Hedge fund

Lucky hedge fund managers?

2011-11-11T11:11:00.145+09:00

Luck or skill? It's much easier to become a movie star or sports legend than to be a fund manager worth investing in. I prefer absolute returns at low risk than relative returns at high risk. Such managers are scarce and don't run beta-dominated funds. Beta is dependence on a risky benchmark. Alpha is profitably choosing specific securities to short sell or buy. Talent must be leveraged with ten years of 100 hour weeks actually managing alpha strategies BEFORE skill might emerge. In aggregate, "hedge funds" aren't worth investing in. Useless hedge funds and funds of hedge funds shutting down is POSITIVE for the industry. Good riddance to the many amateurs.

You need to invest in the best hedge funds not asset classes. The "average" hedge fund underperforms cash in the long term. Most products claiming to be absolute return are useless. Alternative beta and hedge fund clones were failed ideas as they guarantee weak returns. Almost as dumb as portable alpha and 130/30. Remember them? The "new" things today are leveraged beta risk parity and minimum variance! Shame. Low volatility is NOT low risk. Long term returns require short term alpha. Forget new spins on beta. Long only stock or bond funds have no place in anyone's portfolio except perhaps for gamblers and economics professors.

Great managers produce consistent alpha. Beating the market isn't useful and doesn't require skill. Cash has performed better than most developed equity markets over 15 years (Japan for 30 years) and bonds have outdone stocks for 30 years. Gold has risen EVERY year so far this century. The MLP index ^AMZ has crushed the S&P 500 twelve years in a row. Does that mean cash and bonds have alpha? No. Are they worth investing in at these yields? Do gold and MLPs have skill? Should you rush into gold and MLPs now? Invest in skills NOT asset classes. It takes a minimum 50,000 hours to get good. Most won't succeed.

There's been a massive brain drain into hedge fund firms in recent decades. Manager selection is crucial when asset class dependent funds perform so poorly. Long term investors need clairvoyance to predict the distant future. Static beta allocation fails when stock markets don't compensate for volatility and most bonds have insufficient yield for their default probability. Every investor signs MONTHLY checks including pensions, foundations and university endowments. How to identify top managers in advance and avoid the minor leagues? Index funds ALWAYS underperform quality managers over time.

Risk and return are unconnected. Investment grade bonds or investment grade funds? It's no longer a question of whether to invest in alternatives. Alpha is the ability to produce higher returns than the risk taken. Bombastic passive pundits say you must have X% in stocks and (100-X)% in bonds for all scenarios changing only as a function of "risk aversion"! If "risk free" bonds yielded 10% perhaps "age in bonds" might have made sense but not at these yields. It's no surprise many investors feel discombobulated. Quality funds are for those seeking alpha regardless of the economy.

Most portfolios are overexposed to stock or bond market drawdowns. Ignore asset class labels and focus on the best unconstrained funds. Let them decide the what, where, when and how of making money for you. Identifying them is itself a form of alpha. Anyone managing their own portfolio should compare themselves to the best not the average and make sure their capital is being put to work optimally.

Index products are unsuitable for cost sensitive, risk averse people like me. Prudent investors avoid "cheap" funds that don't bother to analyze securities and hold any toxic waste included in benchmarks. I'm only interested in managers that work hard and are incentivized to deliver consistent absolute returns. If a client asks "Should we invest in China?" I interpret that to mean "Do Chinese markets offer short/long opportunities that a highly experienced specialist can generate alpha from?" to which the answer is of course YES. Some think it just means "Do we buy China beta?".

Incentives are necessary for a functioning economy and incentives are critical to a successful portfolio. The best managers don't run funds without incentive fees. Investing in hedge funds is about replacing market risk with manager risk. Constructing a portfolio of good funds is as difficult as selecting securities so I use similar processes. You need powerful metal detectors to find alpha needles in beta haystacks. Few people have the combination of talent, expertise and work ethic to produce absolute returns in excess of absolute risk on a consistent basis. The FORWARD-LOOKING estimation of alpha is non-trivial but if beta > alpha then it's too risky else if alpha > beta then it's worth further due diligence as it could be a real hedge fund.

I separate manager returns into market dependence and value added. Most define an index fund as designed to track indices but I broaden it to funds whose returns are mostly driven by underlying benchmarks or factors. In the last three years the MSCI World and HFR Fund Weighted Composite had +0.91 correlation. Most so-called absolute return funds lose money in down markets. Any product whose performance is dominated by index direction is more an index fund than a hedge fund. Many "hedge funds" are simply beta repackagers. Typically I can screen out 90% of the universe very quickly.

Of the remaining 10% of managers, I then calculate what percentage of alpha was due to skill and what from luck. I also use hidden Markov models to uncover hidden factor dependencies. After further qualitative and quantitative analysis 90% of that 10% is also eliminated. Starting from thousands of funds I end up with less than 10% of the 10%. The cream of the cream of the crop. Those who refer to "hedge funds" as an asset class know NOTHING about hedge funds. Ignore people that say they can't forecast the short term but claim to be able to predict the long term!

1. Buy GOOD funds in drawdowns. All genuine hedge funds lose money sometimes. No matter how brilliant, even the best managers only have small competitive edges. I doubt there is anyone that gets even 60% of investment decisions correct over time which is why great defense is more important than good offense. Every true hedge fund is CERTAIN to have drawdowns. "Hot money" amateurs usually redeem often creating great entry points for new clients. Bad drawdowns include those by John Paulson 2011, Ken Griffin 2008, James Simons 1989, Warren Buffett 1974 and Munehisa Honma 1769. Avoid funds with infinite Sortino ratios because the crowd loves them. To their ultimate cost. Skill is persistent, luck runs out. Bad luck also ends.

2. Don't avoid proven strategies. Only invest in what you understand? If you don't understand a strategy, find someone that does. Many times I look at the - losing - portfolio of a "diversified" fund of funds and see no black box quant, no managed futures, no short biased, no volatility arbitrage and no frontier markets funds. No surprise such FOHFs are losing assets while the good ones that look at all strategies are thriving. High frequency trading is a reliable source of returns but no institution globally has issued an RFP for a HFT allocation. Yet. A strategy's holding period is irrelevant. For the past 250 years the best performing funds have always been quant.

3. Do proper due diligence but don't take too long. Many investors take months and months, often years, to decide whether to invest in a fund. There is no evidence that such a slow process adds any value or avoids incredibly rare frauds. We live in a high frequency world. It takes me a few minutes to decide to avoid or exit a fund. Deciding to invest in a fund takes a few days provided I have visited all its offices and interviewed the most senior and most junior decision-making staff. And if someone I trust is happy with the operational, back office side and I am familiar with the administrator and prime brokers.

4. Never invest in a fund that is often mentioned in the mass media. Ideally you want funds the mainstream has never heard of. It is very hard to produce returns when a manager's every move is followed and scrutinized. Beware of overly transparent funds. Transparency to ACTUAL investors is important but not to anyone else. I receive and read over a thousand monthly performance letters and commentaries each month but you won't see any here. Secrecy is the edge.

5. Ignore pedigree. Many investors place great emphasis on managers' previous firms or education. Practical experience is important but track records are rarely fungible or relevant. More importantly it is not a predictive indicator. Even more dangerous is paying any attention to universities attended. Common sense is not so common and no-one has a PhD in it. Avoid any fund advised by Nobel prize "winners".

6. Always redeem from funds announcing their intention to IPO. Every hedge fund firm in the world that went public hasn't made a cent for clients since it went public! Serving two CONFLICTING masters - LPs and shareholders - does not work and shareholders haven't been served well either. Check out hedge fund IPO prices and the value today. Price is what IPO buyers paid, value is what shareholders received.

7. Every investment in a hedge fund is venture capital. It makes no difference if it was set up yesterday or 60 years ago like BRKB. People worry a lot about capacity and AUM. Some strategies only have room for $200 million, others $200 billion. A good manager closes his fund long before returns reduce. Never fall for the old "closing soon" trick. Don't believe the "We are closed but for you we are open" nonsense. Beware of the "endowment" effect and holding onto funds past their prime. Every fund has to justify itself every month. Otherwise it's time to upgrade to a better one.

The great thing about hedge funds is there are always new ones to look at. As great funds close, successful managers retire and unsuccessful ones go out of business, better strategies are developed. Like everything it's a dynamic active selection process unsuitable for policy asset allocation. The average hides funds in the far right tail of the talent distribution. The stock market is a market of stocks. Who lives in a passive world? Who wants average portfolios with average performance? Whether it is trading stocks or choosing funds, the aim is to maximize use of capital and minimize opportunity cost. The long term investor must negotiate many short terms.

Tail risks?

2011-08-15T11:11:00.131+09:00

Risk is minimal if you diversify properly. Sad to see peoples' savings and pensions hurt by the stock market. Again. No returns despite vicious volatility for so many years. An equity risk premium but no performance premium? I invest in skill instead of gambling on asset classes. Why let alpha be crushed by beta? Bear markets and low interest rates don't impair the ABSOLUTE RETURNS of intelligently constructed portfolios. The future is unknown so robust hedging and multistrategy alpha are essential if you have ABSOLUTE LIABILITIES to fund. Almost everyone does.

How can long only portfolios be considered "diversified" when codependencies are so obvious? If stock markets and real estate crash, "risk free" yields also drop, doubly worsening retirement liabilities. Hedge funds aren't alternatives; they are replacements. Quality replacement investments are the way to reduce risk and secure viable income streams for the long term. Adding long only commodities and geographic diversification doesn't help much since they depend on similar global demand factors. At current money-market rates, cash is NOT a safe haven either.

Hedge away the wild ride. Market turbulence still hurts too many investors. Keeping to "low cost" index funds is like using slate and chalk when you could have an Apple iPad. Low cost for whom? Financial innovation has progressed but most portfolios remain in the stone age. Hedge funds seek alpha. Total alpha sums to zero but the hedge fund industry generates large positive alpha. That's despite wide return dispersion and "average" hedge funds being useless. The reasons are simple: the best managers run hedge funds and many trades by non-hedge funds are non-alpha seeking.

Efficient markets aren't efficient. Many securities get bought if they are in an index not because skilled analysis shows them to be good investments. Forced selling from pressure to be fully invested at all times amid redemptions and forced buying so as to minimize index tracking error means many trades aren't made in the pursuit of alpha. Most currency and commodities transactions are not alpha driven either. That creates vast alpha capture opportunities for people who know what they are doing.

The S&P has had no price gains since 1998, FTSE since 1997 and TOPIX since 1983. 28 years! Japan isn't an exception, it's the leading indicator and little was learnt elsewhere. Keep to the plan but what if the target date glide path for stocks is much lower? Smart investors adapt to changing regimes while passive dinosaurs die out. Don't waste time and capital in unskilled funds that supposedly might go up eventually. Don't let beta "expected returns, unexpected risks" destroy YOUR wealth. Why invest in anything else when the top talent is at hedge funds not long only?

Shorts are mandatory; longs are optional. How many more lost decades can we afford? Government debt concerns hit markets so "rational" investors buy "safety" in zero yield cash! My retirement plan needs real absolute returns in all market conditions so is ONLY invested in alpha. I don't want a cent run by "cheap" managers. I prefer +8% every year after fees no matter what happens and only the best deliver that. Proper hedge funds aren't the problem; they are the solution.

Time to buy? Volatility is a blessing since forced trading, mispricing and arbitrage situations increase. Unacceptable losses for so many years show unskilled long only is for speculators but skilled long/short is for widows, orphans and retirement plans. Time to REPLACE the risky beta bet with alpha solutions. Beta bandits had their chance but the damage they have wrought must now cease. The only fund manager mandate that makes sense is absolute return, not to beat benchmarks. The asset class fixation should make way for superior MONEY MAKING strategies. It's always time to buy alpha but not beta. Is your portfolio stress tested for the possibility of stocks being lower in 2030 than today? 2050? If not, why not?

Emerging and frontier markets offer alpha opportunities NOT beta anymore. Real hedge funds are in the business of trading, finding inefficiencies and monetizing volatility for absolute returns. Managers needing bull markets to make money are running closet index funds NOT hedge funds. Acid tests like market drawdowns and volatility are great for differentiating true ability from random luck. Triumph of the realists or revenge of the pessimists? Passive pushers buy stocks in an index not because it's growing or cheap!

Value-added analysis is impossible? Ignore TVaR despite the devastating damage index funds inflict? Every debt capital markets professional knows the criteria for a bond to be in a fixed-income benchmark. No matter how badly priced or default probability, passive funds buy REGARDLESS OF VALUE. That's the problem of rules-based index construction and beta dominated asset allocation. Dog stocks and bonds bought by index and relative return funds while good hedge funds avoid or short sell them. The result is net POSITIVE ALPHA for hedge funds, of which the best produce the mother lode.

The three decade bull market in "risk free" bonds continues despite "more" default risk. Last year I must have seen at least 200 presentations on how yields would rise in 2011! If you bought 30 year Treasuries in August 1981 you locked in over 14%, outperforming ALL equity indices but massively underperforming hedge fund "retirees" George and Warren. Soros and Buffett had outstanding track records from the disastrous (for beta) 1970s but were ignored by most allocators even then.

Unconventionally lucky David Swensen urges YOU to invest in index funds so he can keep better alternatives for himself. Track what people do not what they say. Not that Swensen knows much about prudent investing or manager selection. He doesn't as his poor RISK-ADJUSTED returns show. While the Yale endowment avoids it, he says the common man should make do with VFINX which has done NOTHING for holders since summer 1999.

Today the 30 year Treasury yields 3.55%, woefully inadequate for anyone looking to preserve wealth, fund retirement or beat inflation. There's not much safe haven in bonds at those rates. The Fed says it's keeping rates low till 2013 but it'll be much longer than that. Bank of Japan has had "temporary" zero interest rates for many years but people still love the yen reserve currency. The record of credit rating agencies is bad but more importantly ask yourself are current yields worth the trouble? I don't care if a bond is rated C or AAA, only how wrongly priced it is to its value. There are no toxic securities only the toxic prices the unskilled pay because it's in an index.

Bonds don't yield enough, stocks aren't reliable so how to get an adequate return? The answer is long short security selection and tactical market timing; better known as ALPHA. If your portfolio needs high consistent performance over the long term, you need to be able to analyze securities and time markets yourself or hire dedicated managers who have PROVED they can and whose ENTIRE personal cash is invested alongside yours. All I do everyday is analysis and due diligence to find the NEXT Georges and Warrens.

Skill at long short security selection and market timing are the drivers of consistent return. How can index funds be "low cost" considering the wealth destruction they wreak. I'm too conservative to take beta risk. Even if I was CERTAIN of a bull market I could never advocate a long only portfolio. I just try to make +10% after all fees each year at the lowest risk whether the Dow and Nikkei go to zero or 50,000. If your portfolio isn't stress tested for any eventuality you have the wrong portfolio.

I'm glad brilliant managers make their skills available for such bargain fees as 2 and 20. It would be simpler for them to just trade family and friend money. The sooner pension plans are 100% invested in hedge funds the better for society. No need to cut benefits or raise retirement ages and capital contributions. Pay those absolute liabilities from absolute returns. Avoid typical hedge funds by doing sensible manager selection and portfolio optimization. Access consistent returns and eliminate tail risk with REPLACEMENT investments. There are no alternatives.

Asset classes or skill strategies?

2011-03-20T09:55:00.163+09:00

Invest in assets or strategies? The world's first hedge fund manager Munehisa Homma, invented quantitative investing, event-driven arbitrage and algorithmic trading. Many good hedge funds increased exposure to Japan after the earthquake. Others lost because their "quants" and "risk managers" hadn't stress tested for an event that was certain to occur.

Inevitable unfortunate happenings aren't black swans. Taking the other side of panic usually works. In 1755 the developer of systematic pattern recognition and candlestick analysis wrote "Buy when the crowd is selling". The current emerging markets and commodities "booms" are ideal for his relative value strategies. Some investors even attempt to find alpha without mastery of his methods. No wonder most of them lose over time. As they will find out soon, bull markets hide many problems.

Apart from immediate cash, the best way to help a region get back to business is to go there and invest. In the north it's a rescue situation now but the worst hit areas will be looking to reconstruct. Northern Japan having been the home of the world's greatest ever money manager also has superb hot springs, traditional ryokan, ski resorts and mountain hiking. The local economy will need customers. And investors.

I'm arranging an investor trip to the affected areas in Japan. The values and opportunities now are compelling. Anyone or any group interested is welcome to get themselves to Tokyo in September prepared for a one week journey. I can sort out the logistics within Japan. It's a great time to visit Tohoku. The best ryokan and hot springs are available then. The region will need assistance long after the media goes home. There really is a triple bottom line for win/win/win investing.

A rough one week itinerary:
1) Head to Homma's home town to visit his historic house, trading room, garden, art gallery and the family office/corporation he founded that exists today
2) As far as is practicable and respectful, visit the worst hit parts of the north east coast. And hopefully directly help some devastated local families and villages
3) Visit some alpha places in Tohoku I don't want the beta crowd to know about

A week of your time that won't be wasted. All participants will receive the only English language translation of Homma's great work on investing - "The Fountain of Gold". That's after viewing the real fountain of gold. The Sage of Sakata paved the way for modern day alpha capture superstars like the Oracle of Omaha and the Brain of Budapest.

Since the earthquake, tsunami and radiation scare, I haven't been able to contact several people I know that were in the worst affected area and their chances look remote. But the survivors will need plenty of help. Also having rescued and adopted many animals over the years, I'm concerned about the fate of displaced Japanese pets and work animals. Whether it's guarding an injured friend, a forlorn horse, baby dolphins, deer on sacred Kinkasan or the famous Cat Island.

If you can donate it would be great. Soon the north Japan situation will drop off the headlines but problems and desperation will remain. Bigger cities like Sendai, Kesennuma and Kamaishi have lost thousands in population. I've been to those sadly now well-known places like Minamisanriku, Minamisoma and Rikuzentakata. Charity now but socially responsible infrastructure investing soon.

