others never went or have never expressed an intention to go public yet seem to have monetized their businesses fairly well and attracted talented employees. For a quality hedge fund there is no need to IPO. Selling a stake to a strategic investor might make sense, listing a fund might be a logical move but the manager itself going public is a clear short sale signal.

Fees for failure have impacted shareholders of financial corporations where senior management were neither competent nor motivated to prepare for difficult times. While PROPER hedge funds are structured in ways that provide upside AND downside alignment, this is NOW not always the case. There needs to be financial punishment for being wrong or taking on too much risk. Allocators of capital need to ensure that fear of failure, ongoing motivation and single-minded FOCUS on running the fund are present. There are many good hedge funds around where that remains true.

There are a few funds now more motivated by the 2 than the 20. Shareholders like the 2 while obviously limited partners should like the 20 since the more fees they pay the higher the returns. Asset size is usually the enemy of performance. Surely the best motivator is that if you don't perform then the money will desert you. Lockups and redemption penalties reduce this fear but are only appropriate for some strategies. With permanent capital the fear of losing the assets is taken away. As we have seen with subprime CDOs, SIVs or executive compensation, take fear out of the equation and greed ALONE leads to problems. There is little wrong with greed per se provided it is not a free call option with no downside.

A large proportion of new assets into hedge funds have recently gone to more established funds. With most investors it made sense to enter the space through funds of funds but as their familiarity has grown direct investment into larger funds is the stage we are in now. But with the superiority of early performance and higher returns on smaller asset sizes there is always going to be capital for niche managers with new ideas and strategies. With the industry still so tiny compared to future demand there will be plenty of space for large AND small hedge funds. Core-satellite is how the traditional world evolved and is how the hedge fund space will evolve. A core of fund of funds and multistrategy behemoths enhanced with specialist managers filling a specific portfolio gap. Lots of room for good hedge funds of ALL sizes as long as the people in charge are incentivized AND feel fear.

Almost all QUALITY hedge funds operating today BEGAN with less than $100 million under management. Every one of those funds was motivated primarily by the performance fee. So the argument that the biggest funds will win ignores factors that have underscored the success of the industry since inception. There is strong empirical evidence that newer and smaller hedge funds perform better. Yet currently more money is flowing to the biggest funds by naive investors operating under the delusion that large AUM equals large FUTURE returns. There seems a strange dichotomy here. Isn't money supposed to go the funds likeliest to perform better? Whether a firm has $500 billion or $500,000 under management gives little indication of its abilities. People should have learnt that expensive lesson from the traditional world by now.

Motivation and incentives are the fuel of any functioning economic model. Fees for failure threaten that system. There are plenty of billionaires working just as hard today as when they started out. But there is a danger that some managers might lose their motivation if the worst case scenario isn't that bad and when shareholders generally reward AUM more than performance fees. Will the Och-Ziff OZM partners burn the midnight oil in 2008 as much as in 1994 even if the Och-Ziff IPO proceeds have been reinvested in the fund? Hopefully they will but it is yet another question investors will have to ask themselves.

Nomura and the China and Dubai sovereign wealth funds can't be very impressed with the post-IPO performance of Fortress FIG, Blackstone BX and now Och-Ziff OZM. It is not often such obvious short sells come along but when someone stands on a street corner throwing free money around, you try to grab all you can. Some shorts this year like credit or the dollar weren't completely obvious unless you did your homework but shorting those IPOs WAS blindingly obvious. If the principals are selling it is logical to sell alongside. Since there was previously no easy way to short hedge funds it makes sense to short OZM even if you think Och-Ziff is a good firm. OZM now serves as hedging instrument in the same way the FIG and BX IPOs enabled a way to short private equity.

When a hedge fund manager "takes home" a billion it is GREAT news for their clients since it is FAIR compensation for strong performance. Any management team should be incentivized to do a good job. But with an IPO there is a danger of becoming similar to a CEO of Bear Stearns, Merrill Lynch or Citigroup as it does not align shareholder or client interests with management. Those properly motivated don't play bridge or golf when their firms are taking massive losses. Any hedge fund manager worthy of the name was available 24/7 during the recent problems. Non-permanent capital and easy redemption rights forces managers to work hard especially if their net worth is also threatened. Keeping AUM at a suitable size keeps attention on performance for that uncertain 20 NOT gathering assets for that certain 2.

Alignment of economic interests matter. Why buy an investment banking stock when the CEO and other senior managers can still parachute out no matter how bad a job they do? Why listen to a sell-side "economist" opine that the economy is strong when they aren't impacted for not realising that credit and real estate were absurdly mispriced and that would weaken the economy? Why buy an "AAA" rated CPDO when the ratings agency won't be financially damaged if it drops to a C rating? Why purchase a "Strong Buy" equity pushed by an analyst who won't be punished for being wrong? Why buy into hedge fund or private equity IPOs when the founders are selling? Why provide permanent capital and permit monetization of future fee cash flows when the possibility of having that capital taken away is such a powerful incentive to keep performing? Permanent returns guarantee permanent capital.

As in any industry if you want cheap you can get cheap. "Cheap" hedge fund clones and replicators are out there as are so-called "hedge fund" style mutual funds. As usual you get what you pay for. While proper hedge fund fees remain stable there has been some recent fee reduction in the funds of funds arena. An investor may be proud of getting "lower" fees instead of the modal 1% and 10% second layer but the chances are they are being penny-wise, dollar-foolish. There are costs to due diligence, infrastructure, monitoring and attracting the quality of staff able to identify good hedge funds. It is easy enough to just pick names that had good recent performance and charge less and cut corners on the massive due diligence you claimed in your powerpoint. It is much harder and expensive to do a good job picking quality hedge funds that WILL perform.

Someone asked me what I expected to be the best performing strategy over the next 10 years. I answered that considering financial incentives and innovation that the chances are the top returning strategy over 2008-2018 probably hasn't been invented yet and that the managing firm is likely not YET in existence. They figured "China short only" would be the best performer which was interesting.

They might be right or they might be wrong but if they do find such a manager they need to make sure anyone they provide non-permanent capital to is properly incentivized to 1) make money 2) not lose most of it. Managing money is a vocation which needs full-time focus, proper incentives and close attention.

Human versus computer?

2007-11-01T01:05:00.043+09:00

Human versus computer? Beware of hedge fund geeks bearing greeks? Some models don't work therefore all models don't work? Black boxes are complicated so stay with "simple" ways of making money? Humans do the programming at all quant funds so it is their sagacity or stupidity driving the outcome.

Pablo Picasso once said “Computers are useless. They can only give you answers.” What matters is the questions HUMANS ask them. I consider managed futures CTAs, equity market neutral, statistical arbitrage and volatility trading to be essential strategies to include in ALL portfolios. The fact that they take rare skill and superior PROPRIETARY models to implement should not scare away any investor. Quant hedge funds are "finished"? Nonsense.

Computers are just an analytical and execution tool that ALL good fund managers use to varying degrees. The darkest and least understood black box is the human brain. Due diligence on a quant strategy is much EASIER than evaluating a fundamental strategy. The BIGGEST risk is KEY PERSON risk at a hedge fund. I don't need to see formulae to determine if someone knows what they are doing. Hyperbole and generalization often lead to misunderstanding. Presumably that is why some think quants are in a quagmire, derivatives are dangerous and leverage is lunacy. There are far more bad qualitative than bad quantitative funds so beware of the QUALS as much as the QUANTS.

I've heard many times that quant investing will replace humans but conversely I am hearing, yet again, that "this is the end of quant"! Both are wrong. There is nothing new about BAD quantitative models having problems. Recent implosions are similar to the portfolio "insurance" of 1987, the mortgage-backed securities "models" of 1994 or Long-Term Capital Management's options geniuses in 1998. Just as there are good and bad human stock pickers there are good and bad human quants. Show me a fundamental strategy that hasn't run into problems at some time. The quant is dead - long live the quant.

Some multistrategy hedge funds that couldn't unwind illiquid credit instruments were forced to unwind what was liquid to meet margin calls. The risk of mixing liquid and illiquid securities is one reason why there will ALWAYS be demand for single-strategy hedge funds despite the "expert" predictions for the dominance of multistrategy funds. The recent situation was also exacerbated by rookie short sellers from the 130/30 newbies panicking when their shorts began to tick up on the short covering. I wonder how many of them knew beforehand that short positions get LARGER as you lose money. I wouldn't be surprised if some of the less experienced 130/30 managers were temporarily more like 120/40 or even 110/50. Mandate infraction!

Funds of hedge funds that avoid ALL quant funds are doing an incompetent job. Intermediaries should earn their fees by identifying skilled and the unskilled managers in a particular strategy NOT avoiding quant strategies period. Process driven investment decisions are the foundation of EVERY successful fund manager. Given the large amounts of data that silicon-based computers are able to analyse that their carbon based masters deign to provide, it makes sense to outsource such work to them. If the strategy blows up, is the hammer or the handyman to blame? Computers are just a dumb tool that simply follows what a HUMAN decides to input.

Even odder are those investors who make an allocation to "quant" and then refrain from other quant funds. As if all quant strategies were the same! Investing successfully is hard. It makes sense to use all available tools. A systematic, replicable investment process using qualitative AND quantitative analysis is surely the foundation of any successful hedge fund, though how they weight the two varies. The simple fact is there are GOOD pricing and trading models around and there are BAD ones. It usually takes bear markets and volatility to show which is which. But whether the models produce positive or negative alpha is ENTIRELY up to human input and specification. Garbage in, garbage out or genius in, genius out.

Investors should be wary of everything. Considering the non-quant problems and dire risk management policies on display recently, the faith in the value of human discretion seems ironic. Sure there are plenty of poorly designed and badly tested quant trading systems out there as there are delusional pricing models but that does not preclude the existence of robust quant fund products. A computer making the trading decisions rather than a human does NOT mean an increase in systemic risk or a decrease in the persistence of a good strategy. It just puts the emphasis on ensuring the computer is making decisions in a different way.

One of the biggest risks for any fund and a critical due diligence issue for any allocator is that the human assets walk out of the door each day. Computers can monitor the world 24/7. Their loyalty is absolute and they don't lose interest after buying the yacht or doing an IPO. Computers can absorb and react to information on a 100,000 securities instantly unlike a human trader. They can analyse new data, have the order in and executed before a human has even noticed.

Computers don't think they are a star when they fluke a lucky trade. They don't take lunch, vacations or calls from headhunters. They don't quit and try to set up their own fund with proprietary information from their current employer. They don't have clandestine meetings with competitors. They don't complain about colleagues, clients or bonuses. They don't get sick or crash their Ferraris. There is a lot in favor of purely systematic strategies IF they are good.

With quant funds it comes down to the fear of the unknown and traditional hatred of opacity. Discretionary investors can be reasonably open about how they pick stocks since the edge is the skill in implementing the strategy. Good systematic strategy developers cannot be so open since 1) the edge IS the strategy 2) no-one outside quant land will understand 3) those inside quant land will steal it leading to the inefficiency disappearing and trade crowding problems. The main distinction comes down to whether the human decides or the computer, programmed by humans, decides. But is that really a distinction? If a systematic trading model needs adjusting to "new" phenomena then it wasn't properly tested in the first place.

Any successful investment strategy needs a robust decision-making framework and elimination of emotions. The best way is a division of labor between humans that are good at gathering data and machines that are good at processing that data in the way a human asks them to do. The more short term the trading the more useful trading technology is going to be. It makes sense that PROVIDED the algorithm has been put together competently to ask the computer to trade WHEN time is of the essence. High frequency trading is very dependent on low latency and incorporating a human override into such strategies will miss opportunities. With high frequency the speed of execution and reduction of slippage often IS the profit driver. People wonder how Renaissance Technologies' Medallion Fund performs so well but it is clear where its competitive advantages are.

Just because public domain quant strategies using the same methodologies will identify the same ideas and opportunities does not invalidate other proprietary methods. The models that ran into trouble - 1) find pairs of stocks historically cointegrated and take the other side when they are X sigma apart or 2) throw every fundamental and technical variable you can find into the hopper and data mine for what patterns worked in the past - are now very crowded. Apart from some now very large hedge funds - a few good, many bad, there were investment bank proprietary desks heavily in the statistical arbitrage and factor model strategies.

Models are only as good as the assumptions humans give them and the programmer's representation of reality. Unfortunately interpreting reality is rather complicated. To put it mildly, the facts have not been kind to the theories. If you code up some VBA, C++ or C# and tell the computer that we live in a nice "normal", "standard" world of rational entities that spend their days maximizing their utility and immediately changing prices accurately to incorporate new information then you WILL run into trouble. The computer only knows things that YOU choose to let the program know about. If you lose money beyond statistical expectation then that is a human error NOT computer error.