Please let me know. If you can't make it, please consider donating anyway. You can email HedgeFundBlog@gmail.com if you have interest in the trip.

Alternative investing?

2011-02-09T08:08:00.102+09:00

Are alternatives really alternatives? Most investors' portfolios are basically funds of funds so the main decision is WHO chooses the managers. You or someone you or your firm appoints. Replacing long only with long short doesn't help unless skill is evident. People with rare talent go where incentives are highest. Why risk YOUR money on "low cost" index lemmings? The best don't compete on fees.

Forecasting alpha and identifying good funds is complex but not impossible. After intensive due diligence, predictive financial analytics and non-linear multifactor modeling I've found the key drivers for FUTURE superior performance are innovation, hard work, great teams, aligned interests and exclusive focus. Amazing how many "famous" long only funds don't meet those criteria.

Value added alpha comes from selecting the right securities or the right managers. It's a similar process. I look for new ideas and asymmetric payoffs. But conventional "wisdom" favors old cheap products with low returns at high risk and minimum margin of safety. Despite investors needing consistent performance, passive pushers resist innovation and even dispute after fee alpha exists! Manager evolvability is a selectable trait.

I wouldn't mind were it not for the disastrous effect such high risk financial "advice" has on hard working peoples' retirement savings and institutions with fiduciary responsibilities. According to some economists it's simply luck but I do get most manager and security selection decisions correct. It's not rocket science. Just common sense, mathematical rigor and tracking the ENTIRE world.

Seek alpha, avoid beta. The persuit of perfection requires understanding over knowledge. I like shibumi investments. Improvize and adapt strategies to CHANGING alpha capture opportunity sets. I hire top teams to focus on making money and hedging risk NOT gathering assets. Hedge funds are called "replacement investments" in Japanese for good reason - traditional long only hasn't worked. Warren Buffett has been a heavy short seller of Nikkei puts. A bullish outlook on Japan which few BRKA watchers know about.

In Japan, like anywhere else, there's lots of inefficiencies for alpha capture. Why wouldn't you want "replacement investments" when bonds don't yield enough and market "recoveries" notoriously give back gains? Dow 12,000 again is almost as boring as the many previous Nikkei 12,000s. I prefer manager skill than risky buy and hold. Constant improvement - kaizen - and continuous innovation - kakushin - are essential for absolute returns in bull AND bear markets.

Luckily 2010 was good for my retirement plan. Not as great as the supposedly "difficult" 2008 or easy 2009 but still above required actuarial returns. Most external alpha vendors did better than +10% after fees - the minimum acceptable target. I directly manage a few special situations if I have an edge and the time to analyze properly. Alpha from emerging markets was a major contributor if only because volatility and mispricings are so prevalent.

My largest USA holding MSB went from 14 until by luck I sold near the high at 56. The second biggest BPT having been ignored after years of double digit dividends finally got attention and I reluctantly took profit at 122. Why waste time in SPY when stock picking is safer? Japan and China aren't sources of beta but fantastic for alpha. I love it when people outside their circle of competence say the places are about to implode. Watching those JGB and yen bears get trapped in short squeezes was lucrative. FXY for the yen but no ETF for the world's largest government bond market? Better to use JGB futures. Long new Japan/short old Japan positions like long Skymark Airlines 9204/short Japan Airlines 9205 did fine. Making 200% on the long and 120% on the short was even better than long Southwest LUV/short Northwest a few years ago. Yes you CAN make more than 100% on shorts.

Just weeks into 2011 and reminders from Tunisia and Egypt EGPT that security selection with innovative research and risk management is the BEST route to absolute returns. And short selling whatever groupthink says is "hot". There's lots of money to be made in China but it won't come from a "passive" China index fund. Maybe it's better to border BRICs than be a BRIC. Not surprisingly Mongolia was the top market in 2010 - all those natural resources sandwiched between Russia and China. I just bought my first Laos stock EDL, years after the initial visit. Of course I also made a few mistakes last year, which is why TRUE diversification is important. Small losses are the cost of doing business. Large drawdowns mean there is something very wrong.

Semantic arbitrage? Despite the name of this blog, in my professional life I long ago stopped using the term "hedge fund" when referring to skill-based strategies. Even "alternative investments" has become a catch-all for any manager not doing long only relative return stocks and bonds. Alpha is available from many sources in public and private markets, in numerous countries over many time horizons. In assessing a fund I strip out any betas and luck to calculate the proportion of returns due to the manager. Skill is persistent, luck isn't. I now use "innovative strategies" as a better term than the overused moniker "absolute return". That was almost as misleading as "market neutral". Every fund I look at that says it's market neutral ISN'T.

All good strategies innovate to keep performing. Alpha is extracting returns out of other market participants. Beta is too risky and unreliable to gamble on for the long term. The best managers make use of the latest financial products and drive the invention of new ones. Style drift is not bad; it may even be preferable in good manager. Paulson & Co. was a merger arbitrage fund but now trades everything from CDOs to commodities. Berkshire Hathaway is wrongly considered a buy and hold shop but Warren Buffett has used alternative strategies and hybrid securities for 60 years. Convertible bond arbitrage, derivatives trading, value investing, event driven were all "new" once. Any style not adaptable to changing market regimes is obsolete. Abnormal returns require keeping ahead of copycats.

There is still massive scope for innovation in portfolio construction and wealth management. Many investors have processes that fail to reap the full benefits of modern investment methods. New strategies and financial products are being developed all the time. Blaming credit derivatives for the recession and GFC - Global Financial Crisis - is like blaming match manufacturers when a house burns down. John Paulson's net worth rose by $5 billion in 2010. Warren Buffett was "paid" $10 billion from eating his own cooking and making clients far more. Their strategies have little in common other than thorough security analysis and working harder than the "crowd". How "hard" does a passive "manager" work? Be proactive not reactive. And definitely not passive.

Variant perception drives alpha. But portfolio optimization remains mired in the beta driven suboptimal mean variance world of Markowitz and Sharpe. Policy asset allocation still dominates while others pay it little attention and INSTEAD focus on security selection and strategy diversification. John Paulson, Warren Buffett and many others aim to put 100% capital to work in good opportunities. They are not concerned with 60% in stocks and 40% in bonds. I find this unrewarded, unhedged faith in asset class returns rather than skill-based strategies strange. Currently it appears we are in a bull market but that will change soon enough. Passive funds end up getting crushed.

Good managers that can make money in any conditions have to be incentivized for the hassle of accepting outside capital and undergoing exhaustive evaluation and monitoring. It's great for investors that so many still make their services available for low fees of 2 and 20 and often cheaper. The crowd fears "exotic markets" and "frontier strategies" but smart investors enjoy spending the returns the mainstream miss. Forget about alternative investments and focus on "innovative investments". Construct robust portfolios that GROW and PRESERVE capital no matter what happens. That takes hard work and it's worth paying for. Invigorate return streams with replacement investments.

Pension plan crisis?

2011-01-11T19:01:00.106+09:00

Pension funds have a fiduciary duty to hire the world's BEST managers. Great managers do NOT run long only funds. Pensions must urgently de-risk by transitioning to 100% in quality hedge funds and getting rid of minor league mediocrities. Why let retirement benefits, income streams and funded status be affected by low interest rates and volatile stocks? There is no need to reduce benefits or raise contributions and retirement ages. Expected stock and bond returns have nothing to do with funding liabilities if you invest prudently. Replace market risk with manager risk. No-one should have to work past age 60 if they don't want to.

There's no pension crisis. Only a need for better capital usage. It is a return assumption versus interest rate crisis. Liabilities can be met without severe benefit cuts, major capital contributions or excessive risk taking. The problem stems from bad theories, weak diversification, overoptimistic scenario planning and poor manager selection. Asset allocation isn't risk management. Hope for the best but hedge for the worst. Risk free bonds are not risk free. Miracle of compounding is only miraculous at HIGH returns. The gap from 3% to 5% is much lower than 8% to 10% over long periods. Too much in bonds guarantees required returns won't be met.

Forget about asset allocation. Experts caused the mess. Capital market assumptions are irrelevant. 100% in skill is the way forward. Avoid unhedged stock and bond funds. Why put fiduciary capital in beta benchmarks when you can invest in top alpha funds as REPLACEMENTS? Take lower risk than the market for higher returns. Use 10% as the discount rate and hire the best. Many are reducing "expected" returns and increasing the burden on capital contributors. Nothing wrong with de-risking as long as it's not de-returning. The solution is investing sensibly with competent managers. The prudent man invests in skill strategies (alpha) not asset classes (beta).

Invest in skills not assets. The pension underfunding crisis disappears by investing carefully and intelligently. The trustees and CIO are glad that plan will outperform peers and match long term liabilities. Retirees won't need to pay in more or worry about income after working and sponsors will avoid devastating drawdowns like 2008. Someday 100% in skill will be standard for all investors. Why ignore safer strategies and financial innovations? Why take headline risk of unskilled "passive" beta? Minimize tracking error to liabilities not assets. Hedge liabilities with proper hedge funds. There is no inherent return from any asset class including bonds.

Increase expected returns, lower age eligibility and invest smartly. As the most sophisticated investors have realized, good hedge funds are the cheapest and safest solution. Bonds are expensive and default prone. Absolute liabilities need absolute returns. It's now rare for institutions to not invest in alternatives but allocations are often too low or made to mediocre managers. Promises must be paid regardless of the economy or discount rates but how to optimally fund future needs today? Most investors don't have time to rely on stock market beta or suffer its vicious clawbacks. Skill is the friend, time is the enemy. Some sovereign wealth funds are already 100% allocated to external and internal alpha strategies. Long term success needs short term focus. Some say assumed returns are too high. NONSENSE. Raise them and invest in skill.

Alternative investments are the cheapest liability solution. Increase performance and reduce shortfall risk with the best risk/return strategies. Expect and require +10% after fees. I do. Global markets are complicated and codependent so invest in unskilled managers or those with the ability to capture alpha? Social security and portfolio optimization from assets or strategies? Fiduciary duty requires putting capital to work in the most cost-effective ways to maximize growth and minimize risk of not being able to deliver. Whether you have $1,000 or $1 trillion to invest the issue is the same. A $1 million portfolio provides annual income of $100,000 with principal protection. Age in bonds at these yields?

Portfolio stress tested for negative asset returns over the NEXT decade? Why fixate on the stock/bond split when you can hire top talent to exploit market inefficiencies? Hope for the unrequited love affair with stock indices to finally deliver? Even when they do go up it's at unacceptable risk. The total return S&P 500 has underperformed cash since 1997 and the Dow was higher in 1905 than 1942. What if US markets are lower in 2030? Or 2050? The Japanese Nikkei is lower today than in 1983. I'd rather find brilliant managers than bet on asset classes. Obeying "World" stock and bond weightings, missing emerging opportunities and new investment strategies has cost too many retirement plans too much money.

It's not WHAT or WHERE to invest but WHO can best decide. Some investors still pick managers to simply deliver asset class performance but I prefer teams that generate higher absolute returns than the risks they take on. I'm very conservative so no investment opportunity gets my attention unless there's a high chance of +10% total return each year. My VALUE philosophy requires managers with skills priced much lower than their worth. 2 and 20 for alpha is cheap, 0.20 for beta is expensive. Why not ask top asset managers to make money to fund long term income streams? A few institutions even have a "maximum" percentage in hedge funds! As if managed futures and global macro are affected in the same way as equity long/short and distressed debt. Only the ignorant treat "hedge funds" as an asset class.

How to fund CERTAIN cash flows in an UNCERTAIN future? Stay the course with long only or replace with short/long? Retirement "fixed-income" needs higher yields than most "investment grade" bonds and stock dividends are paying. Over the long term passive can't win in an active world. Risk assets fluctuate together more so how to diversify properly? 2010 and 2009 were "up" years so equities are back on track to compensate for risk? Those gains were lost in 2000-2002 and 2007-2008 but this time is different? Bet on the commodities bubble or hire the best commodities traders? Focus on alternative alpha, upgrade the manager mix and reduce risk OR cut benefits, raise retirement ages, increase capital contributions and remove economies of scale?

Prudent portfolio construction for the long term. Who is best equipped to navigate markets and perform no matter what happens? We live in a high frequency economy. Beta bets are being replaced by alpha capture opportunity sets. Long only relative return is being substituted by long/short absolute return. Pensions affect all people of every age, everywhere whether they are called superannuation schemes, mandatory provident funds or retirement systems. Many employees and plan sponsors pay in more than necessary because of lower expected returns. Static 60/40 stocks and bonds fails to take advantage of dynamically changing environments or the wide dispersion of security returns. Pension funds themselves are short/long. No point in "long term" if beneficiaries need their checks in the short term.

Fixed-income arbitrage? Return assumptions matter. Some people just won the $380 million Megamillions lottery. Or was it $2 BILLION? Simple NPV arithmetic favors the one time net payment of $180 million rather than the 26 year option of $14.6 million annually. The publicized future value is discounted by interest rates not by the return that conservatively can be achieved by sensible portfolio construction and manager selection. Good strategies deliver +10% a year over time. The very best funds +20% CAGR. Getting $180 million today is equivalent to $2 billion then, given the jackpot is the amount received after 26 years. Lump sum or annuity? Always the lump sum if you can invest the proceeds at better than discount rates. Provided they are advised competently!

The cheapest way to long term income and capital gains? The LOWER future returns the MORE capital needed. If you owe $1 million in 2030 to yourself or employees?
1) Invest $500,000 in bonds. "Investment grade" yields are "correct" discount rates.
2) Invest $300,000 in betas. Hope for 6-8% CAGR in "assumed" risk premiums and bonds.
3) Invest $150,000 in alphas. Receive +10% net from the best absolute return funds.

Interest rates should not impact "expected returns" used to calculate liabilities. Despite conventional "wisdom" there is nothing wrong with assuming 10%. What is wrong is thinking buying and holding stocks and bonds will deliver it. Invest in strategies applied to assets not asset classes themselves. Despite an "up" 2010, equity beta is too volatile over any time horizon to be relied on to help meet liabilities. Long term bonds don't yield enough and have too much duration and default risk. Decades count more than years. The percentage required in alternatives rises inversely with bond yields.

Hedge fund capacity is not a problem. Some say there isn't sufficient room in alternatives to rapidly increase allocations. That's nonsense. The passive index and ETF mania creates MORE mispricings and arbitrages than ever before. Securities bought because they are in a benchmark not because they are good investments! 80% of hedge funds are bad so the more that appear the more money to be made out of them by the 20% genuinely skilled managers. Depending on strategy, size does not damage performance though obviously hedge funds do hard close if necessary. 2008-2010 was a great 36 month period of varied market conditions to assess who knows what they are doing. Most don't.

The best deliver. 3,000 hedge funds made money in 2008. 2010 was fine. The third largest, Paulson & Co., +15%. The biggest hedge fund, Berkshire Hathaway, did +20%. The second largest hedge fund Bridgewater Associates returned +30%. Most good managers returned +10% in 2010 and those that didn't, performed very well in 2008. Smaller, newer hedge funds as a group have higher returns than larger, older hedge funds. Never have more than 5% in any fund NO MATTER HOW SUCCESSFUL. Everyone has losing years sometimes. It's losing decades that are unacceptable. Stock AND bond indices have had losing decades and will again.

Suppose you need to put $200 billion into hedge funds. I already know who the best 200 managers are so it would be straightforward to allocate each $1 billion. Then remove and add new managers when even better strategies appear. The hedge fund industry AUM is tiny compared to its ultimate size. I've seen strategies like high frequency trading go from very limited capacity to running decabillions today. Emerging markets emerge continually. There is no lack of room for alpha capture. Innovative strategies and financial products are being developed all the time. When hedge fund capacity actually is an issue there will be interplanetary markets to arbitrage. Then that speed of light issue really will matter. Low latency helps every strategy. The quicker you make and execute an investment decision the higher the return.

Treat "hedge funds" as an asset class and you will be disappointed. There is huge dispersion in ability. The strategy universe is too diverse to be pigeon-holed into one neat asset allocation box. Security analysis and manager due diligence require similar expertise and experience. If an investor hasn't spent 10,000 hours analyzing and trading a wide range of securities, and ANOTHER 10,000 hours researching managers and strategies it is unlikely they have what it takes. I can't think of any consistently successful investor anywhere that hasn't served those 20,000 hours. Lucky investors don't need them but skilled ones do. There is no short cut to acquiring the acumen required to get good enough to make that +10% CAGR. What can be done is to begin as early as possible. I did my first frontier markets arbitrage trades aged 11 but still have much to learn.

A pension with 100% in "average" hedge funds in 2000 would be fully funded. With proper analysis and due diligence you can do much better than the mere "average". The "typical" hedge fund is no use and zero-sum alpha means "aggregate" performance converges to the risk free rate. The best way to fund retirement is to have the best managers in the portfolio. Those with their own wealth at risk and who have demonstrated the ability to deliver absolute returns in all market conditions. Benefit promises to yourself or others are mandatory payments no matter what the markets do.

Top hedge fund?

2010-11-28T08:08:00.036+09:00

Top hedge fund? Why risk YOUR capital with portfolio managers not the best in the world at what they do? Warren Buffett runs the largest hedge fund firm and George Soros is the top performing living hedge fund manager. They searched for "successors" only from other hedge fund firms and, like most prudent investors, allocate their ENTIRE liquid net worth to absolute return strategies not asset classes. Hedge funds are replacement investments NOT alternatives.

Top sportspeople play in major leagues not the minors. Where do you find the best managers? Running a hedge fund of course. As any coach will confirm, it is possible to identify FUTURE winners in advance. George and Warren's edges were clear long ago so there was plenty of time to invest. Their success has brought major philanthropic benefits for society and secure retirements for clients. Sadly most pension plans missed out on Warren and George's performance due to bad asset allocation and manager selection by their advisers. It's no surprise there's a pension crisis when the best firms are ignored and allocations to hedge funds remain WOEFULLY low.

Some people even claim Warren isn't a hedge fund manager! But his focus is on absolute return and they seem unaware that leverage, arbitrage, derivatives, event-driven and macro trading have added heavily to his returns. He was short selling cocoa futures in a special situations deal as far back as 1954. He also got into insurance early on so as to access the float and not need to borrow from prime brokers for leverage. BRKA is the archetypal hedge fund. Invest in SKILLS not ASSETS.

George and Warren generated high alpha from low frequency trading via various legal entities. Double Eagle - Quantum, Buffett Partnership - Berkshire Hathaway. Like many other hedge funds, they don't report returns to databases, only to clients. Neither has a PhD or CFA but both have exceptional quantitative skills. I have never found a good manager that doesn't even if they run "discretionary" styles. Skilled managers do deliver reliable absolute returns and prove that market prices are ALWAYS wrong.

Portfolio performance is determined by your manager mix NOT asset allocation. The more people believing in efficient markets the more inefficient markets become. Trillions in index funds creates more alpha capture opportunities for those with skill. Mid-career professionals like Warren and George are thriving while hedge fund managers aged under 80 gain experience. Over 41 years and net of fees George has turned $1,000 into $14 million and Warren to $3 million from his actively managed closed end fund. He charges less fees than "cheap" unskilled index funds and his hedge fund is available to anyone with $80 to invest.

George's track record is better but Warren is richer. Why? The snowball of POSITIVE compounding for longer. Both were born in August 1930 and Warren ran his hedge fund from 1957 but George didn't set up his until 1969. Warren was lucky to be in Omaha while Dzjchdzhe Shorash was in Budapest, more affected by WW2. Also Warren got into currency trading and philanthropy later. George's outperformance is due to stronger international diversification and because reflexivity is ignored. Value investing is copied more than reflexivity investing. The boom bust of Eurozone sovereign credits and subprime CDOs are quintessential examples of reflexivity. Crises are PREDICTABLE. And profitable if you have expertise.

Warren ran the partnership from 1957-1969 and then implemented his strategies via Berkshire Hathaway. He first bought BRKA shares in 1962 at $7.60 and now it's $120,000 for a 22% CAGR. But the Buffett Partnership did better with all 13 years positive. Gross returns of 29.5% were net 23.8% to investors after his 25% incentive fee above 6% hurdle. What if, instead of "retiring" in 1970, Warren had continued the partnership and performance had persisted? Investing $1,000 in 1957 would now be $100 million. Fees that Warren might have been "paid" for turning $1,000 into $100 million would be $1 billion. That's fine since clients would STILL have $99.9 million MORE than wasting their life gambling on passive funds.

Difficult to prove a conjecture but to disprove it ONE counterexample suffices. Warren, George and many others have destroyed efficient market hypotheses, random walk assumptions and the myth that asset allocation drives portfolio returns. BHB Brinson et al cost too many investors too much money and wrecked retirement plans, foundation spending plans and endowment budgets. In the real world fiduciary investors want ALL their capital in attractive opportunities and that requires skill. George and Warren's alpha capture from security selection worked better than static beta bets. No-one says it's easy but if you work hard it is possible as they have proved. Such teams CAN be identified at an early stage and charge whatever hedge fund fees clients are prepared to pay.

Some hedge funds shut due to SUCCESS. Warren closed his in 1969 despite a strong track record as Stanley Druckenmiller did recently with Duquesne. The Buffett Partnership was set up when Benjamin Graham decided to shut his Graham-Newman hedge fund, operating decades before AW Jones' "first" hedge fund. Warren is correct that the best investment book ever written in English is The Intelligent Investor. The runner up is Alchemy of Finance though fortunately hardly anyone else attempts to understand it! The top finance book in any language is of course Fountain of Gold, written by the best hedge fund manager ever. If you master every page of all three, as I have, you will likely be more able to generate alpha than 99.99% of people considered investment "professionals".

Academics say Warren is just an ex-post lucky outlier but some spotted his talents ex-ante. Were they lucky too? The S&P 500 also began in 1957 but has performed terribly by comparison - $1,000 would now be just $100,000, huge opportunity cost and pathetic "compensation" for its risk. Investing for absolute return using competitive edges and outside the box thinking has existed for centuries. Long only relative return is the fad. Passive indexing is even newer. The trouble with owning dartboards is that you get the treble 20 but you also tie up precious cash in 1s, 2s and 3s. With proper analysis, average hedge funds can be avoided just like average stocks. I prefer to identify the Phil Taylor of each strategy. How many darts must you throw to show skill? George and Warren have hit many treble 20s.

Warren wants to be judged on book value not stock price but you can't eat book value and I evaluate fund managers by what investors really receive. Partnerships are marked at NAV but the switch to BRKA subjected clients to the irrational and highly inefficient public markets. In 2008 BRKA book value dropped -9.6% but shareholders lost -31.8%. George made money in that allegedly "challenging" year. While the stock has returned slightly more than book value due to the valuation premium, the volatility has been high. Warren's actual Sharpe ratio is lower than his book value "Sharpe ratio", dropping from 1.4 to just 0.6. Of course that is still much better than the high risk S&P 500. VFINX and its brethren have been disasters.

The Oracle of Omaha and the Brain of Budapest have "quit" before. George has hired "replacements" since 1981 and the extent of his fund management involvement has fluctuated since though never without close knowledge of and implied oversight of the portfolio. For each Li Lu or Todd Combs there was a Jim Marquez or Stanley Druckenmiller. No man is an island and both sought out strong partners and talented employees from early on. Jim Rogers and Charlie Munger added significantly. Accredited investors - anyone with $80 - can access Warren and Charlie's abilities through BRKB, a listed closed-end hedge fund. The active stockpickers at benchmark construction firms missed 45 years of massive growth but then add it to their "unmanaged" index! Real fiduciaries do not go near EXPENSIVE index funds.

Would Warren and George have bothered managing outside money if they hadn't been incentivized to do so and perform? It's skill that adds value. No alpha, no incentive fee. George's partnership fees were lower than Warrens's for gross returns above 25%. Since George and Warren's gross performance was in excess of 25%, George's fee structure was actually cheaper. Jim Simons and team have outperformed both for the past 20 years with much higher fees but the net returns of Medallion Fund were superior. The technological and personnel infrastructure requirements for high frequency trading cost more than for low frequency. If you don't like the fees, don't invest in hedge funds. Capacity for a good strategy is limited and demand exceeds supply of alpha. But it's expensive and dangerous waiting to find out WHETHER bargain beta might one day deliver.

Those "outrageous" fees? George charged 1% and 20% no hurdle whereas Warren charged 0% and 25% on 6% hurdle, then offered his money management skills for FREE in return for permanent, leveraged capital. But you would have done much better going with Soros Fund Management in 1969 and paying those "high" fees than you would with BRKA. I am delighted for people to be well compensated for delivering what I need, ABSOLUTE ALPHA, from their RARE abilities. If someone turns $1,000 into $100 million from skill not luck or riding the market, they deserve $1 billion. Especially when manager interests are aligned with clients by them being the largest investor in their fund. When George or Warren has a bad month, they PERSONALLY lose more than any client. That INCENTIVIZES them to do their best to minimize the downside.

This chart assumes fees compounded without the manager needing to eat, live, pay employees, run the business etc. which of course they do. In recent years, with investor demands for larger teams, deep benches and operational infrastructure, fixed costs for hedge funds have risen to the 2 and 20 mode. Two people, a computer and a phone do not get institutional money today. Sad though to see an Omaha pension fund deep in a $600 million deficit when they could so easily have hired a local hedge fund run by Warren Buffett to get them into surplus. The Hungary retirement system is not in good shape either but they could have invested with George Soros and would now be doing fine. Why avoid top absolute return managers when you have ABSOLUTE LIABILITIES to fund?

You can't eat relative returns but you CAN eat absolute returns and I'll take $100 million over $100,000 every time. I assume you would too. Sadly most "advice" focuses on asset allocation NOT manager selection. Save fees or upgrade skills? So what if the manager becomes a billionaire? They deserve it for the essential entrepreneurial service they offer. If clients get rich, it is fine by me if the manager gets richer. Plenty of "discount" funds are available but at what performance? Avoiding "high" fees for alpha is like saying to a Porsche dealer you will only pay $100 for a new car because that is what the raw materials cost. Or that Shakespeare was just a lucky fool who "randomly" chose words from the dictionary. I am writing this on Apple AAPL hardware using Microsoft MSFT software uploaded to a service owned by Google GOOG. Using those products may further enrich several people who are already billionaires. Does it matter? Or do SHARED incentives work?

No-one is forced to invest in hedge funds. Investors are free to make do with passive beta and relative return if they so choose. Some even say alpha doesn't exist! For those "surprised" by the Euro crisis in Spain, Ireland, Greece, Belgium, Portugal etc., George saw the dangers long ago. Yet macroeconomic "stability" maven Robert Mundell keeps his "Nobel" Prize for now. Optimum currency areas aren't optimal so he should give it to George. If you flip a coin 10 times and get 8 heads it might be a fluke but NOT if you flip 1,000,000 coins and get 800,000 heads. Warren and George have flipped too many coins for their returns to be considered luck. They made their clients rich, deservedly got richer themselves and are giving their wealth away for the social benefit of the world. A rare financial win/win/win.

Correlation or dependence?

2010-09-18T08:08:00.163+09:00

Correlation? Markets moving together? Correlation is a misleading metric of no help in achieving diversification. "Modern" portfolio theory is based on flawed and dangerously simple statistics. Conventional "wisdom" is wrong: highly correlated funds CAN diversify portfolios but some "uncorrelated" strategies are too dependent on underlying markets. Diversification has nothing to do with correlation. Correlation is not causation! It is NOT indicative of connection either.

Below is a hypothetical fund with absolute returns every year and CAGR +17.65% but PERFECTLY correlated to a risky index fund which lost money amid vicious volatility. Risk and return are unconnected AND uncorrelated. The fund provided great diversification despite that so-called calamitous correlation. More "sophisticated" tools like cointegration and copulas are also useless. Invest in truly skilled strategies. Throw the econometrics texts away. Know anyone that learnt to drive a car from a book? Would you accept a ride from them?

Most quants seem unaware how easy it is to prove that for ANY time series there are infinitely other perfectly correlated data sets that DO add diversification! So much for Markowitz and Sharpe portfolio "optimization" nonsense. The converse is also true. A zero correlated asset can be completely determined by the underlying. Check out something as simple as Y=X*X. Y has no correlation to X but is totally dependent on X. Plenty of "uncorrelated" products pretending to be "hedge funds" need a bull market to make money. Why bother with closet index funds delivering leveraged beta marketing themselves as "absolute return" products?

The diversification "free lunch" has been arbitraged away, at least in mainstream risky asset classes. The best way to diversify a long is with a short NOT another long. Diversify the right way not diworsify the old way but correlation is STILL used as a critical input for portfolio construction and risk management. Why? During meltdowns correlations rise but now it occurs in "normal" market conditions as well, adding to risk rather than reducing it. Securities may move together more due to herding, ETFs and algorithmic trading. The passive mania forces benchmark components up or down regardless of value whether stocks, bonds or commodities. Hasn't everyone learnt the danger of "cheap" index tracking and its expensive cost?

Beta is often cited as a measure of volatility. But it's really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta security that is high risk and a high beta fund LESS risky than the market. Idiosyncratic risk isn't a risk; it's the idiosyncratic alpha you want. Alpha and absolute returns aren't the same. The textbook calculations of beta and alpha are based on correlation which, as the example above shows, isn't useful. The identification of true beta - dependence on underlying risk factors - and true alpha - value added through skill rather than luck - is much more complicated.

The omnipotent correlation matrix drives much portfolio "optimization". A bunch of inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On "up days" most stocks go up but they don't all rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don't mind if an investment has correlation of +1.00, 0.00, -1.00 or anything in between. It's irrelevant. I do care it has minimal sensitivity to anything else in the portfolio. Sadly for investors MVO and CAPM have been shown to be simple, elegant and completely useless. MPT is pronounced EMPTY and is better called Medieval Portfolio Theory.

"Modern" portfolio theory requires lots of wild guesses known as capital market assumptions, including expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor "results" speak for themselves. Those variables aren't robust, stable or likely to be accurate in constructing a long term portfolio. I've kept track of such facile forecasts and the tea leaf reading so-called "experts" who made them. Pretty bad outcomes but those fortune teller predictions keep being used. We are ALL affected by assets being (mis) allocated in this failed framework. Unlike the crystal ball gazers, I find mispriced securities and safer strategies whose returns outweigh the risks. Is that so radical? At least it works.

Severe drawdowns are unacceptable. It is not surprising conventional wisdom has performed so badly with fake "Nobel" prizes awarded for such "efficient", mean variance "optimized" nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random, right? CMA causes almost as many problems as absurd actuarial assumptions. If you keep doing what you always do, you receive what you always get: growing liabilities AND declining assets. Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.

Dispersion? Every month reports emerge on how AVERAGE "hedge funds" performed. Those numbers are meaningless with such disparity of skills and zero-sum nature of alpha. Many public domain strategies are too well-known now so it is not surprising AGGREGATE alpha tends to zero. Skill is rare. The average hides a range of numbers from managers performing very well to many that did not. 2008 saw huge dispersion. The typical hedge fund lost -20% but 3,000 MADE money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of R-squareds, covariances and variances just don't make the grade.

The best sources of low dependence are diversifying by time horizon and spatially. High frequency trading continues to perform well. Amazing how the majority of portfolios still don't allocate to this reliable source of alpha. Last decade was great and returns have also been good this so-called "challenging" year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Despite many years of superior returns most investors avoid high frequency strategies! Perhaps "buy and hold for milliseconds" is the natural evolution from the archaic "buy and hold for years". Everything operates on short time horizons nowadays which is a mismatch with so-called "long term" investing. Instead I favor long term performance.

Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term "emerging markets" is often semantic arbitrage for countries that are actually developed. The big BRIC has lost badly to my BRIC but the SLIME has been the star this year. Sri Lanka, Iran, Mongolia and Estonia were missed by almost all international strategists. Could the geographic diversification strategy nowadays be to invest in places that don't offer ETFs? Don't asset allocate X% to emerging market beta. Invest 100% in alpha WHEREVER it can be found.

Unlike that unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistical parameters, I know that a properly diversified portfolio of the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver over time in all possible scenarios. Changing markets and crowded trades are no excuse for not being able to deliver absolute returns. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important.

Two investment products might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on underlying markets and focus on skill-based strategies. I prefer calculating co-relation and association metrics not coRRelations. High asset co-dependencies show the markets are even more inefficient. But REAL strategy diversification is what investors actually need.

Stocks or bonds?

2010-08-19T08:08:00.146+09:00

Stocks and bonds? Or alpha capture? Why does most investment advice fixate on how much to bet on various betas? My long BRIC versus short the street BRIC delivered good alpha this year. Since I wrote about it, long Colombia/short China returned +50%, long Indonesia/short India +30%, Bangladesh beat Brazil and Romania rocked Russia. Relative value doesn't usually make money on BOTH sides. Despite China hype, $1m in Colombia in 2000 is now $25m but only $2m from China and even less in "developed" countries. Economic growth doesn't imply strong stock markets.

Seek alpha or bet on beta? The more "risk averse" the more in bonds? Is it sensible to maintain the same static allocation at 1% yields as when they once paid 10%? Can opportunity cost, interest rate and default risks be ignored with coupons so low and borrowing so high? There are no risk free bonds but at least higher yields delivered the fixed-income on which many individuals and institutions depend. Regulation has as much chance of preventing the NEXT crash as ordering oceans to stop rogue waves. Get sunk again or ride them?

I've researched many successful investors and a common factor is that none paid attention to asset allocation. Instead they skillfully analyzed securities and tactically timed markets. I have also studied numerous unsuccessful investors and they all put static asset allocation front and center. Conclusion: 1) why waste time on something that the best don't? 2) asset allocation drives returns ONLY if you decide to emphasize it. Selecting which beta to track and then searching for funds to deliver it (and maybe a bit of alpha) hasn't worked. What does work is finding good unconstrained managers and let them figure out how to produce absolute returns. Passive "managers" take no action regardless of risks on the radar. Fiduciary duty? Better to focus on skilled strategies not unskilled asset classes.

Many investors suffer from Anton's syndrome. They think they can see but they can't. The mind confabulates a vision of smooth-sailing for their portfolio. Investment inertia and the endowment effect favors what they own not what they should own. Chronic cases delude themselves that efficient frontier combinations of unhedged asset classes will achieve +8% over the long term. Market timing is "impossible" so buy and hold for the economic utopia they can see but blind people like me cannot. Security analysis is a waste of time so buy them "all"? Whether inflation, deflation or biflation, the 60/40 portfolio is "optimized" for all yields and default probabilities? Buy even more bonds if you "see" yourself as conservative?

What if your required return is much higher? Worrying how quickly 2008 is being forgotten and falling off track records. Asset class amnesia is hazardous but financial anosognosia is worse. To have a defect is bad but to be unaware you have the defect is dangerous. The world divides into the few that know they don't know and the many that don't know they don't know. Using financial legerdemain that masks huge risks, famous index fund clairvoyants sell their "vision" that everything will be fine one day. I hope passive stock and bond portfolios don't die before then. How many planned retirements and retirement plans were wrecked by long only? Too many. A bond bull market is almost as bad for liability matching as a stock bear market. Pension underfunding is considerably worse discounted at CURRENT government and corporate bond yields.

Asset allocation varying by age? High opportunity cost putting capital in low yield securities. Bonds are good to trade but not buy and hold anymore. There are no stable laws in finance. Conventional wisdom was to put one's age in "bonds" and the rest in "stocks". But the rapidly growing cohort of centenarians needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The gradual switch from stocks to bonds over time doesn't cut it. More sensible is to have 100% of the portfolio in alpha strategies. The bond bull market has persisted for 30 years. Long only funds are like the Titanic; unsinkable till they do. Portfolio lifeboats include puts, shorts, derivatives and most importantly ALPHA for when beta hits the iceberg. Again.