Few investment managers admit to using that institutional no-no called technical analysis despite the fact that so many do. But calling it quantitative analysis is still ok...just. Yet another example of semantic arbitrage, like calling something market neutral when it isn't remotely market neutral. Humans using computing power allows detection of predictive patterns and structure and we've progressed beyond moving averages, breakouts, candlesticks, RSI, MACD and Elliott waves. Technical analysts look at patterns of prices and volume while fundamental analysts look at patterns of earnings and book value. Growth investors are trend followers while value investors are countertrend. Are fundamental analysis and technical analysis that far apart or is it just a change of inputs to the model?

Computers are just a tool. Humans design "discretionary" investment strategies and they also design "systematic" investment strategies. If they are good or bad is all up to humans. Whether they data mine the past or test hypotheses of the future is up to us. Computers are good at information processing but can only analyse the data they are given in the way their human masters designate. Quantitative risk management is only possible based on the factors input to the system; if the machine is blind to a new factor there will be error propagation of non-linear orders of magnitude. Computers are simple creatures; if you only tell them about bell-curves and the "rarity" of six sigma moves then they are obviously not going to perform well when 25 sigma moves inevitably come along.

There are no axioms or proofs in real world markets. Asset classes don't go to business school or finance class. A standard IQ test can be coached but the markets are an IQ test where the questions AND answers change while you are taking it! If you assume randomness and try to impose rationality on a deterministic, chaotic process like the markets then your models are wrong. Everything is connected so models that assume independence are headed for trouble. A good model is one that provides a persistent trading or pricing edge, can cope with a non-linear, dependent, varying risk factor world and whose underlying theory and equations have NEVER been published.

As simple fools, computers are not good at complex event analysis because most programming hasn't focused on that area. Unless its human owner has informed it that most CDO pricing models are wrong, that if A defaults then the chance of B and C also defaulting is MUCH higher than "assumed" and that there are a bunch of other people out there running very similar equity mean reversion programs, then the model won't pick up that maybe it should change things. It just follows orders.

Correlation crisis? If quants neglect to tell their computers that if a weaker player is forced to unwind then the opposite of what "should" happen might occur then that is also human error. If the computer doesn't know that liquidity is variable and can even vanish then whose fault is that omission? CDO mispricing was primarily based on the gruesome Gaussian copula model. Quick investment tip: never, EVER risk capital on anything with the word "Gaussian" in it. Gaussian things make the mathematics easy which is why they don't work. Bank CEOs might bear that in mind; there are quite a few careers still being bet on the multivariate normal curve.

Even if you buy into this "normal", "independent" market price movements nonsense, 95% VaR estimates mean that about 1 day every month on "average" you will lose more. While $480 million losses may look bad, on $10 billion notional it is only 4.8%. If the Morgan Stanley quants made the human decision to run $2 billion notional cash at 5X leverage, losses of that magnitude, while serious, are not beyond the realms of expectation. The valuation noise on large portfolios is going to be tens or hundreds of millions even in quiet times let alone market stress.

Strangely no heads have rolled at Goldman Sachs' Global Negative Alpha "hedge fund" despite squandering over $3 billion of client money on its disastrous trading "models". $8.4 billion losses, mostly from buying market share in CDOs and structured credit with little concept of risk or trading acumen, are another matter. The Merrill Lynch losses were entirely due to human decisions and inexperience as are many of the yet to be announced severe credit drawdowns from other firms.

Computers are at the mercy of what data their programmers choose to give them. Even genetic algorithms and neural nets rely on the system constraints, parameters and data sets provided by their controllers. Computers have solved simple finite systems like a chess game because it is a closed and rational problem. There is always an optimal move in any situation. But financial markets are much more complex, require decision-making under uncertainty and the rules change WHILE you are playing.

Sports and investing are similar. Hard work, talent and coping with variables that a robot, with current technology, is not going to be able to handle. We are far away from artificially matching the kinesthetic intelligence of a basketball or soccer player. I saw a robot try to play ping-pong recently; it wasn't very good. The intelligence necessary to master ball games is far beyond that required for board games. Chess is easy but baseball and football require much higher intellect and computational prowess far beyond the clunky computer you are now looking at. Chess is for people not smart enough to play hockey, which requires faster data processing and analytics than ANY computer can currently achieve.

In financial markets computers are just an aid to human decision-making and will ONLY be that for a long time. Some humans create good pricing models and black box trading systems but other humans create bad ones. Due diligence on qual funds and quant funds, YES but totally avoid all of them?

Stagflation investment?

2007-10-01T12:35:00.029+09:00

Stagflation investment strategies? Recession was not anticipated by many but skilled investing is about expecting and preparing for the unexpected. It's known as HEDGING. Those who ignore history are condemned to repeat it but those who rely on history inevitably blow up. Inflation or deflation? Either will be bad for the stock market.

Anyone who believes that conventional economics can "explain" the emotional and illogical non-linear processes underlying financial markets is headed for BIG problems. Investors would be advised to have lots of shorts as we enter the bear market, own plenty of puts and have a SUBSTANTIAL portfolio weighting in LONG volatility sources of absolute return.

Recently I was asked to show some investors how speculative bubbles form, why intelligent does not mean rational and why market prices can far exceed intrinsic value. I auctioned a $100 note, offering it to the best bid with the covenant that the 2nd and 3rd highest bidders MUST also pay but will receive nothing. Sure enough $5, then $10 bids started things off but it was not long before the bids went far ABOVE $300! This despite them being professional investors with an alphabet soup of qualifications after their names and knowing, with certainty, that the value of the asset was $100. If the security's value is uncertain the behavior is MORE extreme. The actions of those who bid $90 and $95 when someone bids $100 are fascinating. They are facing a certain loss or they can...

Price and value have little connection when emotions control the game. Markets NEVER accurately determine the value of a security. All markets are informationally inefficient and every participant is IRRATIONAL. Some might say such an abnormal auction is not a model of how markets function but many herdlike investors DO behave like that ESPECIALLY towards the END of bull markets, like now. Many asset gathering fund managers are scared of being that second or third bidder. The COST of losing to the winning bid can be high.

Some who invested in subprime CDOs may have suspected they were overpaying but bought anyway due to the risk of underperforming their "peers". Buying China at 6,000, India at 20,000 or USA at 14,000 might have looked good compared to the possibility of having clients redeem from you to go into another fund that did take that risk. I know plenty of investors long Japan from 30,000 because every economist and stockbroker said it was going to 50,000. They are still waiting. Not that we will be seeing such stock market index levels again for MANY, MANY years. Auctions lead to not only winner's curse but also loser's curse. Long only buy and hold is for losers.

Adding fuel to the fire of auction based securities markets is the moral hazard when the risks of overpaying are not adequately punished. The "Greenspan put" was exercised last month so apparently everything is now fine? Time to dump those "expensive" hedge funds as the five year old bull market just got more rocket fuel? Not quite. The probability of recession must have been considered dire, more likely a certainty, to warrant an immediate cut of 50bp. But can the cure for easy money be to provide more easy money? Could we be setting up for a despression? In the stagflation of the 1970s the ONLY investment products that performed were, of course, good hedge funds. Long only stock AND bonds fail miserably in such times and will this time ALSO. In the deflation of Japan in 1990s the only performance came from proper absolute return strategies.

September has historically been the worst month for stock markets so the data miners won't be happy that it turned out to be such a strong up month. The last quarter of the year is HISTORICALLY the best so it will be interesting if we get a reversal of that trend also. According to the "experts" there is little chance of a bear market since Ben Bernanke will be there with another cut if anything bad happens. But options, like auctions, are not free and the "Bernanke put" might yet cost investors a high premium if and more likely WHEN it leads to stagflation.

With so many fund manager searches decided on the basis of recent performance, the danger of not being the highest bidder can be significant. As well as stock and bond markets, auctions dominate asset sales ranging from private equity deals to distressed debt and it can often seem safer to be the winning bidder than the also ran. You have to be in it to win it so therefore it pays to bid high so as to avoid the "expense" of not winning. Research, due diligence and the cost of information gathering and analysis are also borne by losing bidders. Ultimately however, as we are already seeing with LBO leveraged loan syndications or real estate speculators, some end up wishing they had never participated in the game at all. That is why markets oscillate between ecstasy and ennui and why stability is inherently unstable.

The faith in the power of the authorities is probably storing up problems for the future. Several individual investors have insisted to me that China stocks can't go down because of the Olympics next year. Really? Similarly USA stocks won't go down because the Fed is the Fed. Irrationality again. If only the causality of central bank and government policy on financial markets were so simple or direct. "Don't fight the Fed" usually proved true in the PAST but does not mean the Fed or other central banks WILL win.

August non-farm payrolls were not -4,000 but were actually +89,000! What confidence would investors have in a hedge fund that first said it lost 0.4% and then "revised" to +8.9%? The error in economic reports is so high that it is a wonder so many pay attention to the initial number. Inflation, in particular, is MUCH higher than the "core" inflation numbers are showing. If anything I suspect the rate cut decision came down to the risks of doing something aggressive (50bp) versus not (25bp). In the short term it is perhaps safer to give the crowd what they want even if it could be VERY wrong in the long term. Not very long from now the Fed will have to RAISE rates, heavily.

The recent volatility nicely demonstrated the value of quality hedge funds particularly the opportunities created out of crisis and possible recovery. Buying and holding is not optimal compared to shorting before a problem is generally realised and then buying as the crowd overreacts to those problems. Now that the Bank of England has effectively "guaranteed" the deposits at Northern Rock and UBS, Deutsche, Citigroup, Merrill Lynch and other banks have "warned" on earnings, are the credit problems really over so quickly? Super SIV fund? ABX at new lows? Have they REALLY valued everything correctly, i.e. at a price SOMEONE ELSE will buy with their own REAL CASH? NO!

Underlying the credit situation is a bear market in many areas of real estate that is NOT going away anytime soon. Lending without awareness of risk has similarities to Japan in 1980s; unconstrained lending and optimistic default assumptions and massive loans backed by collateral that historically had never dropped steeply in price. There were many false dawns and credit "recoveries" but Japanese real estate just kept going down.

Overlending is like the second bidder dilemma. Getting the deal looks better than completely missing it and underperforming your competitors' loan book or sales of mortgage originations. Perhaps other countries have learnt from Japan but more likely they haven't. The bailouts and proposed super SIV fund sounds suspiciously like one of the many temporary "price keeping operations" or "solutions" implemented by the Japanese authorities in the 1990s.

The so-called hedge fund meltdown didn't seem to last long. Just a month ago there were supposed to be wholesale redemptions because of the "apocalyptic" August (-1.5% including the blowups and all the non hedge funds that wrongly get included in these "indices") but now apparently everything is fine. Hedge fund inflows continue and the firms that "calculate" hedge fund redemptions admit they did their sums wrong just like governments can't seem to count new jobs accurately. The main lesson of last quarter was losing 20 or so investment products out of over 10,000 (0.2%) that purported to be hedge funds and whose assets were quickly bought by real hedge funds and the "discovery" that some public domain alternative investment strategies are now a tad crowded.

August was a bad month for hedge funds but September was one of best months ever for hedge fund performance though how some strategies will do if stagflation does show up will be interesting. Recency bias is perhaps the most pernicious disease in finance. Funny how many supposed long term investors worried about just a few weeks of hedge fund turbulence. Now with the September data point in, all is forgiven at least until the next drawdown. I find the common reaction to good hedge funds in a temporary loss to be silly. A good stock that goes down is a buying opportunity; a GOOD hedge fund that has a rough period is also a buying opportunity.

New strategies that are not crowded performed well. NEW quant strategies were able to make money out of OLD quant strategies. Real credit hedge funds and short sellers took advantage of the long biased credit crowd. Carbon trading, shipping freight and property derivatives have all created new alpha opportunities. Many established strategies were affected despite the previous appearance of being independent. Investors demanding transparency has led to significant strategy know-how leakage and trade crowding to less-skilled firms.

Interesting how the market gets LESS efficient and MORE irrational as more "smart" money enters the field; precisely the opposite of what "should" happen. That is because the smartest money gets to arbitrage the money that isn't as smart as it thinks. There is MORE alpha available than ever before; it just requires higher skill and uncrowded methods to capture it. The investment universe offers a universe of opportunities and the more "hedge funds" there are, the better chances for the GOOD hedge funds to make money out of BAD hedge funds.

With the hedge fund industry still so TINY at $2.5 trillion AUM, compared to the much larger future demand, the scope for new funds, new strategies and new asset classes is clearly going to continue to grow. It won't be a straight line of course but I wouldn't consider the hedge fund industry mature before $25 trillion AUM so there is clearly a lot more industry expansion to go. There are so many NEW ways and NEW products appearing to make money in global markets. Today there is $64 trillion money being "managed" mostly not very well. Look for the AUM in mutual funds and hedge funds to exchange places over the next decade.

Global economies and developed stock markets are so correlated these days that Federal Reserve decisions almost amount to Central Bank of the World decisions. You have to wonder how much longer dollar pegged currencies like the HK$ and Middle East petro currencies will want to get dragged down by the subprime US$. I wouldn't want to sell my oil or gold for dollars unless they happen to be Canadian or Australian notes.

It is a shame Hyman Minsky didn't ever receive the "Nobel" Prize in Economics. But then if he had, the equilibrium, efficient market cult would have had to return theirs. The recent Minsky moment is a reminder of the PERMANENT instability of markets. And the inevitability of bull AND bear markets overshooting. Stock markets start by climbing a wall of worry but then clamber over it due primarily to the fear of being the losing bidder in the auction scenario I described above. Later on markets descend a cliff of chaos. Risk appetite, like pride, is always highest before a fall.

In many parts of the world there are still $300 bids for $100 securities going on right now. Am I therefore bearish? I try to stay on steamrollers not collect nickels in front of them although I jump off if there is a another steamroller approaching from the other direction. So am I bullish? Not on the stock or credit markets, of course, but on the ongoing availability of alpha generating opportunities and the existence of fund managers with the skills to identify them.

The ONLY thing to ALWAYS be long of is alpha; everything else needs to be hedged, especially beta. There are potentially some bigger steamrollers rolling into view and in the opposite direction to the always bullish "stay in for the long haul" zealots. Get hedged and get SHORT of equities and commodities.

Quant fund?

2007-08-19T12:34:00.025+09:00

Quantitative hedge funds? The steamroller of the credit crisis flattened some stock market nickel collectors who didn't even realise they were in its path. Damaged collateral has caused plenty of collateral damage. Some quantitative hedge funds saw "hedges" become Texas hedges as their short sales went up and longs fell. Market neutral is NOT risk neutral when there is no mean to "revert" to.

The best risk management rule I use is "If it can happen then it will happen". The trouble with standard deviation is it just measures STANDARD deviations. The market is never "normal"; it oscillates from one extreme to the other. Very volatile or very steady. Chaos and complexity aren't black swans; they are permanently present features of the markets.

Volatility is analogous to energy in that it can hide as potential energy but it is ALWAYS lurking. Unless you have the resources and expertise to model and make money from non-linear, non-rational phenomena yourself, wire your money over to the FEW fund managers that do. Before the long only crowd lose it for you...again. "Low cost" long only funds are actually very expensive.

Curious how OFTEN these "once in a 100,000 years" storms occur and blow away anyone who hasn't battened down the hatches. Usually after just a long enough gap in time for some to say volatility is "permanently" contained! The butterfly effect from US subprime mortgage securitization has propogated to many other areas in finance. Those "securities" weren't very secure despite the "ratings". Credit ratings are even more useless than equity ratings. Ignore them. "AAA" is as meaningless as "strong buy".

EVERY investment strategy is directional including the ones that market themselves as "non-directional". Interesting how some models have major trouble when a NEW risk factor emerges. An investment edge means a manager WILL produce alpha in the long run but NOT necessarily every month. Some quant hedge funds have competitive advantages but most do not.

For those investors intent on redeeming from good quant hedge funds it is worth recalling that after the October 1987 crash, statistical arbitrage produced excellent returns in the following years. Statistical arbitrage has been around for a long time and has had several difficult periods like any other investment style. This overdue shake out will ultimately be a positive for good systematic hedge funds. No matter what happens I'd rather bet on alpha than beta. Before people get too hysterical about hedge funds they should remember the much larger amounts at risk in unhedged long only.

"Quant fund" is as poorly defined as "hedge fund". Some quant funds have done well recently. There are not only factor models and stat arb within the quant space. Most of the better CTAs are quantitatively orientated. There is countertrend trading and volatility arbitrage among others. I am not a quant but I certainly utilise obscure mathematics and proprietary statistical measures to evaluate fund managers, develop investment models and trading algorithms. I'd argue most viable investment strategies have an element of "quant" about them, even the "discretionary" styles.

If you can't quantify your investment edge then you don't have one. If you can't measure your risk you can't manage your risk. If you don't know whether the performance was from alpha or beta then it was undoubtably beta. You can test and evaluate quantitative trading methods rigorously but human discretionary funds rarely have a long enough track record to differentiate luck from skill. A bad period for some prominent, possibly oversized, quant hedge funds does not change the STRONG diversification case for quant strategies.

"Rare" events are NOT very rare and they tend to cluster together leading to other "rare" events. Pundits seem surprised that what started in illiquid credit could affect funds as diverse as liquid equity funds, currency or energy traders. Contagion and hysteria will often impact leveraged strategies. The irrational swamps the rational yet again. Economic expectations and logical assumptions are not good for modeling such an inherently irrational and emotional process. Fundamentals are irrelevant when fear grips the markets and that in turn negatively effects the fundamentals.

The idea that "this has never happened before" is wrong. Volatility is not new. Correlation regime shifts are not new. Some "quants" use just 5 years of historical data so it is interesting that the storm hit exactly as the most volatile month this century dropped off their spreadsheets. DURING July 2002 the Dow fell 18% then rallied 12%. We've seen nothing like that, YET. Many quants have similar risk factor driven stock ranking systems so an unwinding means popular shorts will go up while popular longs will go down. Convergence trades only work if there are reasons they should converge. In a regime change like this, "reasons" get overwhelmed by the shift from low volatility to high volatility. Historical relationships are just that - HISTORICAL. Beta and correlation just describe the PAST. We can learn from previous behavior but can't rely on it.

Factor models and statistical arbitrage are not black boxes anymore. More a crowded, transparent box. It used to be off the radar screen for most investors and involve relatively small amounts of money. But success has led to significant trade crowding and transparency of methods that MUST be kept proprietary. All arbs eventually get arbed out so you have to keep finding new ones. With every strategy there is a point beyond which the dangers of copycats exceed the rewards. However, just like credit hedge funds, there were losers AND winners in quantitative funds. High frequency trading is actually safer than low frequency trading and it was the "slower" systems that performed worst recently. Some smaller, more agile quant funds using different models and shorter time frames were able to arb the bigger funds.

To ANTICIPATE risks it is important to develop as much expertise and information sources as possible across products and geographies. There are other strategies and assets not YET impacted by the subprime meltdown. What started as a small part of the credit markets has spread to many other areas. Contagion is contagious and bear markets tend to RAISE correlations across risky assets. To anticipate risks you need to be aware of what is coming out of left field. Part of the problem is the silo mentality of a lot of the street; while cross-product expertise has grown the basic stance remains "I am equity, you are fixed-income, he is currencies and she is commodities" when in fact it requires competence across all asset and strategy classes. There is often also a sharp divide between fundamentalists and quants when you really need to know and understand both.

Deleveraging is having an effect on some good hedge funds just like in 1998 and the recent stat arb problems were probably inevitable. 1) Spreads have been getting very tight requiring more leverage to maintain returns but the lending banks now want out necessitating liquidation of positions 2) Due to losses in OTHER areas investors are redeeming and quant funds are very liquid 3) Clients now demand more transparency and trade secrets have leaked into the marketplace allowing less competent funds to try to emulate the better ones. Loose lips sink ships. 4) Fund employees left to start their own firms but with the SAME strategy DNA eg Goldman Sachs Asset Management to AQR or DE Shaw to Tykhe 5) In some quant areas, capacity was surpassed a while ago but many funds continued to take in assets. It is not just the AUM in a fund, the total AUM in an industry strategy also matters.

If there is one term that needs to be removed from the fund marketing lexicon it would be "market neutral". Salespeople and other capital raisers love it since it sounds so "low" risk and sellable. But "market neutral" strategies just transform one set of risks into another set of risks. If you short 250 stocks in the the S&P 500 and buy the other 250, is that market neutral? Absolutely NOT. If you put on a Ford versus General Motors beta neutral pair trade. Is that market neutral? No. All you've done is transformed single security directional risk into double security directional spread risk and spreads can be even harder to forecast than the outright. You've introduced correlation issues that are even more difficult to model. You've also now got four trades to do instead of two. No strategy is MARKET neutral. More importantly NO strategy is RISK neutral.

Mean reversion assumes there actually is a stable mean to revert to. Some models are based on notions of economic equilibrium and no-arbitrage efficient markets, ie that prices "must" EVENTUALLY come back to someone's guess of fair value. Although there are many useful aspects of econophysics to trading just because there is a proven gravitational attraction between pairs of objects does not guarantee reliable FUTURE relationships between pairs of securities. Past market data is widely available and if you throw enough variables and optimizable parameters into a data mining model it is certain you will come up with patterns and factors that "predict" the past. What separates the good from the bad are those with the skill to find predictors for the future.

There is skill dispersion in quantitative hedge funds as in every investment strategy. Every fund has difficult periods and nothing has altered the fact that Renaissance Technologies remains the best quant firm currently operating. Their hedge fund product, Medallion Fund, is well up for the year and is where the managers keep their own money. In fact it doesn't need outside clients anymore. Medallion had a rough 1989 and any investors that redeemed THEN would have missed many years of subsequent high capital growth.

The 175/75 fund product in the news, the Renaissance Institutional Equities Fund, is NOT a hedge fund, has a longer term trading outlook and reveals more information. More disclosure attracts copycats which creates problems for everyone. Other firms have been trying to reverse engineer James Simons and his team's quant strategies since the excellent returns in the difficult year for many other firms of 1994. RIEF, being newer, larger, less opaque and nimble and 100% net LONG, has been closely watched by competitors since inception.

Contagion can affect any strategy. Bad funds can hurt good funds. DE Shaw had poor returns in 1998 mostly due to Long-Term blowing up but did fine afterwards. AQR shorted tech and internet stocks throughout 1999 and took a lot of pain before ultimately being proven correct in 2000. EVERYONE loses money sometimes. Say you are a good small cap stock picker and someone else is not good but also has a position in those stocks. That fund gets into trouble and investors and leverage providers want their money back. The bad fund is forced to dump the stocks you also own. Even though you yourself are good, you lose money. That is exactly what is going on in stat arb right now. Fortunately while the short term means problems for everyone in that particular strategy, in the long term the outcome is positive as the worst funds close down while the good funds will thrive.

I wish CEOs and CFOs would ask their CIOs and CROs about CDOs and CLOs before denying any exposure. Interesting how many insist on investing in things they "understand" and then proceed to pile into things they clearly never looked into other than the yield spread and "rating". The market decides what deserves to be considered AAA not some ratings agency. Almost by their own admission banks don't know what they don't know so they want their money back NOW from anything liquid. Contrary to popular belief the credit markets have not ground to a halt; cash credit may have temporarily but credit derivatives have seen massive trading recently. Could the next shoe to drop be in CDSs, SIVs or CLNs? CPDOs are priced a tad wider than "AAA" rated treasury bonds these days.

The 2/20 crowd are NOT to blame for quite rightly adjusting their portfolios. The 2/28 crowd, better known as mortgage brokers, were the catalyst. It is noteworthy how current laws won't let hedge funds sell to the mass affluent yet allowed subprime lenders to aggressively target less affluent homebuyers with predatory loans. They were clearly NOT making people aware of the risks with option ARMs and low 2 year/high 28 year loans which has put many in negative home equity and delinquency.

As usual it is all embedded optionality; the option to raise mortgage rates, the option to not pay those rates, the option to foreclose, the option to try to stay put and call a lawyer. Given the on-selling and repackaging of mortgages and structured investment vehicle conduits nowadays the ultimate owner is not always clear so the subprime mess is going to impact the markets for a long time. The credit default virus is already moving to higher grade credit areas.

I doubt the Dow will be above 10,000 by the time the credit crisis has been played out. Reverberations and panic are creating opportunities each day. At least good fund managers are taking action and reducing risk during this storm. I find this stay in for the long haul, ride out the turbulence "advice" ludicrous. Ships get to the nearest port and airplanes avoid hurricanes but sell-side strategists are mostly recommending staying invested in the stock market! The quant fund and other hedge fund strategy turmoil is NOT over.

With some investment strategies having problems during this complex financial phase shift, getting hedged or getting out is surely prudent unless you are very confident of the skill and risk management capabilities of your fund managers or personal trading abilities. It is not as though "common sense" traditional stock and risky bond funds are immune. The long only crowd should dig their well before they are thirsty and DEFINITELY before everyone runs for the exits.

Stress test for hedge funds?

2007-08-03T01:56:00.015+09:00

Hedge funds haven't had a stress test since 1998. Then, as now, there were even "experts" who said short selling didn't work anymore! Speculators that were marketing themselves as "hedge funds" had also been playing positive carry and riding the stock and credit bull markets despite NEITHER being a legitimate skill-based strategy. The problems had also been brewing for ages but the "efficient" market failed to immediately factor them in thereby giving plenty of time for those with the expertise to make money or protect client capital.