Portfolio dead weight? High grade bonds were thought to match liabilities. They did once but now they do not. More a liability mismatch. A flat to down equity market combined with lower interest rates is not positive for the pension crisis. If you need an +8% income you can hope the stock market will deliver that "expected" return or focus on better alternatives. At such low yields, every cent in "risk free" bonds is a wasted chance for higher risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises as bond yields decline.

Keep it simple investing? Occam's razor? The only bar in William of Ockam's home town is called The Black Swan. Simplicity requires preparing for the worst case, most "unlikely" situations. I don't worry about unlikely events happening. I presume they are imminent and act accordingly. Every investor should apply a PROPER stress test to their portfolio. Instead of VaR, assume all stocks, bonds and real estate are worth ZERO tomorrow morning. Preparing for the doomsday scenario is true risk management. It has happened several times in many places in the past. That is not economic eschatology; it is prudent fiduciary duty. How many investors are ready for a 90% global stock market crash and widespread debt defaults? If not why not?

Someone asked my forecast for the Dow 1 year from now with 90% confidence. My best guess is between 0 and 20,000. That is as tight a bid-offer spread as I can manage. Predictive accuracy declines exponentially with time. While the Dow might never see 20,000 it is a physical and astronomic CERTAINTY it will one day fall to zero. Before then there are numerous armageddon scenarios that would nullify the stock market. Just takes a few drunken generals or mad scientists accidentally pressing the big red button. How do you know a large asteroid isn't on its way here? What would assets be worth if a black hole from a Magnetar was discovered headed towards us? If it can happen it will happen is not a prediction, it's a philosophy. Buy and hopers should remember that they are betting AGAINST the inevitable end-game. The true long term drift is down.

Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent "flash crash" was a reminder of the ephemeral "value" in the markets. It came back, that time. 2008 offered an expensive investment lesson for risky long only but still some invest in index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It's the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes. Unskilled AND unaware of it. Scarier than a real black hole but with similar results. No-one with a sensible risk tolerance invests a cent in index funds.

Invest in alpha opportunity sets. How much to allocate to "emerging markets"? How much to "submerging markets"? So many countries, cultures and disparate outlooks for all those stocks, bonds, commodities and currencies. "Frontier markets" don't have long track records but weren't all countries "frontiers" once? The China economy is larger than 3 years ago but the stock market is over 60% below its high water mark. The Japan economy is bigger than 20 years back but Nikkei 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to "hedge funds"? Every investor needs 100% in skilled strategies and that requires a lot of analysis and due diligence.

Search for yield? Earlier many experts said inflation was inevitable so short sell bonds but now deflation is the hot topic so buy them instead? Many gurus have lost big money shorting JGBs over the years but now treasuries are doing the same. If you need an explanation for the rally it is as much a short squeeze as flight to "safety". Trade bonds but don't hold them. Just like stocks. Applied skillfully, long/short equity is safer than long only. I'll take long/short credit, fixed-income arbitrage and distressed debt strategies over unhedged "investment grade" bonds every time. Some returns compensate for the risks. Asset classes never do including during bull and bubble markets.

Hedge fund?

2010-07-30T08:08:00.107+09:00

Hedge fund? Despite vastly superior risk-adjusted returns after fees, skill-based strategies are avoided by most. Stocks may eventually go up (or down) but why wait decades to find out? Since this blog began it's been great dialoging with many interesting people I might never have met. Away from the blogosphere I was busy helping investors make money and reduce risk. Developing portfolio rescue strategies and liability solutions takes time. Fiduciary duty is attempting to preserve client capital. It's better to hedge. It's best to select the best managers not the biggest ones.

Don't let the beta behemoths crush your portfolio, again, prudent man. Could individual and institutional investors afford ANOTHER severe bear market or credit cataclysm? There is no need for retirement savings and personal net worth to suffer the unreliability and volatility of long only strategies offered by the minor leagues. Better alternatives and uses of capital are available. Some bet on beta - the unskilled returns of asset classes. I favor alpha - absolute returns from skill. Major stock markets are lower than 5 and 10 years ago. Good for alpha but bad for beta.

I don't predict but can prepare. It's called "hedging". Industry inertia stops many from being allowed access to superior risk-adjusted returns. Strategy evaluation and manager due diligence require specialist expertise but it's cheaper than the damage wrought by "simple" portfolio construction. I don't know how much longer failures like "strategic asset allocation" and "time in the market" will exist. I do know that smart investors accept that safer strategies, radical restructuring and portfolio triage are required if long term returns are to be achieved irrespective of the economy. Below are the most popular Hedge Fund posts.

Hedge fund blog? I wrote this after flying up to New Zealand for a beauty parade. The sole reason they hire any manager is for REAL absolute returns. Relative return funds emerged out of "Modern" Portfolio Theory. Managers were asked to beat a benchmark INSTEAD of making money! To add insult to injury, "asset allocation" required funds to fully invest regardless of market conditions or valuation. Asset allocation even meant risk management was claimed to be "unnecessary"! Evaluate products for return on risk and alignment with clients. Don't get caught by tail risk. Hedge for black swan and purple sheep "rare" events.

Hedge fund test? In the real world, paper qualifications don't help much. A PhD in finance is not a PhD in making money. Spend 50 years theorizing at the Ivy League but 50 days on a trading floor delivers far more useful education. Economics Nobel prize winners are infamously negatively correlated with investment acumen and financial expertise. Random walk models, mean-variance "optimization" and CAPM have not aided investors that seek consistent returns. Check out the performance of traditional portfolios obeying ivory tower "advice" and groupthink "asset allocation". It hasn't worked and it won't work.

Private equity IPO? I don't usually recommend specific securities or mispricing opportunities since this is a free blog and it would be unfair to investors to reveal proprietary information. But the hyperbole and paradox of PRIVATE equity firms going PUBLIC at ludicrous valuations was a short sell opportunity that couldn't be missed. And some say liquid equity markets are efficient! It is rare to short sell the high (IPO time) and cover at the low (December 2008) but sometimes the harder you work the luckier you get. Shorting doesn't cause securities to go down of course; that happened when the market figured out the true value of FIG and BX. Why buy when insiders were selling?

2 and 20? Skill costs in all business sectors. With proper hedge funds, the after fee return to investors is higher than traditional products. Paying a few basis points for -50% losses isn't cheap. Many long only funds have 90% of returns explained by the benchmark. So the residual 10% explained by active management "justifies" a 1% expense fee? The IMPLIED expense fee for many traditional funds is nearly 10% since index tracking costs almost nothing. Often lower and sometimes higher the 2% management fee and 20% of new profits for a good hedge fund is a bargain by comparison. All alpha strategies are capacity constrained and in most cases the 2% is NOT a profit center. The more clients make the better "pay" for the manager. Incentives work over time.

Hedge fund quant? Curiously quant hedge funds are reviled even more than non-quant strategies. Even some "professional" hedge fund investors won't go near systematic trading. Bizarre considering the outperformance and diversification benefits. Almost everything has been blamed recently on a "new" quant strategy - high frequency trading. Humans are slow at large data set analysis, complex event processing and trade execution, so faith in only carbon-based managers seems quaint. The "random" markets are full of anomalies and computational intelligence is often the first to spot them. Anyone that avoids quantitative strategies does not have a diversified portfolio. Why ignore NEW ways of making money and reducing risk?

Hedge fund arbitrage? Those dollar bills are still being dropped on streets all over the world and being scooped up by the quick and nimble. Why take unhedged directional risk when the markets offer so many inefficiencies. The experts hate this notion because it goes against the house of cards theory that no securities are ever mispriced and so arbitrages cannot appear. Risk and return have no connection. Some arbitrages offer a good return for low risk. Meanwhile long only funds in major stock markets have delivered negative returns on very high risk. Finding lucrative arbitrages does take talent and expertise. Some even blame hedge funds for crashes. Causality is cloudy: did EWP have a good month due to "stress tests" or soccer success?

Rich enough for hedge funds? Retail hedge funds. Absolute return strategies on 401(k) menu options? Why can't investors of ANY net worth be allowed to invest in skill-based strategies? In some countries they can but in many they still can't. UCITS may help in certain geographies. There is no correlation between being an accredited investor and a sophisticated one. Whether you have $1 trillion or $1,000 to put to work, everybody needs as much alpha and strategy diversification as possible. The regulatory wealth test seems incompatible with personal freedom. Why "protect" Mom and Pop from products that perform and diversify portfolios?

Jack Bogle versus hedge funds? Jack Bogle is brilliant. A brilliant salesman of BELIEFS but the index crowd doesn't like being confronted with FACTS. Another 3 years on and "stocks" are even lower while "bonds" don't pay enough yield. While the S&P 500 has lost money, some component stocks dropped -100% whereas others have risen massively like AAPL, GOOG, PCLN, ISRG and CRM. Equities are opportunity sets for long/short alpha capture NOT buy and hope beta. Security selection can't be done? Market timing is impossible? Hold every stock regardless of price or prospects? George Soros, Warren Buffett and Jim Simons were just lucky flukes? 3,000 hedge funds making money in 2008 wouldn't have helped cushion the crash? There are no arbitrages?

Portable alpha? Don't add alpha to beta. Get rid of the beta and isolate the alpha. The portable alpha fad was weird. Now thoroughly discredited I've always advised any institution that asked against this crazy concept. Why waste alpha by "porting" it back onto a beta. It nullified the absolute returns of hedge funds by transforming it into relative returns! Shocking that it ever got traction but some promote it even today. As we saw in 2002 and 2008 and will again soon don't let beta drown the alpha. Strip out beta factor exposures by shorting derivatives and ONLY invest in alpha. Strategy alpha diversification not strategic beta asset allocation is the way to go.

Hedge fund definition? Uncorrelated? One of the problems with the "hedge fund" industry is that it is not rigorously defined and only a subset actually are hedge funds. The number of GOOD hedge funds is even less. As a rule of thumb I have found that 80% of "hedge funds" are unsuitable. Thorough manager due diligence, heavy qualitative and quantitative analysis permits the separation of the skilled from the lucky. Skill persists, luck runs out. Managers that make money in up markets and lose it in down markets are running mutual funds NOT hedge funds. Fortunately there are currently over 2,000 open hedge funds globally that do have skill. And the number grows every month.

The tipping point from beta-centric to alpha-centric portfolios is now here. Most mainstream commentary on hedge funds is uninformed and therefore negative. Those who criticise hedge funds have never invested in one. Few that take the time to understand skill-based absolute return strategies revert back to risky long only. Other industries embrace innovation but improvements in investment technology are still fiercely and often successfully resisted. Sad for those that need access to new sources of return. Whether the Dow is on its way to 50,000 or 0, the growth of the hedge fund industry is guaranteed. Smart investors demand ACCEPTABLE risk-adjusted returns on capital. Long only stocks AND bonds don't meet that standard.

Long and short?

2010-06-30T08:08:00.133+09:00

Long short? Diversification is "Don't put all your eggs in one basket". Instead I assume that some eggs WILL get broken. They always do. Short selling REDUCES portfolio volatility and systemic risk. Long short strategies, not long only assets, are the way to go. In a flight to "safety" investors ought to have more in hedge funds but instead buy low yield "risk free" government bonds! Why do some academics claim the market is rational? Why are they allowed to retain tenure?

National bias? Most investors expect the country they live in to have the best performing stock and bond market so they overweight "domestic" versus "international"! South Africa and Australia won the World Cup of equity index performance over the long term, 110.5 years. Presumably passive fans are loading up on EZA and EWA passive funds since "past is prologue" or is local bias still wrecking their portfolios? Unlike them I'm biased to skills NOT geographies. Where that skill gets applied is the manager's decision not mine. I allocate capital to brilliant minds NOT asset classes.

France are out of the soccer World Cup and it's Warren Buffett's fault? He shorted Les Bleus and profited from their demise. Where are the regulators? How dare he! Negative bets "cause" failure according to those who blame short sellers. Is failure due to fundamental problems or short sellers? Have eurozone sovereign debt spreads widened due to some belatedly realizing there are no risk free bonds or credit derivatives? Some say short selling is a drag on returns, derivatives must be banned while security analysis and market timing are a waste of time. They can try their luck with index funds but I'm too conservative for that. Anyone not shorting is not hedging.

A portfolio without shorts and derivatives is like a soccer team with no defenders or goalkeeper. The unhedged, unskilled equity crowd has underperformed CASH since France won back in 1998; so far my best ever year but commonly regarded as "bad" for alternative strategies due to the blow up of one fund staffed with Nobel Prize "winners". I was long vol but they were short vol. Absolute return funds have demolished traditional managers since England won back in 1966; the year when the flexibility and lower risk of long/short was first widely publicized and shown conclusively to be a vastly superior and safer strategy for portfolios. The fact is that markets where short selling and derivatives are not allowed have WORSE crises.

After 45 years of vexatious volatility, insidious inflation, debt defaults and failed financial dogma, how much longer must most investors wait to be allowed to properly diversify and allocate to genuine skill? That "long term" stock market upward drift doesn't seem to be working and "risk free" bonds carry yields woefully inadequate to compensate for their MANY risks. Even worse is that bond benchmarks force traditional investors to lend the most to those that borrow the most regardless of yield! Not what a prudent man would do. Why invest in such toxic waste as capital-weighted fixed-income bond funds? Cheap? Hardly.

Anyone competent knows FUTURE talent is detectable in any field. It just takes hard work, due diligence and experience to find the top performers in advance. Skill must be unconstrained which is why mandating good active managers to be long only gets similar results to blindfolding good football players. For those who still prefer human decisions to computer driven strategies, check out the results of world cup referees not using modern technology. Then check out the portfolio performance of investors that avoid BETTER ways of making money with skill-based strategies. If there is no such thing as investment skill, there is no such thing as sporting skill? Imagine the world cup if EVERYONE that has ever kicked a football was eligible to play. Dumb but that is what some advocate in the investment world. Buy and hold ALL stocks since "no-one" can pick stocks!

For long term investors, long/short is better aligned with economic reality than long only. People exposed to commodity price volatility have hedged with shorts and derivatives for centuries but even today there is not enough hedging of equity and credit beta risk. Those seeking consistent performance invest in skilled managers not asset managers. For funds that held the largest stocks to minimize tracking error, BP is yet another reminder that there are no blue chip, buy and hold "securities". BP stock crashed due to poor management or short sellers? If one hedge fund drops a few billion, some urge avoiding all hedge funds but when a stock loses $100 billion they don't say avoid all stocks. Argentina bonds lost over $100 billion a few years ago.

Avoid all bonds because of Greece? I recently met with a fund that blamed the "unprecedented" Greece situation for why they lost money! Proud of their terabytes of "historical" data, amazingly they were unaware Greece has had many defaults over the past 2604 years. Starting with the attempts of Solon for financial regulatory reform in 594BC and more than 100 of the past 200 years. Investors can learn a lot from the greeks. On trial for daring to challenge conventional wisdom, Socrates' prophetic last words were "Please don't forget to pay the debt".

Archimedes invented leverage and was prescient in saying "Give me enough leverage and I will move the world" considering how borrowers have moved world markets recently. It always puzzled me how pundits worried about hedge fund leverage but treated government bonds as risk free. The only risk free rate is zero. Every country is a great place for alpha from long/short NOT long only beta. Solon rule = 594 BC, Volcker rule = 2010 AD. Not much changes in finance.

Aristotle also offered investment advice. "The aim of the wise is not to secure pleasure but to avoid pain" - the wise short sell and hedge downside risk to avoid portfolio pain. "Hope is the dream of the waking man" - if you hope a losing position will turn into a profit or a long only stock and bond portfolio will fund retirement liabilities you are dreaming. "A great city is not to be confounded with a populous one" - invest with great funds not necessarily the biggest managers. "The greatest virtue is those which are useful to other people" - absolute returns are very useful to clients but they can't eat relative returns in down markets.

Much hope for the future relies on dubious assumption that "stocks" eventually rise. Sorry but there is NO expected return and NO equity risk premium. NONE. Long only credit is bad, long only equity is worse, long only commodities is crazy. Over time most equities FALL as any thorough empirical examination of buy and hold confirms. Short selling permits absolute returns from the majority of stocks that go DOWN over time. In my experience bear markets create increased alpha opportunities. As with the World Cup there are always more losers than winners which makes it OPTIMAL to have more shorts than longs and benefit from the natural selection and creative destruction of the markets. 130/30 or 30/130 since MOST stocks are short sells not buys over that infamous long term.

The weakest prey are the easiest. There are far more long positions than shorts out there. Broker dealer analysts issue far more "buys" than "sells". Long only fund management has much larger AUM while weaker hedge funds tend to be LONG/short rather than long/short or market neutral. Lack of performance incentives means many long decisions aren't made for legitimate reasons. Too many stocks are bought because they are in an index NOT because they are good investments. Many bonds are held because of investment grade "ratings" regardless of yield. Low returns and high correlation in May 2010 shows little has been learnt from 2008 in terms of proper risk management, reducing market dependence or focusing on truly uncorrelated strategies.

The congenital long bias means shorting attracts a higher percentage of people who know what they are doing. In general the PROPORTION of smart money in shorts is higher than the smart money in longs. Since alpha is generated by the skilled out of the unskilled, position against where the most unskilled money is. Despite what some still(!) say, there is no evidence that risky assets rise over time or compensate for risk. Alpha is zero sum - smart money makes alpha out of dumb money. Identifying dumb money most often means looking for weak longs and taking the other side. There is obviously more dumb money on the long side than the short side.

REAL alternative investments offer alternative returns. I evaluate hedge funds to REPLACE market risk with manager risk. A "hedge fund" that is dependent on up markets is of no use. Making money in bear markets is more valuable than absolute returns in bull markets. In good economic times traditional assets perform, people have more spendable cash, greater access to credit and rising real estate prices. Individuals and plan sponsors have more earnings to contribute to DB and DC pensions. Foundations and endowments receive more from benefactors. But in negative periods for asset classes, the need INCREASES for absolute returns. In May 2010 we saw a repeat of 2008 where thousands of hedge funds MADE MONEY but the "average" did not. Beta pollutes many alleged alpha engines. Alternative beta is as unsuitable for risk averse investors as traditional beta. Absolute alpha is what to look for.