There were also predictions of the end of the hedge fund "fad" when in fact it strengthened the industry and emphasized the need to diversify investors' portfolios properly. The SAME market phenomena and manic behavior that has repeated many times throughout history. Some investors have learnt very little from the lessons of the Long-Term Capital Management crisis or the earlier credit-induced panic of 1907. Would Knickerbocker Trust have been called a "hedge fund" if it were around today? The crash of 1807 was even worse. Is the "correction" over or could the markets be setting up for the "panic of 2007"? The volatility is NOT anywhere near over.

As in 1998 some funds used massive leverage and useless models that bore no relation to actual market prices to invest in dubious credit products - subprime Russian debt then, subprime CDOs now - while shorting liquidity, shorting the Japanese Yen and shorting optionality. Clearly not all subprime CDO buyers were aware they were effectively writing embedded put options. Both times VaR provided misleading information on the REAL value-at-risk being taken. With debate still raging on where to mark all this margin and distressed "collateral" I wonder how many vacations have been cancelled this month. Interesting how often these things happen in the summer "doldrums".

Many risk assets fell recently; stock markets, high yield bonds, high yield loans and high yield currencies. Many real estate and private equity holdings also fell but their price won't be known until someone bothers to value them correctly. Asset allocation doesn't help much when correlations across risky securities tend to +1. The mythical "LBO put" also evaporated; there is no floor on the market. Maybe the "Greenspan put" will belatedly vanish too; it would be sad if Ben Bernanke is pressured to bail out the beta bandits. Credit and equity are two sides of the same coin yet some still seem to treat them as if they were unconnected. A portfolio of assets is not sufficiently diversified to be sure of making money in turbulent times. Strategies that do NOT rely on easy conditions are a MANDATORY portfolio component.

Limited losses are acceptable but meltdowns are not. Every strategy, every fund AND every asset has negative months sometimes. Skill, risk management, short selling and portfolio nimbleness are what determine if the loss can be kept low. It is why strategy and manager diversification is even more important than asset allocation. SMALL losses are inevitable but a wide spread of bets, hedging and knowing your risks AHEAD of time are what prevents BIG losses. Illiquidity and other non-linear exposures combined with leverage is asking for trouble. Why did so many believe in the free lunch of high yields at low yield risk?

Hedge fund pioneer Alfred Winslow Jones considered the purpose of his equity hedge fund was to guard against a stock market drop. He got it right over 50 years ago yet the semantic abuse continues. Hopefully recent market events will bring renewed attention to Jones' definition. A credit hedge fund's purpose is to guard against a credit market drop. Period. If a proposed "alternative" strategy is not set up to do just that what is the point in investing in it? I've been doing strategy evaluation and due diligence for a long time yet still encounter many "hedge funds" with scant risk management, reluctance to be net short and dependent on optimistic assumptions. If you want optimists go with the long only crowd.

Many passive index and long only funds are underwater for the century yet again. Curious how the media goes crazy when an endowment or pension fund loses millions in a hedge fund but not when they drop billions in traditional funds. "Alternative" ASSETS don't help if they fall just like traditional assets but are able disguise this price volatility and market dependence through delayed mark to market. We are also getting an overdue shake-out of "hedge funds" that were NOT managing strategies that diversified a portfolio. Risk-managed funds are the way to be more confident of protecting capital whatever the conditions. Hedge fund critics will cite summer 2007 to show they were right all along yet the truth is the subprime-induced meltdown PROVES the case for real hedge funds and diversifying by STRATEGY not only by ASSET.

Credit modeling and risk measurement are NOT rocket science. It is much more complex than that. Rockets have more predictable trajectories. CDO waterfalls can be like real waterfalls - take one step over the edge and there is a good chance you'll drop all the way to the bottom. Debt spreads are basically options premiums; if you buy a risky bond or loan you are in essence writing a put. Such a strategy is short volatility and hazardous if the premium does not compensate for the intrinsic default probability. As with many options selling strategies, taking in premium works fine UNTIL you get blown away by a fat-tailed move. It is with good reason that the ONLY thing I try to do with explicit or implicit optionality is to own it, NEVER short it. Bear markets are better than bull markets in that you make money much quicker. That is why I like buying "value" volatility. Unlimited upside with a known downside and guaranteed to produce lots of alpha in kurtotic markets.

The latest, but not the last, leverage and illiquidity blow up is Sowood Capital. Interesting how "market-independent" Sowood turned out to be dependent on credit beta just like Amaranth was on energy beta. Being concentrated in one area and charging hedge fund fees for simply gearing up investments in credit spreads is absurd. What they were doing was more complicated but simplifying the scheme: suppose you raise $100 from investors and borrow another $900 from leverage providers (really cheap in yen!). Then place the entire $1,000 into higher yielding assets and short something low yield. A year later you've "made" over 10% after fees but with no skill, no alpha and no justification in calling your product a hedge fund. Sowood wasn't a hedge fund; effectively it just took in inadequate credit risk premiums and hoped for the best.

Citadel, which actually is a hedge fund, bought out some of those positions because it is "hedged" and like anyone sensible keeps capital available for good opportunities. Other real hedge funds like Tudor and Caxton apparently had a rough month, giving back a minute fraction of their cumulative capital gains over the last two decades. It is much easier to pilot a speed boat than an oil tanker. Both were among the best speed boats in the 80s and 90s but have become oil tankers in recent years. It is very difficult to reconfigure large portfolios and take aversive action when a regime change hits the market which is why staying in liquid areas and closing strategies to new money is important. Paul Tudor Jones and Bruce Kovner are probably good enough to figure out ways to make the money back. Ken Griffin had a difficult 2005 during the CB arb meltdown but seems fine for now.

Jeremy Grantham, the permabear "G" of GMO, thinks 5,000 hedge funds will eventually disappear. There will certainly be more clueless credit spread speculators shutting down soon. But after that I would hope we lose 80% of good and bad hedge funds to attrition like in any other entrepreneurial business sector. Some will close down because they were outstanding but more will go because they weren't. Managers with genuine ability will thrive and alpha is a redistribution game. We've seen plenty of alpha transport in recent weeks as the skilled made money out of the unskilled. That's real "portable alpha"; other funds' negative alpha becomes your positive alpha. If anything a crisis just increases the money-making opportunities. Creative destruction and business Darwinism is healthy for any industry. The dotcom implosion didn't hurt internet growth and shaking out the beta bundlers won't hurt hedge fund industry growth either.

I am a permabull as far as innovation and people continuing to figure out ways to invest money safely is concerned. I certainly prefer manager risk than market risk. It is easier to find good managers than good markets. Markets don't hedge. It is so long since we had a proper shakeout to show who has been swimming naked in an outgoing tide. Ideally we have entered an extended period of flat to negative asset returns which is the ideal environment to detect genuine alpha-generating ability. Whatever the market does and whether Grantham proves correct, 5 years from now the hedge fund industry will be MUCH larger than today and there will be many more "start-ups" to replace all those "close-downs". Hedge funds are no more a fad than the internet.

Markets are a leading indicator not a lagging. At least the economy is "strong" according to economists who always seem to be able to succinctly explain the past. It is true the economy WAS strong but that does not mean it WILL be strong. Seems hard to believe that global risk aversion, reduced loan availability, higher borrowing rates for weaker credits, scepticism of ratings and less private equity deal flow will NOT have an effect on the liquidity driven world economy. The market always tends to "know" a lot more than economists. Equity traders also know a lot more than equity analysts. Credit markets know more than credit models.

As previously blogged I've been long implied volatility and short various credits for months but it is probably time to book those profits. Still short of FIG and BX but no need to cover those since they offer negative plays on private equity industry problems. The implications of tighter credit and stricter loan covenants for private equity are not yet discounted. Seven "analysts" issued "buy" ratings on BX today so clearly there is a lot more downside! If those sales-side cheerleaders were required to put at least 5% of their net worth into BX at the $31 IPO price I might start paying attention to their "opinions". But doing the opposite to what underwriter equity analysts say is usually quite reliable. Yet another example of bad stock, good company but that is hardly a rarity.

I wonder if those "research" reports noted the moral hazard of going public when your rivals remain mostly private. There was no way to short big private equity before 2007 but there is now. Quite kind for Fortress and Blackstone to provide global investors with the ONLY short sell plays on private equity. Even if those firms themselves are good, their public currency allows anyone to implement negative views on the industry. Merger arb used to be "buy the acquiree, short the acquirer". Reverse merger arb worked like a dream recently as spreads widened but normal merger arb might look favorable now strategic buyers probably have the upper hand. With KKR possibly wavering on its IPO, BX and FIG are out there in the cold as proxies for possible private equity problems.

The risk-adjusted performance of real hedge funds has been vastly superior to long only public AND private equity and they offer essential strategy diversification. While I realize many people far smarter than me are skeptical of hedge funds, my analysis of hedge fund performance leaves NO room for doubt that proper hedge funds offer important value to a portfolio. Even if some lose money and a rare few blow up, the spread of returns and strategies is the key value proposition. Asset allocation is less important than strategy allocation and hedge funds are strategies NOT assets. The stress test> is great for showing who is good and who is not.

Risk and failure are necessary in a functioning financial system and during such crises there is ALWAYS opportunity. It has been a long time since tough trading conditions and while many products had been making money easily this year, the numbers show which funds have been generating alpha and hedging out that beta. As experienced in 1998, financial contagion is likely not yet contained. There is plenty more money still to be made out of the situation if you are nimble enough to capitalize on it. The credit market dislocation PROVES the case for quality hedge funds in REDUCING portfolio risk.

Hedge fund crisis?

2007-07-26T18:19:00.013+09:00

Real hedge funds ought to thrive in a financial crisis. It is when market inefficiencies, dislocations and mispricings are at their greatest. The subprime, leveraged loan and structured credit problems are demonstrating the differences between good managers and many unskilled "hedge funds" that simply took on unstable credit risk and illiquid premiums. Long volatility strategies are really the only products likely to profit from market turbulence except perhaps government bonds.

It is important when picking investment styles to differentiate between skill-based and risk-premium based strategies. Funds dependent on positive carry credit spreads can't be considered hedge funds. Many forms of credit and fixed-income arbitrage rely on such phenomena. The yen carry or positive yield curve trades are examples. Similarly with equities only a tiny fraction of emerging market "hedge funds" actually are hedge funds; many are just playing the risk premium often exhibited by such assets during bull markets.

Most public domain arbitrage strategies with a short volatility profile run into problems sometimes especially if leverage and illiquidity are involved. Two years ago we had a CB arb crisis and now we have a subprime led crisis hurting a few beta bandits and helping the alpha dogs. Both situations offered money making opportunities to those managers with the capability to exploit them. Alpha is zero sum so the ONLY way to produce alpha is for other market participants to lose money.

A core strength of the alternative investment industry is performance dispersion. With traditional funds if their benchmark is down, it is likely they are also down. With hedge funds the winners use their abilities and experience to extract money from the losers. It is unfortunate some investor capital has been lost through unjustified confidence in sub-prime linked credit products. This just confirms the need to identify proper hedge funds and even then put in only a small proportion of capital. For many investors that means quality funds of funds will probably be the best entry point. The 80/20 rule tends to apply here; only 20% of hedge funds are any good and only 20% of funds of hedge funds are good at identifying those underlying funds.

In optimizing portfolio construction for alternative investments, I have usually found the maximum an investor should have in any one fund is 5% and therefore 95% in unrelated, independent strategies. Even if one accepts naive credit carry as a legitimate "hedge fund" strategy (which I do not), the most any investor would have lost from these CDO-linked meltdowns would be 5% of their TOTAL alternatives portfolio. If they have spread their bets properly they will also have money with other funds that benefit from the dislocation. That is the reason EVERY investor should allocate to short-biased equity and credit funds; even if the returns have been poor (so far!) the critical importance of negatively correlated strategies to managing portfolio risk should not be underestimated.

Most good hedge funds use quite low leverage, if at all. It is true weaker alternative investment products employing high leverage may blow up which is why due diligence is so important in determining that expertise and robust risk management are evident. Rare event risk and massive losses are hardly confined to incompetent "hedge funds". Pets.com, Worldcom and Enron and thousands of other equities lost all their shareholders' capital but that does not mean people should avoid ALL stocks just because some drop 100%. Hundreds of dotcoms imploded a few years back losing several hundred billion for investors but Ebay, Amazon and Google and many others have performed well. Good hedge funds aren't going away any more than good stocks. The bear market of 1973/74 blew up dozens of long biased beta dependent "hedge funds" while managers like George Soros, Michael Steinhardt and others thrived.

As a value investor I value strategies able to achieve consistent absolute returns at low risk. I think investors should be compensated for risk. When I look at a hedge fund I am looking for a margin of safety - performance should be much higher than the risk. Volatility is NOT risk but it is a useful first cut. Over time the S&P 500 has generated about 8% annually at 15% standard deviation so its returns have been derisory compensation for its risk. Most other equity indices and long only funds offer an even worse value proposition. Investors are better off with products that give DOUBLE digit returns at SINGLE digit risk. 10%-14% a year at 5%-7% sigma is AVAILABLE if you do your homework. 30% a year at 15% vol is also fine but definitely NOT the other way around. Which is common sense - low risk, high return or high risk, low return?