While some still believe that shorts and derivatives fuel down markets, the fact is there is not enough use of them to diversify, hedge and make money. Stock market drawdowns need not negatively impact any investor's portfolio. With so many aspects of people's lives affected by the economy, their savings and retirement plans ought to be immune to the volatility of long biased equity and credit. The bull market tide went out recently revealing many naked, overly risky, poorly constructed portfolios. And for every GOOG, EBAY or AMZN there are hundreds of failures. We get reminded of the rare stock that actually did do well over the long term but not the many, many more that disappeared or whose IPO price was the all time high.

Most of the greatest trades ever have been shorts. Whether it was John Paulson shorting subprime CDOs in 2007, George Soros the British Pound in 1992, Jesse Livermore USA stocks in 1929 or Munehisa Honma's rice short in 1789. There have been many attempts to ban short sales since Isaac Le Maire famous short sale of VOC back in 1609. VOC was established to exploit yet anther "Asia boom" like now. The only way to truly diversify or hedge a long is with a short. Why does conventional asset allocation range from 0% to 100% when investors could use -100% to +100%? Even better would be to acknowledge the failure of stategic asset allocation targets to deliver what investors actually need and put it in SKILLED uncorrelated long/short ALTERNATIVES.

Every investor needs short positions and to use derivatives. It's called hedging. Few managers have the capability to make money in bear markets. Sadly too many fail in due diligence to show they have the quality of risk management, strategy testing and expertise to deliver positive performance in negative periods. Despite the lessons of thousands of years little has been learnt about decorrelating a portfolio to underlying risk factors and immunizing against economic volatility. The fact remains that long short is better for conservative investors than long only. Eliminate beta risk factors and focus on alpha from long short market timing and skilled security selection. The TRUE drivers of portfolio performance.

Socrates said "I am not an Athenian or a Greek, but a citizen of the world" - invest in alpha opportunities anywhere not the country you happen to be in. "The only good is knowledge and the only evil is ignorance" - financial ignorance is abundant but there have been great returns made by the rare knowledgeable. Small losses are a cost of doing business whereas large losses stem from ignorance. The ignorant believe in long only stocks and bonds. Don't join the suckers. Hedge.

Greatest trade ever?

2010-05-06T08:08:00.032+09:00

Greatest trade ever? Alpha capture is war and victors don't take prisoners. What if the Goldman Sachs CDOs, Abacus and Timberwolf, had not blown up? Buyers now called "brilliant" gurus for their perspicacity? GS excoriated for failing to disclose to loser shorts that winning longs had bet against them? Would it have been a case? As ever, the message for investors remains: caveat emptor, caveat venditor, caveat utilitor. Buyers, sellers and users be grateful to those betting against you. How else can alpha be made from them?

John Bogle's nemesis, Dr. Michael Burry, back on double shifts at the hospital? If subprime CDOs had not imploded would Michael Lewis have written "The Big Long" on credit bulls picking off dumb bears? Or Gregory Zuckerman on the "The Worst Trade Ever" how an obscure merger arbitrage trader named John Paulson went bankrupt style drifting into shorting subprime? Magnetar sucked into a black hole? What if Paulson HAD bought and then reversed to the short side. Would it have changed loan selection or credit rating? If I buy a security should it concern me if you are short? Is it incumbent on the broker to inform me that you or they are? Should it affect my analysis knowing others think differently? NO.

Wary of "misleading" non-disclosure, I fled to the relative safety of stocks. I selected 500 overpriced reference securities to bet against. Luckily some quantitative geeks had already assembled a listed structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary failed to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the salestrader herself confided in an email that she was bearish at that time but her function was facilitating CLIENT transactions regardless of personal or her firm's market positions. Anyone long that SPY ETF asset-backed security and not made aware of my short has recourse to the structurer? Ridiculous.

Deception? Designed to fail? For EVERY purchase there MUST be a seller. I wonder about that fateful meeting in January 2007 between Goldman Sachs, ACA and Paulson. Would buyers have walked away if the marketing materials had stated on the front page in bold red ink "A merger arbitrage fund you likely haven't heard of with no known expertise or track record in credit helped choose the underlying loans and might bet against them". Or "Fabulous Fab and some of the other Goldman Sachs proprietary traders at this moment happen to be bearish on subprime but they have been right AND wrong in the past". How might this have changed investor appetite? Lists of shorted stocks are published but does this make every long get out? Never buy IPOs as insiders are selling?

There are ALWAYS bears on anything. If there are no bears get short immediately! If then unknown Paolo Pellegrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an outlier opinion ignored by the street. Even I wrote several bearish posts in early 2007 and investors that followed that advice have made very high returns but most ignored those too.

To make money out of the credit meltdown you didn't have to specifically short subprime as it would obviously negatively impact most risk assets. Was Fabrice Tourre wrong in his "smoking gun" email to express his then view that shorts were more likely to win than longs? There have been many securities constructed on reverse enquiry from hedge funds where that client ended up being very wrong. I also know of IPOs for "overvalued" companies considered "bound to fail" that subsequently went up 1,000% after listing. Everyone gets it wrong sometimes.

Today I naively took the risk of renting a car. After closing the deal I was shocked to see vehicles coming in the OPPOSITE direction. NO-ONE TOLD ME. The salesperson said nothing and the documentation had NO disclosure about this risky two-way flow. More due diligence revealed that despite heavy regulation and licensing, these dubious inventions KILL over 1,000 people EACH DAY from such collisions! Again zero mention in the legal paperwork. Did the arranger commit fraud by failing to inform of the dangers? CDOs can't be traded by most individuals but calamitous CARs are still widely available to the public. Why? Where are the regulators? Get these murderous C-A-R things off the street, NOW.

If I had an accident could I claim they had selected a car they "knew" would crash or would it be outcome bias? Subpoena to Congress those merchants of mayhem and dealers in destruction like car rental firms? I even saw a "rogue" employee knowingly bet against me driving north while I headed south. Such conflicts of interest and idiotic innovation needs to stop before even more people die in toxic tort products known as cars. Ban derivatives trading so ban driving since it is much riskier? The world thrived for a long time before "monstrousities" like C-D-Os and C-A-Rs were created. Get CDOs wrong and just lose money but outlawing CARs would save millions of lives over time.

Alpha battles have casualties. Finding alpha is a zero-sum ADVERSARIAL game of losers AND winners. Zero-skill, crowded beta is "cheap" but insightful analysis and variant perception costs 2 and 20 or more. Contrasting views make a market. It is dumb and suboptimal to presume a counterparty is looking out for you when they take the OTHER side. That is why they are called COUNTERPARTIES. The juxtaposition of ideas helps prick bubbles earlier than a one-way market. If I buy I WANT as many smart people as possible hoping I am wrong. If I short sell I am most comfortable and make the highest returns when sophisticated professionals are buying and A-list analysts regard it as a core long. PLEASE, PLEASE EVERYONE BET AGAINST ME. Thanks.

You can ONLY produce alpha when others lose. Therefore it is essential for others to oppose you. Longs need shorts and vice versa. The most alpha appears when most are wrong. A rating of "strong buy" on a stock or "AAA" for a bond is just someone else's opinion. It is up to investors to do their own analysis or hire advisors working FOR them. Do your own due diligence or find someone to do it, for YOU, that has the rare expertise and whose interests and INCENTIVES are aligned with yours. Cheerleaders cheer the team that pays them not necessarily YOUR team. It is not of the slightest interest to me that others have the opposite opinion except that the more there are the more likely I will be correct.

If I buy the more shorts the better since there is higher probability of a short squeeze. If everyone is buying, it is often time to short sell. Rather than being horrified that others think differently, it is excellent and favorable news. When I buy a security I assume and expect people are betting against me. If a market maker has a bid-offer spread and I take the offer, they are often left short temporarily if they don't have inventory. They are then technically betting against a client but does it matter? Any market participant surely knows there will be opposing positions. Investors are free to choose pure execution-only brokers or investment banks well-known to have large proprietary trading operations that may or may not be betting in a different direction. The only Chinese Wall in the world runs just north of Beijing.

Would regulation and transparency have prevented the credit crisis? There have been many financial panics and real estate crashes in the past. Did CDOs and shorts "cause" those also? Why have there been worse ones where there were no derivatives or shorting? No security EVER trades for what it is worth; differences of opinion fuel all markets. If you short sell something you need as many people as possible to be bullish. Shorting rarely causes a security to go down. When you buy, the preferred situation is that many others are short. Exploiting the madness of crowds is the key factor for alpha. The more investors doing the opposite is POSITIVE if you have an edge. If you've done you're research it ought to increase trade conviction. If you don't have an edge why are you investing? Some think security analysis is a waste of time and John Bogle was as accurate as usual in ridiculing hedge fund managers who bother with skilled hard work.

All deals produce winners and losers. For every buyer there must be a seller and often a short seller. Is it always necessary to disclose that others including originators might bet against you? And if they do should it change your view or rating given your analytical edge? If you are bullish surely more bears should make you more bullish if you are confident of your ability. Blame the crisis on 2 and 20 and deal structurers or the 2 and 28 ARM lenders? Or on the inevitable boom and bust, greed and fear of the crowd. Manage risk and invest in skill to survive PREDICTABLE cyclical behaviour. Variant perception is what creates value for clients. Some speculate on conspiracy and collusion but it is usually just the Emotional Markets Hypothesis at work. All securities at all times are wrongly priced.

Short selling does not make securities to implode. It can however slow bubbles from turning into superbubbles and potentially worse problems. It may be counterintuitive but short selling subprime may have prevented larger losses and bigger issues. Some argue that credit repackaging exacerbated and perpetuated it but do not explain earlier crashes and meltdowns. With only longs, the Japanese credit bubble of the 1980s happened without CDOs, structured products or hedge funds betting against it. Subprime lending was invented in Japan and the crash's effects still exist with the stock AND real estate markets 75% below high water marks. Short sellers and transfer of risk are positives not negatives for economic growth. Real estate booms and busts have occured for centuries. Sovereign defaults and bailouts are common yet rookies treat the Greek situation like it is unprecedented. Greece has been bankrupt more often than not since 1810.

One of the strangest results of the 2007-2008 post mortem was the slow motion reverberation from credit to equity. Even if you missed the credit short there was plenty of time to get short of equities. No-one could have predicted the crisis? Really? Many correlation "traders" short sold correlation at 0.3 and watched helpless as it gapped straight up to 1.0. Gaussian copulas absurdly assume constant default probabilities just like gaussian Black-Scholes crazily relies on constant volatility to allegedly "price" derivatives. The added complication with credit is the non-linear binary payoff. Either the debt is serviced or bankrupt. With low interest rates, yields often do not compensate for default risk. All an investor can do is their own analysis or hire an expert whose interests are the same as theirs. If you need a friend get a dog.

Full transparency: I am short the SPY, QQQ, EEM, EWJ and many other asset-backed securities and credit structured products, however I might reverse and go long between 20 microseconds and 20 years from now. Whatever or whenever an investor buys or sells, it is PREFERABLE that others are betting the opposite way. To generate consistent alpha it is necessary to have counterparties with different opinions. It is obligatory for others to disagree with you. Their existence is mandatory for seeking alpha.

Hedge fund pay?

2010-04-08T08:08:00.179+09:00

Hedge fund pay? Hedge funds deliver great social and economic value. Pensions fully invested in good hedge funds have better funded liabilities so avoid benefit reductions, raised retirement ages and higher capital contributions. Foundations committed to alternatives have more for worthy causes. Endowments properly allocated to absolute return gain more for students and faculty. Some investors take their chances with "low fee", high cost unskilled index funds but I don't gamble. I prefer hedge funds as AFTER FEE returns are much better.

I'm a value investor and very conservative. I started by purchasing emerging and frontier market debt, equity and real estate far cheaper that its intrinsic worth. Also I spent years buying deeply mispriced options, derivatives and hybrid securities in those "unpredictable" and "efficient" markets fantasized about by Nobel prize economists. Recently I've helped fiduciary clients construct portfolios of managers whose fees are a bargain compared to the VALUE provided. The higher hedge fund pay, the more investors make.

Incentives work. We can be thankful REAL hedge funds exist to deliver when traditional investments don't. 2 and 20 is a bargain to incentivize top managers to take outside capital and build an institutional infrastructure when they could choose to just manage personal and friends' money. If you want to be CERTAIN of a secure retirement avoid long only stocks and bonds and focus on diversified absolute return strategies. Hedge fund salaries accurately align the interests of clients with managers and reflect the enormous demand for and limited supply of true investment acumen.

$5 chalkboard = index fund --> $500 Apple iPad = hedge fund. Investors can choose old products or more powerful performance. Individual investors ALLOWED to invest in good hedge funds retire earlier and wealthier. Make clients billions and receive $1 billion for doing so is a win/win deal. Hedge funds provide deeper liquidity and act as a buyer of last resort thereby REDUCING market volatility. Making money in a recession is when alpha is needed most and what clients hired managers to do.

Those capital gains or notorious "wages" mostly go to hedge fund charity. Hedge fund pay is a kurtotic variable where fat tails render means meaningless. Rich lists miscalculate "income" and customers ultimately sign all "paychecks". Those delivering absolute returns deserve a share for making and saving clients far more. Funds below high water marks aren't paid well in drawdowns as the 20% incentive fee only applies to new profits. Necessity is the mother of invention and we need INNOVATIVE alpha sources and lower risk portfolios.

Successful hedge fund managers are entrepreneurs with an essential service in high demand. No matter how long a firm has been in existence I regard hedge fund investing as similar to venture capital. Angels that stake other private business get just 25%, and often less, of gross returns whereas investors in hedge funds receive 75% of gains. Managers retain the balance for sweat equity, 100 hour work weeks and low pay when underwater. Hedge funds make their talents and technologies available for a very competitive price. The value proposition is over three times better and with considerably less risk.

Positive numbers in 2008 and 2009 is impressive and over 1,000 managers did just that. "Aggregate" hedge fund returns are routinely cited but not AVERAGE hedge fund pay. In finance the average can confuse and disguise risk. Some CDO structurers mixed 700 FICO with 400 FICO scores for "average" default rates and a few managers figured out the dangerous result years beforehand. Some good hedge funds that lost money in 2008 worked nearly gratis last year with the 2% going to employee and infrastructure costs. Much "pay" was capital gains on own cash: shared upside AND downside aligned with investors.

Hedge fund managers able to deliver persistent returns could avoid many hassles by only trading personal, family and friend money. To use up capacity and endure the due diligence and monitoring to accept outside OPM cash it should be financially worthwhile. Many good hedge fund managers like Michael Burry close due to success and before reaching billionaire status. Reverse survivorship bias? Why do so many assume that a hedge fund that ceases to exist must have blown up? Are two of the best shows on TV, 24 and Lost, "failures" because they are also shutting down?

An unbiased qualitative and quantitative analysis of the FACTS shows that absolute alpha is a bargain. I prefer managers to make billions since investors will receive many more billions under that payoff scenario. Hedge funds don't exclusively trade for the superrich; they manage money or soon will be for most retirement plans and eventually a majority of individual investors of every net worth. Few on the rich list spend much time on static asset allocation. They focus on security selection, tactical timing and, most important, value creation for clients.

In other industries "change in net worth" is not "salary". David Tepper, manager of Appaloosa, apparently received the highest "paycheck" of $4 billion, followed by George Soros at $3.3 billion, James Simons on $2.5 billion and John Paulson with $2.3 billion. They and their teams produced a lot of alpha and rightly received compensation for skill and shared capital alignment with investors. Given the anomalies and inefficiencies created by forced selling in late 2008, I wrote it was obvious 2009 would be an excellent year for alpha just like deleveraging in late 1998 and negative sentiment on hedge funds led to a great 1999. The hot money panicked but sophisticated investors saw the opportunity.

I am typing this post on my newly acquired Apple iPad. That might help Steve Jobs be "paid" more billions but, like absolute return, the product is tangibly useful and fills a need. Similar to proper hedge fund managers, the Apple AAPL people deliver performance that most want so they get paid well. The Masters golf championship is being held today where someone will receive a lot of money for the best putting skill. Putt for dough and perform for dough since investment skill is much more valuable. Unskilled golfers don't play at the Masters and unskilled fund managers don't work at GOOD hedge funds. But hedge fund databases list thousands of hedge funds that aren't good, dragging down "aggregate" returns. Can you imagine the typical score at the Masters if every "golfer" played? 100+?

Performance net to clients is what matters. Wisdom surpasses wealth and fees for expert knowledge are more than justified. 20 years is a long time applicable to most investors. Below is the total return of the MSCI World versus hedge fund benchmark, the HFR Fund Weighted Composite. Clearly consistent outperformance net of all fees and the difference will be just as wide in 2010-2030. Considering the 80/20 Pareto rule of thumb I use that 80% of hedge funds do not generate alpha, investors with robust portfolio structuring and manager due diligence processes have done better and will continue to do so. Expertise exists at many levels and has great value.

High frequency trading?

2010-03-21T08:08:00.131+09:00

High frequency trading? The highest LONG TERM returns come from SHORT TERM strategies. My preferred holding period is forever but it's rarely feasible and NEVER optimal. A substantial allocation to HFT is essential for all investors as market volatility, creative destruction, industry innovation and economic instability are omnipresent. Low frequency trading doesn't diversify enough so investors also need high frequency strategies. New time horizon alphas reduce risk. Invest across the entire holding period continuum. HFT adds huge liquidity to the markets but adds vast alpha to client portfolios.

Fractal diversification is mandatory for ALL portfolios. Markets are self-similar at any time horizon. It's safer to hold a stock for milliseconds than decades despite "experts" say. The lazy "buy and hold" no frequency crowd can scoff but high frequency funds are IDEAL for retirees, widows and orphans. Certainly they offer better returns at lower volatility than "risk free" government bonds. Moving from glacial milliseconds to measuring execution latency in microseconds was inevitable but now people are talking in nanoseconds. That's GREAT for investors.

Light takes a entire nanosecond to travel from the screen you are looking at to your eyes. Much longer for my pathetic non-silicon brain to process and act on the information. No surprise most humans are BAD at investing when they are so slow and emotional. Picoseconds next? At least Planck time and Einstein's light speed constraint put a physical ceiling on how quick trading will ultimately get. With co-location competition, the time arbitrage arms race is reaching its zenith which puts the emphasis on developing better intellectual property.

Best hedge fund for the next decade? The chances are that fund does not yet exist though I met with some good start-ups recently. What about the top strategy? That has also likely yet to be invented. Some trends are certain like growth of alpha industry AUM from the currently tiny $2 trillion to at least $20 trillion by 2020. More +$100 billion hedge funds will emerge, most not well-known today. High frequency trading was the best category in the 2000s but it won't win again with so many amateurs entering the field damaging "aggregate" returns. The obscure is now mainstream but the skilled will thrive extracting zero-sum alpha out of high frequency wannabes and has-beens.

To hedge or not to hedge? That is the question. Ten years ago I presented at a conference on "whether" institutions should invest in skill-based strategies. The key takeaways from some gurus also speaking then were that investors didn't need hedge funds and likely didn't even require long only active managers since "cheap" passive index funds were bringing in +20% a year and could be "assumed" to return +10% over the "long" term. Fundamental and quantitative analysis were a waste of time as was paying the "cost" of hedging. Transaction costs and electronic trading didn't matter because you should just buy and hold. Be satisfied with "market" returns? Asset allocation was risk management!

What market returns? Instead I prefer absolute returns. Apart from public markets are "efficient" and there is no such thing as investment skill(!) as it is simply random luck, I heard other dubious "facts" from the experts:

1) the apotheosis of risky buy and hold to its exalted and unjustified status
2) hedge fund capacity was "limited" and $1 billion was "too large" AUM for one firm
3) "high" 1 and 20 fees were "certain" to drop. They are now typically 2 and 20
4) after a weak 1999, CTAs, global macro, vol arb and short sellers were "finished"
5) private equity and real estate returns are "independent" of the stock market
6) short term trading "didn't work" and was "unnecessary" for long term investors
7) liquid equities in major markets were "always" efficiently priced so no alpha!

Those ideas were woefully wrong and I told them so at the time. High frequency trading went on to be the best strategy in the 2000s. Long term performance doesn't require a long term holding period. Most people in high frequency until a few years ago were good but copycat rookies are crowding into an area they think they have the expertise to compete. This creates more trading opportunities and greater AUM capacity for the best players. Contrary to theory, the more liquid and number of participants the more INEFFICIENTLY and WRONGLY priced securities become. Irrationality does not cancel out so there are more anomalies and mispricings than ever before. Alpha is abundant but the skill to find it is rare.

The evolution to very short holding periods is the inevitable progression of Grinhold and Kahn's Fundamental Law of Active Management equation: IR=IC.TC.SQRT(breadth). Translating the formula, if you have an investment edge then apply it as often and as widely as possible. The transfer coefficient is how efficiently active bets can be implemented and lower trading costs helps increase that. Breadth is the number of securities to which you can apply that edge. Stocks, bonds, currencies and commodities all have GROWING numbers of liquid securities suitable for HFT.

The more skilled bets you can make the better the information ratio. Active managers deliver the MOST value to clients by trading as many securities as FREQUENTLY as their competitive advantage allows provided they have talent, excellent execution and are UNCONSTRAINED as to longs AND shorts and what they are mandated to do. Hire managers to make money how they see fit not to just give you unhedged exposure to the ups and DOWNS of an asset class. The move to high frequency is simply the natural and logical progression of investment technology.

Absolute returns are spendable cash unlike in the relative return universe. Higher frequency of investment decisions matters. We know from failed investment policies that rebalanced beta asset allocation is not sufficiently reliable if you seek to fund future retirement liabilities. What works is the dynamic triple alpha process of ongoing portfolio structuring, strategy selection and manager due diligence. We might not exist were it not for the triple alpha of nuclear fusion and the chances are portfolios will not perform over the long term without skill fusion. Real ultra low latency high frequency execution: it takes less than 200 attoseconds for the triple alpha process to complete.

Technical analysis supposedly doesn't work so fund managers use semantic arbitrage and refer to it as pattern recognition instead. The seminal studies are correct: publicly disclosed technical indicators and "charting" methods are useless. However proprietary predictive black box models and artificial intelligence systems continue to perform outstandingly as many quantitative hedge funds have demonstrated over the long term.

Despite being considered "new", temporal arbitrage has been utilized for centuries. There is nothing modern about exploiting time advantages. Didn't the Nathan Rothschild credit hedge fund make money out of slower investors in 1814 with early news of the Battle of Waterloo outcome? He short sold consol war bonds, the CDSs of the day, then went long and short squeezed the crowd the tried to follow him. Munehisa Honma's managed futures CTA hedge fund back in 1753 constructed a high frequency data transmission and execution platform by stationing village runners as information conduits from where rice was traded to where it was grown. Momentum, mean-reversion, trend following and statistical arbitrage have been around a long time and work on numerous time frames.

Samurai trading: the time between the decision to trade and executing that trade must be minimized. The quicker and better you are at information gathering and analysis then the higher the performance. The edge in high frequency is often slippage minimization and better transaction technology. Robo-traders and bid offer spread capture blurs the line between market makers and market takers. The fractal nature of markets means that the main constraint on capturing opportunities from microstructure and macrostructure were trading costs which continue to fall. Long term = investing, short term = speculation or vice versa? Buy and hold for years or milliseconds? They are structurally isomorphic with time the only variable but the LONGER you hold a security the MORE risk you take. Ask General Motors and Japan Airlines buy and holders about that. There are no blue chips, anywhere.

There is still plenty of money to be made out of the unskilled in high frequency strategies and capacity is expanding rapidly. Very liquid ETFs like SPY, QQQQ, EEM, IWM, UNG, EWJ and XLF already have most of their volume from shorter term strategies. Foreign exchange, the E-minis and KOSPI futures are probably the best equity trading vehicles on the planet and being the most liquid are of course the most wrongly priced which creates a lot of alpha opportunities for talented traders. FX offers a vast range of alpha capture opportunities as do the more liquid bond and commodity futures. The more liquid the more alpha available.

When you buy a security you might hope to hold the stock for decades or the bond to maturity but the reality is that a short term outlook is usually necessary for risk management. Commodities and currencies are fantastic for trading but never for buy and hold. Long only commodities is one of the oddest ideas out there. Long/short commodities should be core in any portfolio. The many gold bulls might recollect that GLD remains mired in a six hundred year old BEAR market and nowadays there are more sophisticated and lower tracking error ways available of hedging inflation or for difficult times.

There is a strange populist idea circulating that short term trading serves no economic purpose. The investors that DID allocate to high frequency are today better funded than those that concentrated solely on long term stocks and bonds. Alpha always has superior risk-adjusted returns than beta. Surely added liquidity is good for everyone. Those markets that heavily tax trading or ban short selling have deeper drawdowns and higher volatility than those that do not. Investors gain from lower transaction and slippage costs. The events of 2008 would have been worse were it not for the liquidity provided by automated and systematic traders. If you MUST make a fire-sale during a crash, the presence of buyers is essential. High turnover of a portfolio isn't bad and is often essential to control risk.

Whether carbon-based or silicon-based, sapient entities of all kinds can succeed in quantitative short term investing if they work hard enough and spend many years building core expertise in the hard sciences without the luxury of a steady salary. Get fluent in C++, Java, Matlab, Mathematica and building an ultra low latency execution and market impact minimization infrastructure and anyone can be an HFT player provided you are also better than 99% of the other people trying to do it. A cheaper and quicker way for most is to hire a skilled manager to do all this for you.

The returns can be high but the cost of getting good are very high. Hidden Markov models, speech recognition and compressed sensing can help determine the probability of near future moves when you have methods to analyze recent history and are able to identify order embedded in assumed randomness. Sparsity of data is an occupational hazard in the prediction of financial markets but tick data provides large information sets to detect hidden structure. Hidden to the ridiculous random walk ranters that is.

Low frequency managers need to invest for years before we can be sure it wasn't luck. The more trades you do, the shorter the track record needs to be to demonstrate skill. Rightly or wrongly the world increasingly functions on short term factors. Therefore as an investor you have the choice of fighting the trend or accepting the high frequency attention span of most market participants and mainstream media. We live in a Twitter world where what is hot today is not tomorrow. Stock trading is already a level playing field. Algorithmic execution systems are arbitraged by better algos.

Flash orders and sniper, guerilla or ninja algorithms are available to anyone prepared to pay the high price of access, hardware and software development costs. Dark pools lose out to darker pools. This also creates opportunity for long term investors that have the ability to find good securities amid the fluctuations. Make money from the volatility (HFT) or through the volatility (LFT)? Both but one firm cannot be good at everything which is why broad manager diversification is necessary.

There are very few long term winning securities and price predictability declines sharply with time horizon. Consistently accurate forecasting is extremely difficult but investing with a 30 millisecond outlook has more probability of success than 30 years. Amazingly brilliant are the clever clairvoyants that "know" the stock market will "definitely" be higher in 2040 than today. Wish I also had a time machine that could look ahead that far. Considering the 1910-1940 and 1810-1840 eras I wonder why they are so confident this time around. They must know something I don't.

You need 10,000 dedicated hours to get good at something. To get basically competent at investing probably takes 10,000 separate trades or at least the thorough analysis and due diligence of 10,000 different investment ideas. As a researcher at Renaissance Technologies recently noted, "We try to find these very obscure patterns hidden in a lot of noise". There is also a vast amount of noise in portfolio construction and fund selection but one signal is clear. Strategy diversification with many different managers whose holding periods range from femtoseconds to decades.

The solution for consistent capital growth at low volatility already exists and investors need high frequency trading strategies if they want good risk-adjusted returns EVERY year. High frequency trading is a must for every portfolio. Skill based spatial and temporal alpha is the way to go.

Emerging market alpha?

2010-02-02T08:08:00.275+09:00

Emerging markets have done well. Most investors used to focus on "developed" nations due to the Asia crisis, Russia default and 1990s bubble. They missed high returns "overseas" but endured the uncompensated risk of "safer" home markets. I try to buy when securities ANYWHERE are cheap and sell when expensive but most emerging and frontier newbies do the opposite. That's great as they make more alpha available. No "lost decade" for portfolios that ignore "global" weightings.

Anyone treating emerging markets as an asset class knows NOTHING about emerging markets. Buy the unpopular and short sell the trendy. Recent herding has been into BIG emerging markets not the BEST emerging markets. Countries offer alpha capture opportunities from long short security selection and market timing not "passive" benchmarks. Optimists gamble on long only, realists hedge, pessimists get rich. Emerging market beta = NO, emerging market alpha = YES.

My PUPPIES trade, Philippines, Ukraine, Peru, Pakistan, Israel, Estonia, Sri Lanka, returned +1,000% for the past decade. Ukraine bonds beat Ukrainian stocks despite the PFTS being the top index so it was a NEGATIVE equity risk premium like elsewhere. Ghana continued to be negatively correlated. No subprime CDOs in Accra real estate but having been the best stock market in 2008, it was the worst in 2009. Cocoa and gold demand rises in tough times. It's optimal to transact securities directly on local exchanges when feasible. Emerging market ETFs are beta vehicles but I seek alpha. Local alpha.

The preferred BRIC, Bangladesh, Romania, Indonesia and Colombia, is still performing well. No ETF yet for that group yet but an underperforming BRIC that rookies are excited about does have ETFs. It is certain that securities in Brazil, Russia, India and China offer vast alpha opportunities but as to their beta prospects I have no idea. Overall "emerging markets" did beat "hedge funds" last year but for long term risk-adjusted returns, skilled alpha ALWAYS outperforms unskilled beta.

BRIC for next decade? Botswana, Rwanda, Iceland and Cambodia might be worth a bet and I already own special situations in those countries. For any security to be a ten bagger, sentiment must be very negative when you buy. No ETFs should exist and preferably most people are unaware the country has investable opportunities. With an unhedged approach you could lose every cent but that is true anywhere. Iceland imploded in 2008 but Ukraine and Russia were depressed in 1998 and were two of the best performers in the subsequent decade. You could substitute Bolivia for Botswana. Take plenty of lithium when investing in Bolivia. Like anywhere it exhibits manic depressive traits.

Iceland is simply the canary in the coal mine for the credit crisis that will come to mainland Europe. No risk free bonds anywhere. When China and India become the world's biggest economies AGAIN so what? If you examine the last 20 centuries, the USA was largest for 1, the UK for 1 and China or India for the previous 18. Other things being equal the most populated nations MUST have the largest economies. As recently as 1700 China and India accounted for 50% of global GDP. The "Asian century" is simply reversion to the usual and half the world lives between Japan and Jordan, Turkey and Timor-Leste. The abnormal period was the "non-Asian" 19th and 20th centuries.

Most periods have been "Asian" since the Mesopotamia era when Iraq was the cradle of civilization. No doubt there were Babylon real estate brokers back then saying "House prices always rise over time". They don't. Subprime lending was around 5,000 years ago but few learnt the lessons. Those buying CDOs should have been looking at historical BIG DATA sets. Competent investors analyzed properly and got short. Most "correlation traders" had much too small sample sizes when they should have been looking at real estate time series starting in 3,000 BC.

Lost decade? For 2000s my pension grew nicely above actuarial expected return assumptions and at much less volatility than a risky long only portfolio. Not bad given the low market exposure and high manager diversification. I avoid traditional products due to the deep drawdowns and absence of skill so I use absolute return vendors for most strategies. My manager due diligence process, macro black boxes and micro risk metrics seem to have predictive value. In January 2000 and 2009 too many "experts" said avoid emerging markets and hedge funds! Absurd "advice" that has cost their unfortunate clients dearly. Investment science is much more difficult than rocket science. I follow geographic FACT not economic THEORY and prefer cautious alpha sourcing to risky beta gambling.

Lost century? A year or decade is just noise. Long term conservative investors like me study centuries. Back in 1900 anyone would have been asinine to miss the ASS fund. Australia, South Africa and Sweden have had the HIGHEST real returns over the last 110 years. Note they were not heavily populated countries then or now. Given sales product groupthink and herd mentality I assume an ASS ETF is in the product pipeline though an EWA, EZA and EWD basket is fine assuming you make the assumption that past is future. I don't and have seen NO evidence that stocks are for the long run especially when everyone including famous university endowments need returns in the short run.

Global asset allocation based on capital-weighted beta is out of line with portfolio optimization. Any relative return benchmarked fund obeying global equity weights 20 years ago HAD to put 45% in Japanese equity beta and we know how that turned out. As elsewhere Japan is an alpha source and has been throughout the two decade bear market. Argentina in 1900 was a top ten economy yet was just downgraded from "emerging" to "frontier". Like every country Argentina is a place for smart alpha not dumb beta. Everywhere is "investable" if the margin of safety for reward exceeds the risk. I first invested in Armenia back in 2003. Since then China GDP growth 9%, Armenia GDP growth 11% but economic expansion is not alpha mining.

新年快乐! Learn Mandarin but only after achieving fluency in Zulu, Swedish, Australian, Ukrainian, Spanish, Russian, Portuguese, Romanian, Indonesian, Armenian, Hindi, Urdu, Bengali, Quechua and Sinhala? If so many already speak a language well would knowing it really be an edge? Perhaps but mathematics is the most useful language to master in the financial world. Yet so few speak it fluently or can apply it to REALISTIC models of the world - including most quants. It's time investors were less obsessed about asset classes and looked at strategies applied to alpha opportunity sets. Don't allocate X% to "emerging markets", fully invest in skill. It's not WHAT but WHO you invest with and let them decide where.

Not much changes in investor behavior. A famous quantitative guru was blown up by the first actively managed emerging markets ETF. Isaac Newton got taken for the equivalent of USD $4 million in 1720 with South Sea Bubble shares. Isn't today's SPAC "a company for carrying out an undertaking of great advantage but nobody to know what it is"? Ignore labels, select good and bad listed and unlisted securities and hedge risk. I look for opportunities not asset allocation classifications but all countries are emergent markets.

Geographic constraints and arbitrary asset class names cost investors plenty. Why divide stocks into domestic and foreign? Why developed and developing? Or miss opportunities close to home? USA S&P 500 -1%, Canada S&P/TSX +5.6% or +9.1% in US$ but many USA investors completely missed Canadian stock market returns because they mistakenly split equities into USA and EAFE boxes. It is also time colonial, anglocentric terms like "Far East" were retired. On a sphere everywhere is far east of somewhere. I'm writing this in Beijing so New York is in the Far East for me, this week anyway.

Despite the archaic name, EFA is a good ETF for beta but it misses so much alpha available WITHIN its components. EEM and VWO obscure long/short opportunities INSIDE their security universes. The MSCI "World" has just 23 countries. Diversified? World? Even the ACWI "All-Country" World index only comprises 45. If you are a global investor then invest globally and evaluate opportunities from accurate perspectives.

GDP growth and investment opportunity sets are different. South Africa (nominal) and Australia (real) won the beta battle in the 20th century but are unlikely to ever be the largest economies even though much bigger in area than "European" maps show. You could have made similar arguments for the big BRIC in 1901 as in 2001 and lost a LOT of money later. Of course things may be different this time! "Frontier market" beta is supposedly available with FRN but its largest holdings are in Chile, Egypt and Poland which are emerged in my opinion like many other former "emerging" countries.

Unprecedented times? The historical parallels of 2000s with 1900s are interesting. 1900-1903 bad, 1903-1906 credit binge, 1907-1908 severe credit crisis, 1908-1909 strong "recovery". Wasn't the stock market crash of 1910 brought on by failed attempts at financial reform? Weren't Russian and Chinese stocks and bonds considered core "long term" holdings in the 1900s? Anyone invested in passive "cheap" US equity index funds in 1905 would be waiting over thirty years for a sustained gain. That's good compared to the returns foreign investors in German beta would see: almost -100% twice. Of course those who invested in Germany in the late 1940s made good money though not as much if they had bought Japan.