Ideally performance is generated from securities that are liquid and frequently valued. Funds straying into illiquidity need to provide compensation for taking on that much less manageable exposure. Often it is weaker funds that wander into the minefield of assets that hardly ever trade. The analysis get more complicated when a strategy is taking rare event or assumption risk. Several of the recent blow ups gave the appearance of low volatility due to investing in rarely traded, mark to model instruments. If there is a lot of leverage involved you have to look at whether the returns compensate for that gearing and valuation risk.

It is not in the nature of proper hedge funds to blow up, it is the nature of those who have useless trading models, incorrect assumptions, don't understand complex strategies or rigorous risk management to blow up. It all comes down to experience in actually trading the strategies and due diligence in identifying whether the targeted returns are sufficiently high from the risks being taken. For illiquid, mark to model funds, 1% a month was woefully below the required return for any margin of safety in such hazardous credit strategies.

I am typing this watching the British Open golf championship. The subprime crisis is a Carnoustie effect; defined as "that degree of mental and psychic shock experienced on collision with reality by those whose expectations are founded on false assumptions." Sounds familiar with the current subprime CDO crisis giving a classic reality check. A question to ask investment managers claiming to run a hedge fund, "What exposure does your strategy have to the Car-Nasty effect?". If the strategy assumes sunny market conditions and normal distribution fairways, walk away.

There are other parallels between finance and golf. While everyone recognizes there are skilled golfers able to negotiate "random" Scottish weather some deluded souls continue to doubt the existence of skilled fund managers able to negotiate "efficiently" priced markets. Such skill MUST be in limited supply. Of all the people who have ever swung a sand wedge, few would be justified in calling themselves "golfers". Much fewer deserve to be considered "world class golfers". Similarly only a small proportion of "hedge funds" actually are hedge funds and fewer still are world class hedge funds.

Can you imagine the average score at the Open if everyone who said they are a "golfer" played? The media sports pages focus on the stars while the financial pages focus on the losers. When academics study hedge funds they try to study EVERY product that says it is a hedge fund and bothers to report to some database. Hedge fund indices and "investable" hedge fund index funds are an even sillier idea than stock or bond index funds. The indexers would have you believe every large open hedge fund is worth investing in! Even most legitimate hedge funds are avoids, let alone all the impostors and risk premium players.

Lending to the US government at 5% is not a bad bet but seeking a higher yield from slicing and dicing sub-prime mortgages into allegedly bankruptcy-remote vehicles was not. Despite some tranches being highly "rated" they always traded far wider than proper straight debt with the same rating. Some investors place too much reliance on "independent" agency opinions. Debt ratings are paid for by the issuer and most equity "ratings" are purchased by promises of investment banking business. Proper fund managers pay little attention to what analysts think of a security and are sceptical of ratings agencies. Just because Moody's or Standard and Poor's say something is AAA does not mean it is. There was nothing "High Grade" about those subprime mortgage concoctions, ever, for the simple reason that the modeling assumptions were clearly dubious ahead of time.

It was absurd to assign a measure originally designed for rock solid government and corporate debt to the untested, till now(!), financial alchemy of LSS, CDO, CLO, SIV and CPDO. It is applying a fundamental balance-sheet metric to model-based credit structuring using wildly optimistic assumptions of default and recovery rates and correlations of different borrowers. Collateral is "sound" only if someone else will buy it at prices you assume. Asset-backed securities ratings depend on realistic, frequent valuations of those underlying assets.

Subprime started impacting the markets 6 months ago. If product structurers want to rate shop for a sellable classification that is their freedom but investors should not rely on them. The only bonds "investment grade" are those assets whose future possible rewards compensate for the future possible risks. How shortsighted to gain a few hundred basis points for a while but end up losing 5,000-10,000 basis points.

Just because MSCI, FTSE, Nikkei or any other benchmark providers makes the active decision to place a stock in their "passive" index does not mean it is any good. If a broker's stock analysts say something is a "strong buy" that does not mean you should not short it. The "ratings" put out by various firms on hedge funds and used in hedge fund "index" construction are even less reliable. I have seen industry awards given to "top" hedge funds that weren't even hedge funds and some that imploded soon afterwards.

It all comes down to doing your homework backed up by due diligence and advice from those who truly understand alternative investment strategies. And diversifying sufficiently so that possible negative performance of any one fund or strategy does not have a debilitating effect on your portfolio. Twenty hedge funds managing very different strategies that have little correlation to each other is probably the MINIMUM number necessary.

What is a hedge fund?

2007-07-08T02:07:00.017+09:00

What is a hedge fund? Forward looking due diligence on whether the manager's strategy is likely to produce absolute returns in DIFFICULT periods is surely the acid test. The subprime meltdown has revealed MANY beta repackagers but their bull market credit dependence was OBVIOUS ahead of time.

Anyone with genuine skills and experience knows illiquidity gets expensive during financial turbulence. Hopefully other funds dumb enough to gear up investments in subprime CDOs and other credit exotica and think they wouldn't have to pay the piper will be wiped out. Like every meltdown it is a POSITIVE development and alpha opportunity for REAL hedge funds.

Subprime mortgages still seem to be causing trouble and the effects are NOT yet fully "contained" despite what the vested interests claim. Some real hedge fund managers like John Paulson positioned well and some credit risk premium players like Bear Stearns Asset Management, Dillon Read Capital Management, Queen's Walk and Caliber revealed their lack of skill and NON hedge fund status.

There WILL be others; skill is rare so other incompetent "hedgies" marketing themselves as hedge funds have probably been caught out. Being forced to adjust April performance numbers from -6.5% to -19% shows just how poorly Bear Stearns's portfolio managers had stress tested for difficult conditions or understood credit markets. Why do amateurs think the good times will last for ever?

There has been a lot of commentary on the so-called Bear Stearns hedge fund debacle. It will indeed negatively affect the markets particularly in leveraged credit structured products but it just enhances the case for quality hedge funds. It was clear since inception that Bear Stearns' two troubled credit investment products were never hedge funds. They were just playing credit risk premium spreads and dependent on stable credit conditions.

A few due diligence questions to detect a proper hedge fund IN ADVANCE. 1) Will it make money in a bear market for equity or credit? 2) Are the potential returns sufficient to compensate for the illiquidity risk? 3) Is most of the personal wealth of the senior management of the sponsoring firm invested in that particular product? A true hedge fund would be able to answer "yes" to each question but it was all "no's" for the elegantly named Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund and its "safer" sister. More questions 4) Will you blame funding counterparties if you blow up? 5) Is your "hedge" really a hedge? 6) How independent is your "independent" valuation. There is NO excuse for not understanding how the game is played or the behavior of your portfolio in ALL scenarios. There have been numerous credit collapses in the past; it is only if you just look at "recent" data that credit looks consistent.

The familiar problems of overoptimistic model assumptions, stale valuation, gearing up thinly traded assets and disguising beta as alpha to charge higher fees emerge yet again. Whether it is SIVs, emerging market equities, rare metals or violins, if a fund isn't likely to thrive during future NEGATIVE return periods for the assets in which it trades then it is NOT a hedge fund. Investors should not relax the criteria differentiating a real hedge fund from a bull market product. Hedged means you are able to manage your risks and STILL generate performance with such insurance in place. I can't forecast but I can certainly anticipate and prepare for ANY eventuality.

Credit hedge funds will receive end of quarter pricing marks soon. Will others soon join Bear Stearns, Cheyne Capital and Cambridge Place in getting rather different prices than their "mark to model" valuations implied? Definitely. Pricing to a model is fraught with issues not the least of which is ASSUMING the model is correct. There was obvious serial correlation and Sharpe ratio "enhancement" when I looked at those funds and some others in the credit space over a year ago. Model arbitrage is a great investment strategy since counterparties tend to think they have made money out of you, until the tide turns. Then they also discover that they are short lots of optionality and will not be able to cover that negative liquidity, convexity and gamma anywhere near prices they assumed.

The biggest risk in pricing models is Assumption Risk. The trouble with bull and bear markets is that the price behavior and the width of bid-offer spreads can be quite different under the two regimes. If you are in roach motel assets getting out can become expensive. Bear Stearns was leveraged long CDOs of illiquid securities and "hedged" by shorting liquid ABX indices. As with similar problems in the past, the funds were long illiquid, short liquid. If a fund is leveraged and can only sell to a limited number of counterparties that KNOW it has a problem, getting out becomes difficult. Software for measuring risk doesn't help when risks are unmeasurable. And aren't you supposed to have proper risk management in place BEFORE you lose money not AFTER the fact?

You really have to know what you are doing when designing models of prepayment and mortgage default risks; nothing in the academic literature or public domain works. Credit is neither stochastic nor continuous and when it jumps it really jumps. I can count the number of good mortgage-backed securities hedge funds on one hand but I would need many more limbs for the traders who have been blown away by not having adequate trading AND quantitative abilities to manage ALL the exposures in this complex field. When a product is very thinly traded, indicative dealer prices are pretty useless. If a fund is investing in illiquid instruments the fund valuation needs to be marked to the real bid, in size. Mark to market is possible only when there is a market.

There is nothing inherently wrong with investing in "untraded" assets provided the risk-adjusted returns are sufficient to compensate. In bearish credit conditions ideally you usually want to be long the liquid and short the illiquid but weaker credit funds and less experienced managers do the opposite. Of course there have been skilled hedge funds in the areas of distressed debt and collateralised loans for a long time but their returns have justified the risks. But with some funds, even with apparently high absolute performance, often the excess RISK-ADJUSTED returns (the alpha!) was negative.

Just as with Long-Term Capital Management, being long the illiquid and short the liquid works well until the market reverses and then years of consistently positive months get given back in one massively negative month. Leverage, liquidity and valuation risks are ONLY worth taking if you are compensated for those risks and plainly this was not the case. This is where investors in a hedge fund need to look at whether the potential returns justify the potential risk. With good hedge funds it does but NOT with the many "hedge fund" journeyman.

With public equities, liquid bonds, fx and futures valuation is immediate, transparent, generally unarguable and there is plenty of alpha available in these liquid arenas IF you have the tools and expertise to find it. While liquidity is a variable even on an exchange you have access to the widest number of potential buyers and sellers. Venturing into illiquid areas raises the risk exponentially when there are much fewer counterparties to trade with. Leverage just exacerbates those problems. Funds investing in illiquid assets should be targeting MUCH higher performance than liquid funds as compensation for that extra risk. Yet some investors seems to compare them side by side without modelling the non-linear risks of gearing thinly traded securities.

What's even worse than a closet index fund? A leveraged closet index fund. And that is what most of these toxic waste CDO funds were in effect running. Making money in BAD conditions is what hedge fund clients pay the 2 and 20 for; long only funds are the ONLY products you need in good times. Having criticised some of John Bogle's thinking in my previous post let's make something clear; index equity and credit funds are the best investment IF (and only IF!) you think the asset class is going up. It is a waste of time and money to allocate to higher fee actively managed funds that simply fall apart when their underlying market falls apart.

Investors need to verify that a money management product purporting to be a hedge fund and charging hedge fund fees actually is one. Out of 10,000 funds that claim to be hedge funds, how many actually are hedge funds? The best estimate I have is maybe 25% tops. But of those how many are skilled? Perhaps 500-1000 at most. In other words probably only 10% of products that say they are hedge funds actually are GOOD hedge funds. Skill is rare by definition. While some investors might be discouraged by the bad news of 1/10 odds of picking a skilled fund, the good news is that they CAN be isolated in advance.

Identifying a good hedge fund is as rare a skill as being able to identify a good security. Some multi-manager products and weaker funds of funds have reduced their fees because they think picking hedge funds is easy! Most of them don't have the experience or analytical resources to decide what is and what is NOT a hedge fund, let alone trying to find the BEST ones. It is difficult but NOT impossible. Do "lower" fees help if an "advisor" puts you into a fund that drops 100%?

There will always be semantically-challenged products that screw up which is why due diligence and alignment of interests are so important. Investors should select real hedge funds NOT leveraged beta products that SAY they are hedge funds. The industry needs to rid itself of non hedge funds who can't measure, manage or hedge their risks and ride beta when proper managers aim for alpha. Fortunately we can rely on the market to conduct these shakeouts over time. Unfortunately for some amnesiac investors it has been a long time since difficult credit conditions.

The colleagues of Ralph Cioffi may have liked the fund but how much personal cash did James Cayne have in? A necessary condition for a product to be considered a hedge fund is to verify senior management are eating their own cooking. In bull markets many unskilled traders make money; it is bear markets that tend to show who is good and who knows how to hedge. Many REAL hedge funds are MAKING MONEY out of these ongoing credit events. Marketing something is a hedge fund does not mean it is.

John Bogle versus hedge funds?

2007-06-16T22:47:00.066+09:00

John "Jack" Bogle still likes risky index funds despite the availability of skilled strategies, hedging tools and proper diversification nowadays. After many years below the S&P 500's high water mark and another 50% drawdown it is time to review Bogle's new novel "The Little Book of Common Sense Investing". Unfortunately the title is wrong as there was very little common sense in the book. Investors do NOT need to risk their retirement on "cheap" long only funds. Bogle even thinks people should SPECULATE their savings on the stock market eventually rising! I don't.

Bogle considers EVERY stock to be worth investing YOUR money in. In the real world few equities are "buy and holds". Incredibly he says the largest stocks should get the biggest allocation! There are safer ways to invest than "passively" owning what someone else ACTIVELY decided to include in an index. Why endure massive losses and long periods before a manager makes new profits? An index fund is riskier and more expensive than a real hedge fund. Such a LOW return on HIGH volatility is unsuitable for conservative, long term investors like me. "Passive" managers levy outrageous fees for poor performance, zero skill and devastating drawdowns. Yes investors, you CAN diversify away systemic market risk.

Index funds versus hedge funds is about PRICE versus VALUE and good hedge funds have proven their superior value proposition over many decades and after fees. It is time John Bogle looked at modern ways of managing money with an open mind rather than regurgitating misinformed views about strategies he clearly knows nothing about. Why would an investor today sign up for the often negative and unstable performance at ABOVE average risk of Bogle's "invention" when investment INNOVATION has progressed far beyond the stone age world of long only? Good hedge funds obliterate index funds in terms of risk adjusted returns in ALL market conditions. Index funds simply obliterate peoples' wealth in bear markets. Any investor who knows what they are doing avoids index funds like the plague. Far too dangerous.

Investing is NOT simple. Bogle cites Occam's Razor where the "easy" solution is supposedly optimal. William of Ockam has been misinterpreted and actually wrote "Entia non sunt multiplicanda praeter necessitatem". It is the simplest choice amongst VIABLE solutions that works. Index funds are too simple to be suitable for such ontological parsimony. The correct answer is multiple strategies within and across multiple asset classes and hedging and reducing risk as much as possible. William of Ockam would have seen quality absolute return funds as the answer not the risky trap of just holding assets. Things are also more complex today; when Sir William entered Oxford University 700 years ago, long only commodities and real estate were the only investment choices available.

Is it really common sense to claim investment skill does not exist and investors should not try to identify good fund managers? I guess not many people would want to ride in a car driven by John Bogle. Maybe he would just place a brick on the accelerator, remove the steering wheel, gaze at the rear view mirror and await the nice destination he anticipates. No need to worry about ongoing risks and economic obstacles in the path to riches when huge capital gains loom in the so-called long term.

Bogle says people should just ride out drawdowns no matter how much money his preposterous products lose. Is it "sensible" to suggest ignoring those 401(k)statements since they will supposedly be fine some day far into the future? John Maynard Keynes pointed out what happens in the long run so isn't it better to GROW and PRESERVE capital in the short run? Is it common sense to own every stock Standard and Poor's actively DECIDED to include in their S&P 500 index regardless of the underlying economic conditions and business environment for each company?

Is it sensible or prudent to passively hold onto value destroying corporations when you could be short selling or actively engaging them? Keynes said: "When somebody persuades me that I am wrong, I change my mind. What do you do?" but Bogle says to buy and hold the constituents of some arbitary benchmark no matter what. Absurd "advice" that will cost investors dearly WHEN the recession begins.

Successful ACTIVE investors like Warren Buffett join the pro-index brigade despite avoiding index funds themselves. This "Do as I say not as I do" is weird. Why does Warren have a quote on the book's cover supporting index funds when he manages a foreign exchange and commodities trading, merger arbitrage, event driven, distressed securities, bid for Long-Term Capital Management, own a few core stocks, multistrategy hedge fund called Berkshire Hathaway and has outperformed the S&P 500 since the 1950s? In actions, not words, Buffett's performance is an argument AGAINST indexing and FOR actively managed absolute return strategies.

Buffett's mentor Benjamin Graham was also a successful hedge fund manager. Graham wrote that "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." Since index funds do NOT promise SAFETY OF PRINCIPAL, they are therefore speculative! "Don't take my word for it" as the Intelligent Investor himself would clearly have favored the hedging and limited drawdowns from quality hedge funds versus the lack of capital preservation of index funds. The performance is unsatisfactory and inadequate compensation for the RISK of long only.

Bogle claims index funds are the "only way to guarantee stock market returns". Really? I think ABSOLUTE returns are what an investor needs, not guaranteeing their share of stock market crashes, deep drawdowns, high volatility and sometimes decades of losses. There is no need to take outright market risk when there are so many inefficiencies and mispricings to exploit in global markets. Skill does exist and CAN be identified ahead of time and in my experience alpha is actually more reliable than beta. Strategy diversification, risk management and hedging against disaster are surely more sensible than the unhedged gambling that Bogle favors.

Risk tolerance? I have little tolerance for risk which is why I invest in good hedge funds. "Passive" products are simply too volatile and unreliable for conservative investors. Staying below their high water mark for so long is unacceptable especially when there are superior alternatives. John Bogle's followers were "lucky" to get back to breakeven TEMPORARILY after just 7 years compared to the 17 year drawdown from 1965-1982 or the devastation of 1929-1954. And check out 1905-1942 for a 37 year zero growth nightmare. Should an investor have to endure even the possibility of waiting that long? 2005-2042?

I don't dispute that "passive" funds will likely outperform many, though not all, long only active managers over time. Skill is rare by definition. However that reflects the fact that UNHEDGED funds are too constrained and that talented fund managers are more likely to be at good hedge funds than long only funds. An AVERAGE hedge fund is not worth investing in but SKILLED hedge funds can be identified in advance IF you know what you are doing. Ben Graham and several Nebraska doctors backed Warren Buffett BEFORE his success as a hedge fund manager.

Hedge funds are not mentioned until "Funny Money" in a scathing, poorly researched, diatribe near the end of Bogle's book. "Too much hype"? Most hedge fund commentary is negative so what hype is Bogle referring to? Does he mean the REALITY of top hedge funds delivering absolute returns and preserving capital unlike the "cheap" products he pushes? Hedge funds don't just "invest in the very stocks and bonds that comprise the portfolio of the typical investor"; they use futures, options, derivatives, short selling, new kinds of assets and diverse holding periods to REDUCE risk.

Hedge funds offer "too many different strategies". That's a criticism? You need as many performing strategies as possible; it is a strength of the hedge fund industry not a weakness. Some hedge fund managers are successful and closed because their investors made far more. Index funds are the compensation strategy - you don't have to do much work but you still get paid that huge 18 bp for no work. And the extra layer of fees of a good fund of funds more than justifies itself in paying for evaluation, due diligence and monitoring of common sense investments like hedge funds.

The tyranny of fees fails to consider the product's value. Interesting how people get irate over hedge fund managers making a billion for doing a superb job while the firm Bogle founded levies exorbitant fees on $1.1 trillion and does NOTHING to hedge risk or avoid losses. For what you are getting in terms of risk-adjusted absolute returns the fees charged by proper hedge funds are CHEAPER than index funds.

The "low" fee charged for "managing" passive funds also obscures their enormous OPPORTUNITY COST for investors. While trillions have been languishing for almost a decade in index funds, vast money making opportunities have been missed. Such "common sense" is EXPENSIVE as investors await the assumed upward trend to reassert itself. Bogle also writes of the MIRACLE of compounding but fails to mention the MISERY of negative compounding that wrecked so many institutional and individual investors' portfolios.

Bogle argues for owning "all the nation's" publicly held companies. Which nation? All the companies? Just the biggest firms? Why just the public ones? Most companies are private. Good venture capital and focused (smaller!) private equity funds can offer excellent performance. By the time a company makes it to IPO a high percentage of its growth is often over so why shouldn't investors access private companies. A stock that makes it to the elite S&P 500 has already been a winner for years and there have been many instances of index trackers forced into buying the top but they NEVER have the opportunity to buy the bottom.

Although considered "passive" the S&P 500 is quite actively managed as companies go bankrupt or get acquired. If you had bought the ORIGINAL 500 components in 1957 and held on with no adjustment whatsoever you would have OUTPERFORMED the "real" S&P 500 at slightly LOWER risk even though only 86 names survived 50 years. That should be a very strong argument for TRUE buy and hold but John Bogle doesn't use it, instead pushing the frequently updated quasi-active index.

Innovation is always hated by salesman with a vested interest in the status quo. Predictably Bogle is also not a fan of the equally weighted and fundamental indices that have appeared in recent years or ETFs. Bogle even thinks Exxon XOM and General Electric GE have the best stock price appreciation prospects; a sad consequence of cap-weighted indices is the biggest stocks get the largest percent of your money, regardless of prospects or valuation. Surely common sense is for your cash to go to the BEST stocks not necessarily the BIGGEST stocks.

Why does the intellectual force behind passive capitalization-weighted indices urge a large active bet AGAINST global weightings? Bogle's "advice" to keep 80% of an equity portfolio in USA stocks is simply wrong, insufficiently diversified and logically inconsistent with his indexation argument. The world has moved on and such geographic constraints are not common sense. Investors need ALL of their equity portfolio allocated to the best opportunities wherever that may be. The USA is less than 45% of world market cap and the proportion drops each year. If an investor is a true Bogle diehard then their portfolio should surely be in line with global market cap. 40% of equity in US stocks in the correct "passive" amount.

Japanese stocks were BY FAR the best performers last century. But that is in the PAST. The Nikkei HAS, over the long haul, vastly outperformed the S&P 500 though of course not over the short or medium term! Even though still far below its high and having trodden water for over 17 years, US investors would have done MUCH better holding Japanese index funds for 50 years than US index funds. John Bogle does not mention this either and is generally quite negative on "foreign" equities.

Japan outperformed because decades ago it was an emerging market and offered similar VALUE to certain OTHER opportunity-rich countries today. Based on Bogle's relentless rules of humble arithmetic the dollar return on the Nikkei was MUCH higher than the dollar return on the S&P 500 so, according to his performance chasing logic, should not he be urging Japan as the main common sense investment given his bizarre assumption that past is prologue?

Long term performance has little to do with long term investing. In fact some hedge fund managers with the best long term track records have the shortest holding periods. Steady capital growth does indeed the win the race but index funds are anything but steady. Good hedge funds are the reliable tortoise to the volatile and unpredictable index hare. Equity indices were designed to simply benchmark long only active managers; they are NOT a suitable product for conservative investors to actually put money in given the absence of risk management and high volatility.

You can read the John Bogle blog. Common sense is going with investment skill and the hedging of risk not this Boglehead nonsense. Investors need ABSOLUTE RETURNS, not EXPENSIVE "passive" products that are guaranteed to lose money in a bear market. Staying the course makes sense if you know the destination AND the route. There are safer vehicles for anyone's money than index funds.

130/30?

2007-05-26T23:44:00.040+09:00

130/30? Hedge fund lite? Is the information ratio really higher? Adding some short sales is a step in the right direction away from risky long only but why slightly adjust the performance straitjacket instead of removing it entirely and selecting REAL hedge fund managers to produce alpha in the best, UNCONSTRAINED way they see fit? Vary gross and net exposures as market opportunities occur.

During bear markets, the "innovation" of adding 130/30 funds to portfolios is as useful as rearranging the Titanic's deckchairs. 130/30 is about being able to put on significantly negative ideas on smaller cap equities which are precisely the stocks which have less borrowable supply, a higher lending fee and are more prone to short squeezes. The RETURN ON RISK for most 130/30 strategies will be worse than 100/0 funds despite what the marketing presentations claim.

130/30 is not a hedge fund strategy and does not diversify a portfolio. Relative return is NOT absolute return. It might seem "cheaper" than a hedge fund but what are investors actually receiving? Anyone still wary of hedge funds should remember that these "new" products are riskier than a PROPER hedge fund. 130/30 strategies have higher volatility and WILL lose money in a down market. Short extension is about beta NOT alpha. It is time EVERY investment mandate required fund managers to MAKE MONEY no matter what, not simply to meet some antiquated notion of "asset allocation". Absolute return is the ONLY way to go.

Why invest in 130/30 when there are so many better skilled strategies around with genuine alpha? Of course even in the strongest bull markets some stocks drop and the freedom to implement negative views on specific securities is mandatory for quality fund managers. So if an investor likes the idea of 130/30 here is what I would do:

1) Pick some good equity long/short hedge funds and put them in the equities allocation NOT the alternatives bucket. Hedge funds are NOT an asset class. Most equity hedge funds are long-biased anyway and provide enough exposure data to construct an overall 130/30 portfolio split. Same effect but MORE skill.

2) Allocate $1.3 billion to some good LONG ONLY traditional active managers. And put $300 million with some quality SHORT ONLY hedge funds. Construct your own double alpha 130/30 portfolio by accessing FOCUSED performance-driven managers skilled in selecting either good or bad stocks.