The division between developed and developing is outdated. Having invested in Indian stocks from when I lived near Dalal Street and Chinese, Russian and Brazilian stocks since the mid-1990s why are they STILL classified as "emerging"? Nowhere can be emerging for ever. Given their major roles in the world economy, it is anachronistic to refer to these and many other countries as "emerging". All four had stock markets in 19th century. I saw a nice stock exchange in Saint Petersburg that was built back in 1810. Emerging for 200 years? I think not. Re-emerging maybe 15 years ago but mainstream now. Today's emerging markets are the frontiers. Today's frontiers are the pre-frontiers.

The beta mania hides the alpha available from security selection and arbitrage. Despite the "worst decade" claim, more than 100 USA stocks were up over 1,000% and many more went down to zero. The capital weighted S&P 500 -1% whereas S&P 500 equal weighted +4.54%. It was a fantastic decade for security selection in the USA. Same in Japan and Western Europe. Emerging markets or submerging markets don't matter when you seek alpha.

Risk free bonds haven't existed since the sovereign debt default by England in 1340. Nothing new about subprime loans to overleveraged nations. Thanks to financial INNOVATION we now have credit derivatives to hedge such risks. As I write this Greece is the "new" factor affecting markets yet Greece was in default for half the past 200 years. Everything is connected so everywhere needs to be tracked. Curious how "hedge funds" are considered so hazardous when "government bonds" have had a dire track record over the centuries. The true safe haven is investment SKILL not bonds.

Skill always has and always WILL have a great decade as there are more unskilled participants for the few skilled to extract the alpha from. In most countries public stocks, bonds, derivatives, futures, currencies, commodities, private equity and real estate offer alpha opportunities. Emerging markets "passive" long only is a bad idea if you wish to preserve your capital. Common sense investor Jack Bogle suggests "international" investing is unnecessary! Such advice is the antithesis of prudent diversification required in fiduciary portfolio construction. 10 billion would now be 45 billion to meet liabilities unlike the returns from his "low cost" asset allocation.

As a value investor the time to buy emerging market securities is when they are cheap and out of favor and vice versa for short selling. My best years for emerging markets alpha were 2008 and 1998 which were very negative years for beta. Investors want returns but that should not mean increasing risk by following the crowd. Emerging markets are not for buy and hold so it is sad to see repetition of such mistakes. Is it prudent to eschew bargain stocks but swarm in unhedged AFTER missing large percentages of the gains? The reason some thought there was an equity risk premium is because 1940-1980 was a bond bear market. Some say securities have no memory but it's the passive crowd that has amnesia.

Invest off the radar screen. The highest returns in a country are achieved when the flights to it and premier hotels in the largest cities have plenty of room. Start to sell when you can't get a reservation because the undiscovered has been discovered. My best investments have tended to be buying good managers in drawdowns and good securities in places "foreigners" aren't going. When I tell someone "I'm investing in X" and they look at me like I am crazy then I know I am on the right track. Liquidity is important but that doesn't mean the entire portfolio has to be liquid. I bought Vietnam distressed debt back in 1996 and sold out a few years later close to par yet even today the country is regarded as an "exotic" frontier. I haven't invested outside this planet yet but will this century in the final frontier. Moon and Mars ETFs?

Inertia investing is more common than momentum investing. Innovation and new sources of return are routinely ignored. Having missed a lot of recent beta from emerging markets, the performance chasers are piling in again to long only index funds when they could instead be reducing risk and accessing alpha in skill based managers. Risk averse investors will be better off in skilled emerging market strategies NOT unskilled long only.

Status quo investors continue to use normal distribution curves to "measure" risk and Black-Scholes to "price" options. Busy people keep to QWERTY when they could type faster on DVORAK keyboards. Most still look at the world as those famous Belgians, Mercator and Ortelius, intended them to so long ago. Anyone unaware that Africa AFK is 14 times the size of Greenland should not be investing anywhere. I have been to every African country and once travelled overland from Cape Town down to Casablanca and back. It is a BIG place whatever ancient maps and antiquated asset allocations claim. South Africa should be renamed North Africa. North Dakota is south of South Dakota on my maps.

There is a global alpha opportunity set out there. I don't know if this is another Asian century but it is definitely the Alpha century. Assets are abundant but skill is a rare natural resource with enormous growing demand. Alpha is more valuable than gold, oil, platinum, palladium, cerium or even californium which sells for $27 billion a kilo. In contrast 2 and 20 for "emerging" investment skill is a bargain. I don't classify asset classes or countries into neat little boxes because they are all stigmerging markets in my experience. If you don't have a stigmergent analytical tool set, stop investing right now and find someone that does.

Alpha versus beta?

2009-12-16T08:08:00.227+09:00

Asset allocation is NOT the primary driver of portfolio returns. Many say it's almost all that matters but the landmark academic studies are dangerously flawed. That mistake has dominated portfolio construction for too long and has wrecked retirement systems the world over. Trillions are invested badly due to such nonsense.

It was a BIASED conclusion because asset allocation is what the CHOSEN investors already focused on. In contrast smart investors pay ZERO attention to asset class labels and focus on to long short security selection and timing. Good hedge funds analyze securities using skill. I have no interest in unskilled asset classes. They NEVER compensate for their risk - even in bull markets.

The Greeks got it right: alpha comes before beta. If corporate pensions invested 100% in their plan sponsor's equity the "experts" would have concluded that ONLY security selection drives returns. If investors flipped coins each year to be all stocks or bonds then market timing becomes the SOLE driving factor. You only have to look at the risks and losses in traditional portfolios to see that "bet on betas" asset allocation urgently needs re-thinking. NEVER BET ON BETA. That applies to stocks, bonds, commodities and hedge funds. Alternative beta is an even dumber "investment" than traditional beta.

A stock and bond asset mix determines variation of returns if you DECIDE to emphasize beta. It's easy to debunk the asset allocation dictum. If you encounter any "consultant" claiming that asset allocation accounts for over 90% of returns, don't walk away, run. Risk averse people like me eliminate beta and invest in alpha. The true determinant of superior risk-adjusted returns is investment SKILL not percentages in UNSKILLED asset classes. It's the manager mix NOT the asset allocation. Check out the dire funded status of DB and DC pensions that bet on betas due to bad external advice and conventional "wisdom".

Bad "science". Decide the conclusion you want then choose a data set you know IN ADVANCE will "confirm" it. If Brinson BHB et al had confined their dubious analysis to high frequency strategies obviously they would have found that ability at high frequency trading drove performance! Is it a valuable conclusion to "discover" that asset allocators' returns mostly depend on asset allocation? In contrast top performing portfolios focus on alpha so why waste so much time and money on beta decisions? α yes, β no. How did those pathetic papers ever get through "peer" review? Would not happen in the REAL sciences.

It was a GREAT decade for the S&P. No beta for "passive" index funds but every day offered an opportunity set of fluctuating securities to capture alpha. It was an even better quarter century for the Nikkei. No beta since 1984 but vast alpha was generated from security selection and market timing by those with talent. Some "experts" say investors ought to have more in risky assets due to higher "expected" returns. Instead people would be wise to focus on 100% in skill. For those with liabilities to fund, intolerance of volatility or dislike of deep drawdowns, alpha is the prudent investment. Can't beat beta? Forget about beta.

In aggregate, "stocks" can underperform "bonds" for decades. 60/40 sounds prudent until rephrased as 90/10 risk. Why have a high risk appetite when unhedged equity indices NEVER compensate with sufficiently high reward even in bull markets. Last century's 8% return on 16% volatility was an insult but a last decade's negative total return with even more risk is absurd. Most bonds also do NOT reward enough for their risk. Do not go near index fund garbage. It is for speculators NOT fiduciaries.

Alpha beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/2009. That led to the mistake inherent in the crazy concept called portable alpha. It was a beta-centric way of getting some investors into hedge funds but failed because it kept asset allocation front and center. It diluted the absolute return attribute and changed it into just another relative return index based product. The alpha beta separation idea still has too much risk budget in beta. But why bother with beta at all? "Cheap" beta is expensive considering its risk. Cost and risk conscious investors favor alpha. It's a cheaper source of return.

The more vituperative commentary on hedge funds, the more one should invest in alpha vendors. Why tie up precious capital in riskier beta when lower risk alpha is available? Better to identify mispricings and arbitrages than invest in "the market" itself. It is safer to minimize market exposure and analyze specific securities to buy and short sell that just gambling on benchmarks. Most portfolios are very beta biased while some investors implement a beta plus alpha model. The natural progression is to alpha only which has a much better efficient frontier. I do not understand why investors must surrender their wealth to the hazards of beta when superior alternatives exist.

Selecting the RIGHT betas at the RIGHT time is a form of alpha anyway. Choosing the WHICH and WHEN of asset classes takes as much talent and expertise as at the security level. I have no idea where "the markets" are going in the long term but will not take the chance of finding out. Asset and security selection, timing and hedging skill, though rare, are the only properties a conservative investor can rely on if they need adequate and consistent absolute returns. Beta is passive but do we really live in a world that rewards passivity in any activity? I don't think so which is why they are called ACTIVITIES. Alpha comes from acumen driven ACTION.

Successful investing is about leveraging informational, structural and analytical advantages or hiring those that have them. Let's look at portfolios that did well over long periods but didn't asset allocate, instead focusing on security selection or timing. A low frequency trading firm like Warren Buffett's Berkshire Hathaway identifies specific multiyear opportunities in currencies, commodities, stock and bond markets, derivatives and event driven special situations. In contrast the high frequency trading of Jim Simons' Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Producing alpha depends on your knowledge and technology edge applied to appropriate time horizons.

Beta bets drive many portfolios because that is what most investors do. It is like those who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The anthropic principle applied to finance. It is false logic similar to the "all swans are white because every swan I've seen is white" phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its woeful weaknesses. Efficient, unbeatable markets imply the non-existence of skill! Choose beta because alpha is just "random" luck in a zero sum game? The much cited Brinson Hood Beebower paper has cost too many investors too much money. Beta people advocate index funds since they want you to invest in "the market". But the optimal way to achieve absolute returns at the total portfolio level is to be alpha-centric.

Beta vendors don't manage risk, don't market time and outsource ACTIVE security selection to benchmark construction firms. They even stay fully invested long only in bear markets! A beta-centric portfolio is where investors decide policy asset allocation and then hire managers to basically deliver the return from asset classes and hopefully a bit of alpha on top from tracking error constrained active mandates. Most long only funds have an R-squared with their benchmark over 70% - ie beta explains most of their returns. Alpha strategies and manager selection shouldn't be secondary but that is the result when beta bets dominate the allocation of investment capital.

Alpha vendors see a market of securities offering long/short opportunities in many time horizons within and between asset classes. An alpha-centric portfolio is where investors hire managers to analyze, trade and hedge for absolute returns. Of course you have to be good and work extremely hard to find alpha. Any manager that depends on beta is NOT running a hedge fund. A truly efficient portfolio does not pollute itself with beta. Dismissing all hedge funds is like avoiding all stocks because Enron, General Motors and Nortel fell to zero. Don't invest in bonds because some default and there is no such thing as a risk free rate? Nortel stock lost -100% while a Nortel bond is up +700% but most missed it.

Pure alpha sources do not fit well into the beta allocation process that some find so compelling. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that AVERAGE performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if "hedge funds" were up or down each month. But what does that mean? Some made money and some lost money. Likewise I am often asked where I think "the market" is going. That is a beta question. Some stocks go up and others go down. Seek alpha.

Do I want "hedge funds" that outperform? No. I look for hedge funds that make money which is a very different target. I know that good hedge funds will have high risk-adjusted returns and bad ones will not. Alternative beta is just another beta and is therefore to be avoided. Most betas are becoming more correlated whether by geography or the equity, credit and real estate correlation to the economy. I am not concerned whether a hedge fund is "market neutral" or not. But it must be able to deliver absolute returns that are "economy neutral".

Alpha is the REAL diversifier because there are so MANY different ways of generating it. Focus on alpha if you want good returns regardless of the economy. Why pay attention to asset classes when investing in SKILL-BASED STRATEGIES makes more sense? Others are welcome to unhedged beta bets but for conservative investors like me beta with a bit of alpha is inferior to an ALPHA ONLY portfolio. Making money is simple: do the opposite of "Nobel" Prize economists.

Asset allocation?

2009-10-09T08:08:00.223+09:00

Asset allocation? Wait for the "long haul"? Short term volatility can't be ignored regardless of time horizon. It can be avoided with prudent strategy and manager selection. The endowment model was once seen as the "solution" to investing for the long term but it was deeply flawed and overexposed to recession. It was too long biased, illiquid, unhedged and high risk.

Though asset diversified it was not properly strategy diversified. The "alternative" assets failed to offer alternative returns. The RETURN ON RISK of David Swensen's folly, even in the good times, was poor. Many didn't see the obvious errors, particularly the weak diversification and mistaking of leveraged beta for alpha. Incredibly because he is not smart enough to "understand" quant funds he avoids them, further damaging Yale's endowment.

Long term investors still need short term returns and income. Economic fluctuations ought not to have a deleterious effect on capital growth or spending policy. Having too much tied up in illiquid assets makes it difficult to be nimble enough to capture changing opportunities or adapt to market conditions. Flexibility, adaptability and liquidity are prerequisites for consistent performance. Expecting to be paid for holding risk assets is dubious but hoping to also be compensated for illiquidity is dangerous. When liquid securities sneeze, illiquid assets catch pneumonia. Private equity and real estate are often highly leveraged. More than most hedge funds.

Volatility immunization and portfolio agility matter. The endowment model had little chance of achieving what universities, foundations, pensions, sovereign wealth funds actually need. Reliable absolute returns with capital preservation at minimum risk and maximum liquidity EVERY year. For that you need to hedge with proper strategy diversification. Assets alone do not have the necessary repertoire of return streams to de-risk a portfolio. You also need access to the expertise required for tactical trading, short selling and market timing. The best way to diversify a long is with a short.

I don't believe in static asset allocation and despite reading countless flawed but "seminal" papers have seen little evidence of its utility in achieving RELIABLE long term performance. Why focus so much on beta that fails to work in an alpha world? Such a blunt tool is ineffective for dealing with the sharp complexities of today's markets. It's an anachronism and fails to emphasize RISK. The world has moved on in financial engineering and portfolio innovation. As a conservative investor I favor skill diversification. It works if you know what you are doing and conduct proper portfolio construction and manager due diligence.

The endowment model's percentage in marketable alternatives, hedge funds, was too low while the allocation to long only non-marketable alternatives, mostly private equity and real estate, 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 liquid with illiquid. While you can generally hedge liquid securities, difficult with illiquid assets. Non-marketable alternatives must still be marked to market. Even if there isn't a market! Where was the scenario analysis and stress testing to construct a truly robust portfolio during a recession?

A dynamic investment opportunity set is not optimally captured with occasional rebalances to a policy asset allocation. Overweight alpha, not beta and certainly not illiquid alternative betas. Skill is the driver of outstanding risk-adjusted returns but asset classes don't have skill. Good fund managers do. The opportunity cost from overallocating to illiquidity was expensive. There is no long term; only a series of short terms which require competent navigation and risk management. Ride out deep drawdowns? No. Diversify to avoid them? Yes.

Long term investors still need 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 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 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 fall due to the economy. Hedge for bad times!

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 and coDependencies 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.

Substituting unleveraged long only public equity with leveraged long only private equity was asking for trouble but was widely popularized by the CIO at the Yale Endowment, David Swensen. Amazing how some people fell into such an obvious trap. Why overcommit to 10 year lockups and ongoing capital calls when there is so much alpha available in the VERY inefficient public markets? Private equity was a misnomer anyway; the correct term was private debt with a sliver of equity.

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 do not fit into an asset allocation methodology. The only thing to overweight is SKILL not assumed risk premia. Client wealth can and should be protected and increased regardless of economic volatility. A bear market is no excuse for a diversified portfolio to lose money. Portfolio choice? Simple, choose alpha. Alternative alpha.

Trend following?

2009-08-23T08:08:00.148+09:00

Some mathematical models actually work. Here's a proprietary black box equation that has served me well: good hedge fund + bad year = buying opportunity. But most investors do the opposite and redeem! As I forecast in late 2008, most hedge funds went on to perform very well in 2009. Over a thousand hedge funds made money in 2008 and 2009. Remember the "experts" who said the hedge fund industry was "finished"! Those fools are welcome to invest in "cheap" index funds. Meanwhile smart investors continue to increase allocations to smart managers.

It's no surprise that market dislocations, misvaluations and panic-selling hysteria created fantastic alpha capture opportunities for skilled managers. Performance was certain to be strong when so many "professionals" even recommended to avoid all hedge funds. Bear that in mind next time they offer you their absurd investment "advice". Redemptions by those who didn't understand true diversification benefited investors that REDUCED risk by having more alpha in their portfolio.

All trends end. Inconsistent those who argue trend following has no value but advocate long only equity because of a historical up trend last century that can supposedly be extrapolated into this one. Their insouciant belief in past being prologue is pathetic. The volatility of recent years has shown "difficult" times provide the best risk management stress test.

The more long lasting the trend, the more violent the end. The trend is your friend until it ends. The last two centuries were positive equity markets in some countries so this one will be too? A logic that far too many STILL believe. On a long enough time scale the survival rate of ANYTHING tends to zero. Bear that in mind next time your hear the "value" of buy and hold!

Definition of a trend: “What the wise man does in the beginning, the fool does in the end.” Even more impressive are the hedge funds that made money in both 2008 and 2009. Proper hedging and 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 terrible. Is the mythical equity risk premium positive or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve capital. Invest in managers with the skills to MAKE MONEY when things go pear-shaped - ie markets or economies go bad.