The main argument for 130/30 is that it supposedly maximizes alpha for a given level of tracking error. But does it? There is a lot of smoke and mirrors in that contention and conveniently confuses net exposures with gross exposures. The net market exposure is 100% but the gross exposure is 160%. With 130/30 it seems the CORRECT benchmark is often more like 1.6*beta NOT 1.0*beta. It is the common trick of making beta resemble alpha through leverage.

In a real hedge fund the net exposure of longs MINUS shorts offsetting each other can be the better metric but the way many of these 1X0/X0 are being presented longs PLUS shorts looks more applicable. Alpha is the excess RISK-ADJUSTED performance NOT any return above the unleveraged index. I doubt these products will exhibit less volatility than a normal long only fund. 130/30 are taking MORE risk than an index fund so their appropriate benchmark is not the index.

Then there is the information ratio or alpha divided by tracking error. 130/30 only maximizes the information ratio if more alpha REALLY was generated as a result of that increased market exposure without a similar trade off in volatility. If the S&P 500 goes up 20% the chances are alpha was only generated ABOVE 32% (1.6*20) NOT 20% as they claim. In the dire panoply of misleading performance measures, tracking error targets are a sad example. Investors are basically saying to a manager "Please beat the benchmark by a tiny bit but not by a lot". Dumb.

Next time the S&P 500 drops 50% (and it will!) do you want a low "error" or a high one? The only thing obsessing with tracking error achieves is GUARANTEE that relative return managers follow the index crowd over the cliff. I think ALL fund managers should be hired for one reason alone: to make money into MORE money. If they have their own assets in the fund and are performance-driven NOT asset growth driven the interests with their clients are better aligned as is the inclination to hedge risk. Active risk is minor compared to the absolute risk of the stock market.

Constraints impede risk-adjusted performance. Good hedge funds work because of flexibility in dynamically altering their market exposures. Simply relaxing the no-shorting constraint a little doesn't help and neither does this active short extension or enhanced indexing nonsense. A manager should be allowed to be positioned 190/10, 100/100 or 10/190 and sometimes 0/0 all in cash) if they deem necessary. Active fees pay for market judgement and risk management more than anything else. It is worth noting that in a bear market 130/30 or 1X0/X0 asset gathering products WILL have negative returns. It is STRATEGY allocation that matters not minor changes to ASSET allocation.

130/30 products don't do much to diversify a portfolio. The STRATEGY is the SAME as 100/0; long biased stock picking but just with wider bounds on overweighting and underweighting specific securities. The argument is that it allows more meaningful underweighting of the smaller cap index components. But short selling also opens up issues that a shorting neophyte takes at least a decade to develop the necessary experience in. Short positions get LARGER as you LOSE money. The worst case scenario on a long is losing 100% but better risk control is needed on shorts given unlimited upside.

And there are the ongoing issues of a short sell candidate possibly not being available, being recalled, dividend payments and short squeezes. The adjustment from simply zero weighting a stock to a negative weighting is NOT trivial; it requires many years experience of ACTUALLY shorting. Some firms that have shown limited ability to produce alpha on the long side claim they can now generate "enhanced alpha" by having the freedom to operate on the more difficult - for them - short side.

130/30 is really a dispersion or equity correlation trade. It has been difficult for weaker traditional "quant" long only managers to produce alpha because the bull market led to low dispersion. They claim that by allowing 20-40% shorting it allows them to have a better chance of making some money. But why not allocate instead to hedge funds that have traded dispersion and correlation for many years? Why not use put options to implement the short side and avoid the complications of shorting? Why not equitize a 30/30 market neutral fund by overlaying an index swap or future yourself? Dispersion also varies; in a bear market correlation between stocks tends to be much lower. There are also ongoing issues of position sizing and weighting each stock in these more complex portfolios.

Why procrastinate with this intermediate step towards unconstrained, absolute return mandates? Why put money in a non-diversifying, limited track record product where alpha is calculated on the net exposure while the risk (and fees!) are more dependent on the gross exposure? The ONLY tracking error that ACTUALLY matters is not to an arbitrary stock index but to the assumed actuarial return. In terms of matching assets to liabilities good hedge funds have the LOWEST portfolio tracking error.

Do the due diligence, pick some good hedge funds and let the manager decide how to vary their net and gross exposures. A truly prudent investor would not look at 130/30 when lower risk funds are available from dedicated specialists. Active extension funds have little to do with absolute return and the ONLY reason to hire any money manager, whatever the style, is for ABSOLUTE RETURN. 130/30 is another spin on relative return so why bother?

Hedge fund arbitrage?

2007-04-30T23:22:00.016+09:00

Hedge fund arbitrage? Proper hedge funds identify securities that are trading above or below their "correct" price. Some would argue that arbitrage only applies when the same security is bought and sold simultaneously with zero residual risk. Economists even argue there can be no such thing as arbitrage since any such trade would quickly be copied and therefore eliminated! They are WRONG.

An academic metaphor is that if a $100 bill were dropped in the street then it would immediately be picked up therefore no arbitrage can exist or persist. But what if YOU happen to be the person that finds the note? Someone will. What if you specialize in walking the streets 24/7 looking for drops? What if you spent some of the "high" fees on lots of employees and technology to monitor more streets in many other cities and countries?

What if you had the lowest latency execution and modeled peoples' behavior so you could identify the streets with the highest probability of rewards. What if your costs are low enough that you can make a profit from picking up $10, $5 or $1 bills - even quarters? What if your computers are so quick they can catch the cash BEFORE it hits the ground? What if you monitored areas no-one else had thought to look? If you have the patience and resources there are plenty of arbs available in the markets just as money gets dropped in streets every day.

Of course this can be taken too far and if the arbitrage becomes well known it becomes hazardous. Nickels in front of steamroller strategies are dumb deals where brash traders and incompetent Nobel laureates risk their fund for 5 cents and end up getting crushed for billions. Arbitrages in the PUBLIC domain will inevitably disappear. Transparency is the enemy of arbitrage so opacity is essential. The arbs you want are $100 bills and no steamrollers in sight. The best trades are waiting until there is some easy money in a corner and just wandering over and picking it up.

There are several hedge fund arbitrage strategies of which statistical arb, merger arb, fixed-income arb, capital structure arb, volatility arb and CB arb are perhaps the most well-known. Naive investors even consider these to be "non-directional" which is unfortunate as there is always some directional dependence inherent in a strategy. But within these categories there is a vast difference in the skill and methodologies by which these arbs are implemented. Probably only plain vanilla merger and CB arb are arbed out but even within those there is plenty of room to find non-vanilla opportunities. You just have to be VERY good at what you do. Better than 99% of other "professionals" in the strategy.

Some arbitrage amounts to short selling the liquid and going long the illiquid. That usually works fine in a bull market but can get hazardous when bearish times emerge. Some strategies have become so well-known that doing the opposite can make sense. REVERSE merger arb is betting on an announced deal NOT going through; spreads are so tight on most deals these days that the profits on one deal breaking can more than pay for other losses. REVERSE distressed debt is where you buy credit default options on "highly rated" securities likely to become credit impaired. Performed perfectly in the recent subprime mortgage and CDO debacle.

The carry trade whereby yen or swiss francs are borrowed and sold short and the proceeds invested in something with a higher yield is considered by some to be an arb. A common interest rate "arb" is borrowing short term to invest long term. There is a fair amount of commodities "arb" around playing contango and backwardation term structure. Activist equity and distressed debt hedge funds arb the difference between undervalued assets and their estimated true worth. Too many people have the carry trade on so REVERSE carry is NOW likely the best trade. Buy Japanese yen. NOW!

Lesser known but no less lucrative is model arbitrage. This is where a fund takes advantage of mispricings usually of fairly exotic derivatives and structured products. With counterparty global investment banks all keen to be seen at the "cutting edge" of financial engineering, their different models, software and underlying statistical assumptions can lead to pricing anomalies. It can be as basic as different interpolation methodologies of interest rate, credit and volatility term structures. Even a few basis points adds up when leverage, convexity and optionality get thrown in. Some providers don't seem able to measure correlation or credit risk correctly. Sometimes however the "error" is more subtle often involving stupid stochastic model based mumbo jumbo. A true quant is someone that arbitrages the other quants!

Other equity "market neutral" strategies are "analyst arbitrage" and "IPO arbitrage". A manager uses a carrot and stick approach to ensure they are the "first call" on sell-side analyst rating changes and to get into lucrative IPO allocations. Usually the carrot is paying high commissions and the stick is threatening to take their business elsewhere. There are several "hedge funds" around whose performance is NOT due to stock picking or trading ability but entirely due to their "skill" in analyst arb and brokers seeking favor by providing "market color" on other clients' positions and imminent transactions for front running. Is that skill? I don't think so and I don't allocate to those funds.

Algorithmic trading is so popular these days that arbing some of the more popular trade execution systems can work. Trend following has become so well known that arbing trend followers is possible; trends are readily identifiable therefore it is quite easy to know what positions certain funds have on. Once a particular trend ends, their behavior in exiting the trade can become predictable and exploitable. Again this is where black box trading systems must remain opaque otherwise performance will be temporary. Very temporary.

While the dictionaries need to be updated and the academics educated, arbitrage could be considered to form the basis of everything a true hedge fund does. Namely the identification, monetization and risk management of market inefficiencies, anomalies and mispricings. That's as good a hedge fund definition as any. Given the trade secrets involved in the best arbitrage trades one wonders how hedge fund "replication" can offer much value. Most arbs are not easy to find or exploit which creates high barriers to entry. Interesting how arbitrage wasn't among the list of misunderstood terms in a recent survey of hedge fund definitions. Much arbitrage is really spread trading. Some spreads are reliable but many more others are as risky as the outright position.

The inspiration for this post came from my wandering over to pick up some arbitrage profits that had been lying in the corner courtesy of the ISE. Having begun my financial career designing volatility arbitrage strategies and the current options trading boom it seemed obvious that ISE would likely get bought out at a good premium. It was an "arb" because the acquisition value of ISE was clearly higher than the value accorded it by those "efficient" public markets. Ironically the calls on ISE itself were massively undervalued due to the marketmakers STILL using that idiotic Black-Scholes option mispricing formula.

If only it was always as easy as that. Most arbs are more difficult to identify. Good arbitrages are never signposted but they are out there and ALWAYS will be.

Credit hedge funds?

2007-04-24T23:02:00.007+09:00

Credit volatility has been dormant for years but I doubt for much longer. The hedge fund industry has benefited from easy credit. Funding costs have been advantageous allowing cheaper exploitation of market anomalies. With bond yields so low there was inevitable demand for higher performance. But some popular alternative investment strategies will NOT do well WHEN we enter a period of turbulence. In particular when real estate markets sneeze, credit markets catch pneumonia.

There is a good number of CDO, CLO and CPDO structurers, credit derivatives traders, private equity gurus, overleveraged real estate speculators and benign credit dependent fund managers marketing themselves as "hedge funds" that have little experience of such conditions. Funding and leverage has been cheap for a long time. The infamous yen carry trade made borrowing almost free for those ignorant of the risk. Many borrow short term to invest in the illiquid end of the curve.

It is ages since we had genuine market volatility. The last time we had real US interest rate uncertainty was 1994, a year in which several "hedge funds" that had been considered skilled were revealed as having been previously lucky. The search for yield has reduced credit spreads enormously yet such spreads will not do well when turbulence returns. Private equity and real estate are very dependent on steady borrowing and mortgage costs.

Hedge fund performance is not indexed to inflation. In the 1980s many risk free rates round the world were in double figures. Hedge funds in those days HAD to produce much higher returns to be worth investing in. A few strategies benefit from rising rates; for example managed futures and short biased funds have large cash balances. Put option prices drop as rates rise so those hedging costs reduce. But some hedge fund strategies are negatively exposed to rising rates, costlier credit, steeper yield curve twists and shifts and lower interest rate differentials between currencies.

A lot of time is spent on the alpha versus beta debate but little consideration is given to another equally important but often ignored greek letter - rho or the sensitivity to changes in interest rates. Some hedge fund strategies have negative rho, that is depend on interest rates staying low. Ironically pension funds have positive rho as rising rates permit them to use a higher number to discount future liabilities. That can be a pyrrhic victory because on the asset side of the balance sheet their portfolios of stocks and bonds tend to fall in such times. It therefore makes sense for investors to diversify with OTHER strategies that tend to perform well in a RISING interest rate environment.

Some fund of hedge funds target relative returns like LIBOR + 400bp and not an absolute return. This is an attempt to look "institutional" but ignores what risk free means. LIBOR is not risk free. In Japan that hurdle implies an easy 5% a year while in Iceland that means a much tougher 20% hurdle. Surely an absolute return strategy necessitates an absolute return target. It is not as though most hedge fund returns will magically ratchet up if rates rise. It would be better to aim for an absolute 10% or 15% depending on the risk profile than some relative benchmark. Some "market neutral" hedge funds tout their alleged dollar, market cap, beta and delta neutrality but are not rho neutral. And is a single digit target return even worth the trouble when you can get 5% without risk in the US and more elsewhere?

Hedge fund performance measures also have negative rho. Sharpe, Sortino and Information ratios change significantly depending on what risk free rate is selected. All go lower as the risk free rate in the numerator rises. Yield curves are pretty flat but choosing the lowest point on the curve makes a significant difference. The same hedge fund performance will have very different reward to risk ratios depending on the rate and base currency. In the early 1980s there were some very good hedge funds around with poor Sharpe ratios because risk free rates were in the high teens.

Negative rho can be as dangerous as negative gamma but many investors don't realise how short rho they are in their total portfolios. Rho sensitivity has been ignored for a long time by many market participants. Many countries are already in the process of renewed inflation. Stress tests for credit sensitivity are always necessary. The BEST hedge funds do this but NOT all who claim to be hedge funds.

Private equity fund?

2007-03-23T23:04:00.018+09:00

Private equity IPO? Private equity going public? I still haven't heard a VALID reason why a private equity firm would need to IPO but I will be short selling any that do. If an investment firm wants to keep and lure talent, it would be better to stay private. Apart from undermining private equity's core philosophy and marketing pitch of the advantages of being private, this is a clear sign the future prospects are not good for big private equity deals.

Most private equity funds are simply repackaged public equity beta combined with toxic illiuqidity and use of leverage. Stock markets may change BUT investor behavior remains reliably consistent. It is astonishing that anyone is considering buying into such massively overpriced IPOs. Sad also to see some formerly good firms become journeyman asset gatherers along with creating INEVITABLE conflicts between limited partner and shareholder interests. An IPO is a signal to LPs to immediately get out of future capital commitments on the private equity secondary market. If they can.

Also interesting is that Blackstone only produced a 23% IRR on its LEVERAGED private equity funds which means LPs would have done better simply leveraging a public equity large cap value fund. Adjusting for risk and comparing that long only return to the best hedge funds, the HISTORICAL performance was poor - in fact negative alpha. The FUTURE outlook for big private equity is MUCH worse. Private equity is NOT an alternative investment. LBOs are dependent on cooperatively cheap credit but even then still only achieves a derisory aggregate risk-adjusted return.

Many hedge funds shut down last year. This is portrayed as a "negative" for the industry but it is healthy and Darwinian. "Shut down" rarely means "lost all the money". Beta dependence still bails out many weaker funds. We ought to lose at least the bottom decile ie get 1,000 shut downs each year so it is remarkable how few hedge funds have disappeared, so far. Hopefully the coming bear market, credit collapse and economic recession will reveal who has been swimming naked in the outgoing tide. Private equity WILL also be a prominent disaster as will any banks that don't manage credit risks and derivatives properly. Banks, insurance companies and private equity firms use MORE leverage than hedge funds.

The Blackstone IPO will be wildly overpriced. Then analysts at those same investment banks that overpriced the offering will write reports saying BX is cheap and has terrific long term growth prospects! Where are the regulators? Such hype and hysteria is good news for those able to exploit such pricing anomalies. Market inefficiencies and misvaluations still seem to be available to those with the skills to identify them.

It is comforting to see plenty of irrationality surrounding Blackstone and out of ego there is always opportunity to make money. What did Goldman Sachs say to be left out of the underwriting? Did they dare to use the GS stock pr
ice in the comparables valuation or did someone on the pitch team point out their own IPO in 1999 did nothing to retain or attract talented employees? JP Morgan JPM was also omitted so was it that Marcus Goldman and John Pierpont Morgan ALREADY have century legacies?

Alpha can ONLY be generated when many others will be wrong. There needs to be as much greed, fear, stupidity and emotion as possible in the markets. It would be worrying if no-one bought the Blackstone IPO, no-one put money in Brian Hunter's Solengo Capital, everyone loved hedge funds and always blamed themselves for losing money. If everyone became rational the markets might indeed become random and correctly priced. Clearly this is not remotely the case. The growth of the hedge fund industry has not reduced the vast INEFFICIENCIES in the financial markets. In fact there are more than ever before and that is good news for those with skill.

Hedge funds are now being blamed by some for the recent market volatility. Since "hedge funds" comprise a wide range of strategies, doing different things in different time frames, short and long, it is difficult to see how "hedge funds" can have much to do with it. If anything the recent global mini-correction could have become a major "correction" were it not for hedge funds covering shorts. We have also seen weaker hedge fund managers blaming everyone but themselves for performing poorly. If a trader loses money, it is the trader's fault. No-one else's. Events happen and risks are always present; if you are competent, you prepare and hedge for ANYTHING.

Brian Hunter of Amaranth fame is apparently getting going with a new fund. This is excellent news for skilled energy traders. Let's hope he raises billions. The more silly money out there the more opportunity for smart money to exploit it. I haven't seen the presentation materials yet but no doubt there are plenty of "one off event, thousand year storm, just bad luck, never happen again, strict risk control" powerpoint slides. Real traders do not lose $6 billion, EVER. But it is reassuring that there could be money out there prepared to invest in Solengo even when there are thousands of superior hedge funds. I asked a good commodities hedge fund manager about Brian Hunter; to quote "I made money out of him at Deutsche, more when he was at Amaranth and now it looks like I get the chance to make some more out of Solengo".

The best investments are often those that "experts" consider crazy at the time. The most correct opinions are usually the ones most vehemently opposed. Investors also have to be careful not to confuse intelligence with rationality. Some of the cleverest people around are very irrational. As John Maynard Keynes alluded to with beauty contests, don't buy the things you personally think are good, buy what others think are good. As Long-Term Capital and Amaranth and their unfortunate clients found out to their cost, being intelligent and rational does not help much if the market is not. The market ALWAYS wins those battles.

While I will not be investing with Brian Hunter, I might try getting an allocation in the Blackstone IPO. However I'll be selling out the first day and going heavily short of BX as soon as possible after. Some say greed and fear dominate the markets, but it is actually fear and fear. Fear of missing the boat OR fear of being on the boat. When the recession iceberg looms it will not make much difference which cabin you are in unless you have some true hedge fund lifeboats.

2 and 20?

2007-03-12T19:06:00.036+09:00

2 and 20 fees for absolute returns is a great deal. Demand outstrips supply but some investors still balk at paying for skill. Alpha is like oil - abundant but requiring specialist expertise and equipment to locate and extract. It makes sense that those with the rare talent to generate alpha charge a fair rate for access to that technology. Oil fuels most cars and alpha is what fuels most portfolios; NOT beta if you are risk averse like me.

Every investor needs alpha for their portfolios because "cheap" beta is TOO risky. If you don't like the fees, please DON'T invest in hedge funds. It simply leaves more room for the investors I advise that prefer absolute returns with limited downside risk. The capacity for a quality absolute return strategy is limited just like getting a reservation at a popular restaurant.

A friend ate at a top restaurant recently. As she related the soup to nuts gourmet experience, I wondered if economists would argue she was ripped off. There was a more famous eatery nearby, that satisfied hunger just as well, served far more customers and whose track record was much longer. A meal there cost a few dollars compared to several hundred where she ate. I asked about her "irrational" decision and the "cheaper" food elsewhere but she said that, whilst aware of those "lower" costs, the difference in VALUE was fairly reflected in comparing the prices at a three star Michelin restaurant with McDonalds.

Good hedge fund = 3 Michelin stars
"Passive" index fund = "cheap" fast food

2 and 20 has become the industry mode for many reasons but the main one is due to investors. Rightly or wrongly, lower fees get associated with lower quality products. I have heard "fees are too high and will drop" forecasts for MANY years but they never pan out. I once asked a group of experienced institutional investors which of the following fee structures they would prefer for an otherwise identical hedge fund. A) 2 and 20 B) 0 and 25 or C) 0 and 50 above a 10% hurdle. A huge majority said they would choose A). They feared B and C might induce a manager to take too much risk. I've also seen two similar hedge funds make it to final selection with the first charging 1 and 20 and the other 3 and 30. Guess who got the mandate? Quality rarely competes on price.

It would be great to have a stock market that went up 10% each and every year but we don't. It would be even better to buy a risk free bond yielding 5% above the inflation rate and be certain to receive back interest and principal but we don't have that either. It would be nice to live in a world where car and home insurance weren't necessary but they are. People pay insurance premiums to cover against bad events. Investors pay hedge fund fees to those FEW managers able to make money for them in tough economic conditions.

A listed hedge fund, Berkshire Hathaway, recently issued a new shareholder letter saying the 2 and 20 crowd is not worth it. That is obvious since talent is rare. The "crowd" cannot have skill, by definition. BRKA made "hundreds of millions" trading those apparent weapons of mass destruction called DERIVATIVES. The fee "debate" throws the baby out with the bathwater. As Warren Buffett correctly wrote, "derivatives, just like stocks and bonds, are sometimes wildly mispriced". Surely those able to identify such anomalies can charge whatever fees clients are freely willing to pay. The crowd exists so that the best managers can arbitrage it.

If Warren Buffett can subsist on cherry coke and hamburgers that is his right and privilege but most people need more sophisticated fare in their diets AND their portfolios. No-one is forced to invest in hedge funds anymore than forced to eat at a good restaurant. People do because the after fee product is superior. It takes great skill to become a top chef and great skill to become a top money manager. Just like good food, alpha and outstanding risk-adjusted returns are worth paying for.

Hedge funds might appear to be portfolio deadweight during strong bull markets. It could even temporarily seem like an investor does not need them. The fees are "higher" and the performance will generally be "lower" comparatively when stocks are doing well. Hedging has a cost. Sophisticated strategies are also more expensive to implement. But such contentions fail to take account of the role of good hedge funds in achieving portfolio diversification, reducing volatility and monetizing true investment skill.

The fees for alpha stem from widespread investor demand but limited supply. Good hedge funds are rare but there are trillions of dollars of global money looking for a RELIABLE return higher than government bonds but with LESS risk than long only equity. Competent hedge funds more than justify their fees. Fund of hedge funds and other intermediary allocators charge a second layer of fees to those investors without the resources, time and expertise to do it themselves. Multistrategy is NOT multimanager.

There has been renewed attack on hedge fund fees recently. Some think they are too high so they avoid "expensive" hedge funds and take their chances with the enormous risk of long only equity. That is good for sophisticated investors since it leaves more room for those that understand the diversification value of SKILLED strategies. In a recent paper Mark Kritzman concludes that after fee performance of "all" hedge funds reduces their value to investors. So? We already knew the AVERAGE hedge fund isn't any good and does not merit its fees just like the AVERAGE restaurant.

Reliable alpha producers, after fees, CAN be identified ahead of time and that performance IS of great value to investors. However, it usually takes a bear market for investors to realise this. Mark Kritzman would have reached a very different conclusion had he used solely 2000-2002 or 1970s data. No-one disputes that if a fund makes 22% gross, the client would be better off if the fees were zero instead of 2 and 20. Next time you go shopping insist on paying only what it cost to manufacture what you bought. Good luck with that. And index funds don't seem so "cheap" when they squander 50% of YOUR money.

It surely does not take an empirical study to determine that 16% to the investor is not as good as 22%. What matters is that the 16% performance offers a new, diversifying source of return. 80% of mutual funds are likely to underperform their index and, likewise, 80% of hedge funds are unlikely to be alpha generators. There is no doubt paying 2 and 20 for repackaged beta is unnecessary but 2 and 20 for alpha is a bargain.

The fee structure of hedge funds will not change because there is no incentive to change and professional investors, unlike the mainstream media, look at the after fee RISK ADJUSTED returns. Whatever the critics and hedge fund replicators think, 2 and 20 is here to stay. Warren Buffett was able to charge 0 and 25 in his hedge fund because he was the sole employee and markets were less complex and competitive in the 50s and 60s. The "2" nowadays goes towards the higher strategy development costs in today's markets and paying the deep benches of employees now required by investors. I'd be the first to concede that the "20" should only be charged on the alpha, not the beta.

The AVERAGE gold miner probably won't find gold and the AVERAGE fund manager won't find alpha. Those who figure out a way to generate alpha deserve the higher fees since it is worth more than gold. Alpha is theoretically in vast supply but the research costs are high. This is where these "limited supply of alpha" people get it so wrong. Gold is considered "rare" because no-one, yet, has invented a way to economically isolate gold dissolved in sea water, but the world's oceans contain billions of tons.

Alpha is rare and expensive because very few will ever reliably find a rich supply or develop a sustainable way to mine that seam. But plenty of alpha is out there and investors will ALWAYS be prepared to pay a premium for the highest quality money managers. Just because alpha, oil and gold are DIFFICULT to produce does not mean they are not abundant. It is the extraction costs that merit that 2 and 20. "Cheap" beta just won't do it and is too risky anyway.