The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fans sell a rosy view of a DISTANT future that we can apparently all look forward to...eventually. I hope they are right but CONSISTENT CAPITAL GROWTH requires mitigating the downside. Few investors can afford to ignore deep drawdowns or vicious volatility. Follow the trend? Into the abyss? Thousands of equities have dropped to zero but NONE has ever gone to infinity. Portfolios need to be structured for ANY possibility including a dystopian long term. If your portfolio is not stress tested and hedged for a 90% stock market and real estate crash and all "risk free" government bonds defaulting then you have the wrong portfolio.

Unfortunately the crowd STILL uses normal assumptions which is fine UNTIL things cease to be normal. Pear-shaped situations require pear-shaped analysis. I prefer non-linear pear-shaped equations since they capture the initial quasi-linear uptrend and then nicely model the nasty 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 mathematics is easy which is why too many financial "professionals" rely on it to their clients' heavy cost.

Since most phenomena are non-linear it stands to reason that linear equations are of no use. The simplest pear-shaped formula is y^2=x^3-x^4 which only has solutions in the real world for inputs between 0 and 1. We can define the beginning of anything at zero and ending at one to transform any data set 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 are pear-shaped. 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 seems possible that financial structures also exhibit a similar form. Bonds and loans are great assets till the borrower defaults. Mortgage backed securities are fine unless real estate or interest rates go pear-shaped. Bull markets last longer and have low volatility while bear markets (pear markets?) often eviscerate years of growth. Beta climbs the wall of worry and then speedily descends into the dungeon of delusion.

Recently I read 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 slow 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 and slide rules 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 despite experts worrying about their TEMPORARY losses. Fiduciary duty REQUIRES portfolio construction for optimistic AND pessimistic scenarios. Bear markets or bull markets are irrelevant in a robust strategy allocation.

Bull market?

2009-03-26T19:08:00.258+09:00

Bull market? Financial planning is about achieving client objectives and good hedge funds have delivered superbly. Over 3,000 hedge funds had POSITIVE returns in 2008 but zero long only equity managers. It's best to invest in quality so I'll stay in the safe haven of skill-based strategies NOT asset classes. Every sophisticated institution I deal with is INCREASING investment in alpha. Good riddance to beta repackagers pretending to be hedge funds. The hedge fund industry is stronger than ever despite many "experts" predicting its demise...again.

2008 was a GREAT year for truly diversified portfolios. Volatility creates opportunity. The future prospects for good hedge funds are outstanding. Bonds have outperformed stocks for a long time but skill has done far better. The SKILL premium exists but the equity RISK premium? Naive and stupid 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 big losses. The epochal change is from long only assets to long short strategies.

Stock indices tracked by "passive" managers might get back to where they once were. But even if I was certain that in 2030 the Dow, Nikkei, DAX and FTSE will all 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. If those benchmarks turn out to be LOWER than today, good hedge funds will also have outperformed. Quality hedge funds are a win/win for investors wishing to RELIABLY grow and preserve their capital.

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 and uncompensated mania for 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 urgently need to access that talent. A SUBSTANTIAL allocation to diversified skill based absolute return strategies is necessary for risk averse investors.

Bernie Madoff hedge fund?

2008-12-26T22:08:00.202+09:00

Bernie Madoff "managed" customer accounts as a stockbroker. He did not run a hedge fund and had no connection whatsoever to the hedge fund industry. His firm was "regulated" and fraud has been illegal for centuries. Real due diligence itself is an alpha source. Wide manager diversification with many strategies is mandatory for risk averse investors. Why do some people think the scandal has anything to do with hedge funds?

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", Madoff wasn't a billionaire. With those "returns" he should have been a stalwart of the Forbes 400. Why did so few question his absence from the list? No professional investor put a cent with him. NOT A SINGLE ONE.

Below is the chart of Madoff feeder, Fairfield Sentry, versus Gateway GATEX, a real mutual fund utilising the "same" split-strike conversion strategy.

Split strike conversion is a simple strategy for options traders. It is too well-known to be an edge and does NOT protect against major stock market falls. A watershed event occurred in 2001 from the potent combination of the bear market, reduced payments for order flow and decimalization. The broking income probably 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 just five minutes over a decade ago to decide I had no interest in the Bernie 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 events 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 alpha vendors and don't have time to study obviously irrelevant products.

Bernie did not make the first cut with ANY professional investor. None, globally. Any fund of funds that had money with him was NOT doing its job. A FOHF is mandated to invest ONLY in hedge funds not stockbrokers. 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 products with a big difference between what they should have made and what they did make. Back then I was simply looking around for some good funds that had navigated that challenging year, 1994, successfully.

"It's a proprietary strategy"? The trouble with Madoff was that he performed too well for the split strike conversion on the S&P 100 OEX he was supposedly running. I like good black box 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.

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 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 intermediaries ignore such RED FLAGS? Competent ones easily saw through Madoff.

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 close to all investors long ago. And why was such a high proportion of money from overseas? I was skeptical 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 university endowments and pension plans queue up at 53rd and 3rd in New York for "access" to the master?

Bernard Madoff may not have been a skilled investor but he was a brilliant salesman. There is a reliable rule 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 gatekeepers. That exclusive "capacity" with "super" managers is always 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 IPOs, are driven by sales tactics not value. Decide whether to buy into a product, 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 wide spread of managers. I wonder whether Fairfield, Kingate, M-Invest, Rye, Herald, Gabriel, Frontbridge, Fix or Ascot 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 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 reopened Medallion Fund, the world's best currently operating hedge fund (+80% 2008 return, after those "high" fees), the most I would invest is 5%. It is simply prudent protection. Concentrated 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 ESSENTIAL alignment with clients to ensure shared downside.

A good fundamental stock picker is Warren Buffett, manager of the listed hedge fund Berkshire Hathaway. Unfortunately I had to redeem in early 2008 when I found out about his bizarre options speculation. Naked short selling index puts to collect premium was a rookie mistake far removed from his edges. The "margin of safety" skews to the buyer not the short seller and the risk/reward scenario is OPPOSITE to almost every other transaction he has ever done. Warren Buffett, the derivatives trader, should unwind those dire deals which have lost many billions, so far. When he does, the fund 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 emerging markets where I have a long established edge. My favorite investment for 2008 was actually executed in 2007. Short selling private equity by way of Fortress FIG, Blackstone BX and KKR KFN. Not often do such high 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. 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 fall 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 generalizations to a heterogenous universe. Fund managers range from the vast majority that are honest to the very rare swindler.

Skilled strategy diversification, manager selection, due diligence and portfolio optimization is the key to REAL 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 actual hedge funds. However it does emphasize the need for due diligence and broad manager AND strategy diversification.

Hedge fund drawdown?

2008-10-28T21:08:00.187+09:00

Hedge fund drawdown? First rule of risk management - if it can happen it will happen. In 2008 there have been excellent returns from many hedge funds, hard times for lower quality hedge funds but MUCH worse from long only equity and credit. Skilled managers don't always make money but they do have fewer, milder and shorter drawdowns than traditional long only that doesn't even attempt to manage risk, reduce exposures or preserve capital. As a risk averse conservative investor I'll stick with 100% in hedge funds. It's the PRUDENT approach. Hope for the best but hedge for the worst.

I wrote in January 2008, when both were above 13,000, that the Dow and Nikkei would collapse far below 10,000 as a result of the credit crisis and, as predicted, long volatility strategies, short biased and owning put options have indeed been helpful in achieving good absolute returns. Contrary to common wisdom, the performance of risky asset classes proves the need for investors to have substantial allocations to skill-based return sources and true strategy diversification. The crisis is more damaging for index funds than hedge funds. Losses of 50% twice in a decade are unacceptable so why endure "low cost" funds?

You won't read it in the media but several hedge fund 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 outstanding absolute returns throughout the meltdown. The outlook for distressed debt and CB arbitrage going into 2009 is very positive for focused managers with the necessary expertise. Short biased equity, credit and commodity funds have delivered that so important negative correlation for portfolios. Strategy and manager diversification is crucial.

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 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, 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 a 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. Pundits forecasting the end for hedge funds (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 deep drawdown over a DECADE later. Some financial professionals never let the FACTS get in the way of their 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 if 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 3,000 hedge funds are up for 2008, all long only equity funds are down. Many unleveraged, heavily "regulated" but unhedged funds have lost trillions by speculating on rising stock markets. During this decade those who saw the value of bona fide hedge 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 is usually 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 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 robust 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 unorthodox black box is often early and the stock markets could still fall 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 now favor the bull case. 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 time frame are stock markets supposed to deliver a real return? I'd rather keep the PROFITS that talented, unconstrained managers make than worry about the "long haul". 2 and 20 for reliable absolute returns is a bargain. Long only "passive" and closet index active funds have deep 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 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 WILL be a fantastic year for hedge fund performance just like 1999. Avoid unskilled assets and buy skilled managers in drawdowns.

Best hedge funds?

2008-04-15T03:08:00.318+09:00

Best hedge funds? Just got back from a due diligence visit to the world's best ever hedge fund. On the way I saw a black swan and ate at a restaurant that had run out of rice. Minor observations can signal major opportunities. Volatility is never contained and reverberates across ALL asset classes. Many commodities have risen but wide fluctuations do not bode well for markets. Don't put a cent in long only equity funds.

How to define "top fund"? AUM? A list of the biggest funds is completely different to a list of the best funds. Past performance? Future outlook? Highest risk-adjusted returns? Below is the chart of a very popular well-known fund I looked at a while back.

Seems good. A +20% CAGR after fees for ten all positive years. The fund is open and YOU can, if interested, invest in it. The returns have been independently audited many times. It's fully position transparent, heavily regulated and available to investors of all net worths. Zero leverage, no lockup and no valuation issues. The manager keeps it simple by investing in liquid equities listed on the largest market value stock exchange. No arcane assets, crazy CDOs, malicious models, specious SPACs or dubious derivatives so it must be safe for "average" investors?

After thorough predictive analysis I concluded the fund was unsuitable for investment. Too risky despite being adored by rear view mirror loving "Nobel" prize winners. I decided to figure out who was the best manager ever. The criteria for a good fund are complex but necessary to find the best. If we define the top hedge fund as that which achieved the highest risk-adjusted returns over several decades, the wealth accumulated by the manager from his trading acumen, the consistency and repeatability of performance from protectable edges and a legacy of thought-leadership that permeates modern finance then the best ever hedge fund manager is obvious.

The “god of the markets” and first algorithmic trader, Munehisa Honma, ran a managed futures CTA hedge fund in the 18th century. His fund performed outstandingly for over 50 years. His main writing, "Fountain of Gold", is the best "how to invest" book ever written. Those ubiquitous candlestick charts? That's one of his many innovations. His trading ability enabled the family office to become 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 mountainous region. A set of Honma clubs has "high" fees but like hedge funds versus index funds, you get what you pay for in superior results. Destroy your golf score with "cheap" clubs? Wreck your portfolio with 0.2 for passive or gain and preserve wealth by paying 2 and 20 for skill?

There's a fountain in the main garden of his house as a reminder of the source of wealth - Honma's trading profits. As befits many successful hedge fund managers, Honma was an avid art collector. He also advised the world's first sovereign wealth fund. Though rice was heavily traded and analyzed even in those days, such liquidity did NOT produce an efficient market. He figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether futures brokers themselves were bullish or bearish or prices were rising or falling. That's a TRUE hedge fund. Any firm needing a bull market to make money is NOT running a hedge fund.

In today's money Honma's net worth was well over $100 billion. Some years he "took home" more than the equivalent of $10 billion so it's curious why pundits are so 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. Like Honma, Paulson's performance hedged client portfolios. REAL hedge fund managers focus on achieving good returns to monetize their talents and build customers' wealth. Shorting subprime was NOT the greatest trade ever. Good but not greatest. "Ever" means since 2002? Recency bias...again. Honma's short sale of rice futures in 1789 was far more profitable than Paulson's so-called "big" short in 2007.

Note for the long only luddites: the GREATEST trades tend to be shorts. Hedge fund "pioneer" Alfred Winslow Jones did not "invent" hedge funds. He invented the term but not the philosophy. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that 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 prices would rise over time. Index fans regard those as axioms for "stocks". They are not. Neither equities nor credit nor commodities have a risk premium. Trade them but NEVER hold them.

Munehisa Honma paved the way for the trend following hedge fund 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 economists still hold onto as they continue their futile search for a rational, perfectly priced market.

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 spend valuable time on Fed watching when they could INSTEAD be seeing 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 invented black box algorithmic trading. 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. "Nobel" Prize winning 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.

Stock, bond, currency, real estate and commodities prices are determined by participants with memory, so prices MUST themselves also have memory. Honma ALONE accumulated more 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 candlesticks, Kagi, Renko, Heikin Ashi and ichimoku kinko hyo analytics then that trading may impact the markets and lose money for those who do not master 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 ANYONE able to consistently make money trading the yen, JGBs or Japan equities without a thorough understanding of Japanese charting interpretation.

I didn't trade anything in Japan until I knew ALL the above methods cold. Incredible how some rookies try (and fail dismally) to trade Japan profitably. 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 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 no applicability to the REAL statistical distribution of prices.

Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic is routinely disdained by those who think we live in an orderly, bivalent world of true/false, right/wrong, yes/no and 0/1. I once 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. And given the inappropriate Ito stochastic integral for pricing derivatives, I also adapted 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 is vague 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 fund managed from the 1740s to the 1790s. The chart above is a Japan "passive" index fund performance from 1980-1989 but below is the ENTIRE performance chart since 1980. Past perfomance was not indicative for future performance in any country. The risk and volatility since 1990 have failed to compensate investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy and hope. A good heuristic for assessing investment strategies - if it is simple then it won't work. Easy "solutions" cause difficult problems, as we have seen.

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, so many years into a bear market, the TOPIX remains the top 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 magnificent past. But for those who like "cheap" long only equity funds and historical data dredging, it is interesting they don't overweight Japan. 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 long only index funds. Honma-sensei thrived in volatile market conditions. Recession will make the absolute returns generated by top 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.

Since Honma's era there have been many obituaries written for the hedge fund industry. We are on 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 put options and hoping a black swan won't show up to reveal their fund as a data snooping lemon is very OLD news.

Ten years ago Long-Term Capital Management short sold options and bet the house on convergence and 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.

Seeking alpha?

2008-03-12T08:16:00.168+09:00

Absolute return? Investors need alpha because beta isn't reliable. A portfolio of long only stocks and bonds can lose money over extended periods and is too risky anyway. Fortunately there is a solution - alpha from the world's best fund managers. It would be good if beta does eventually perform but we need the "hedge" of alpha if it doesn't. Diversify away volatility with return sources that don't depend on the economy to make money.

History is a powerful persuader but pathetic predictor. The 20th century was "triumph of the optimists" aided by the anomalous bubble of 1980s/90s and survivorship bias focus on a few countries with continuous track records. As the past decade showed, that doesn't mean the 21st century won't be "revenge of the pessimists". There is no FORWARD-LOOKING evidence "buy and hold" works. Just old data erroneously extrapolated to the "fabulous" future that passive pundits expect. Some even say we can ignore volatility due to the economic utopia coming!

They seem to "know" all will be fine decades from now but my clients can't wait that long. According to the fortune tellers the stock market will be much higher one day. Optimism is good but overoptimism is dangerous as we have seen. Hindsight driven "buy and hope" is the biggest risk most investors take. Reduce unhedged bets on "passive" index and relative return funds. Too volatile and very EXPENSIVE considering the lack of skill. Unnecessary now that financial innovation delivers LOWER risk investment products that people actually need - absolute return. You can't eat relative returns in bear markets.

Listed hedge fund Berkshire Hathaway's annual letter to shareholders is written by Warren Buffett and this year's was as insightful as ever. The 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 say Warren's returns are from luck or reward for taking higher risk! Absurd. The FACT is that he takes LESS risk than "the market" and his investment skill is the reason why his hedge fund has produced copious alpha.

Warren says to avoid the 2 and 20 crowd. I agree. It is the elite teams NOT the crowd you want. Warren Buffett, the junk bond and derivatives trader - "derivative contracts that I manage" - runs a multistrategy hedge fund that has adapted to fluctuating alpha capture opportunities for 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 many to the poorhouse. His bizarre long date options gamble is a nasty case of style drift for which BRKA shareholders 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 value of relative alpha in a bear market? Why have beta swamp the alpha?

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% CAGR 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 doesn't exist?

Professor Kenneth French has even made the absurd attempt to count the cost of active investing but fails to note the obnoxious opportunity costs, vicious volatility and ludicrous losses exhibited by the "passive" funds he adores but his employer shrewdly avoids. 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.

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 the performance of the past. Bond beta cannot due to low interest rates. Perhaps some day in the future, beta may again contribute but in the meantime investors need SUBSTANTIAL allocations to managers who can reliably deliver.

Some say alpha doesn'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 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 are 8.20 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. That's 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 and skilled experts can do so in advance.

HISTORICAL performance was indeed quite good for passive 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 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 an obscure 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.

Passive versus active?

2008-02-15T08:58:00.153+09:00

Active versus passive? There aren't any passive investment strategies. Active is the only choice in the REAL world because "passive" funds require active decisions by index construction firms on which securities to include. Investors also make an active decision as to which "passive" benchmark to track. If you really think the best stockpickers work at Standard and Poor's, invest in a "cheap" fund of the stocks they ACTIVELY select for the S&P500. If you don't like that risk or realize that a competent stock picker is more likely to run a hedge fund, then avoid it. Why tie up capital in a manager's 500th best idea? Do you really think someone with the rare skill to competently analyze equity or credit would work at a rating firm?

The real "debate" is not active versus passive but skill versus non-skill. Investors located outside the ivory tower need to HEDGE the downside and REDUCE risk. The academic "experts" love of "low cost" index funds is expensive since there is no risk management, no hedging or attempt at capital preservation. Easy to be so wrong when they have tenure and the endowment that pays their salaries conspicuously avoids "passive" funds due to the abysmal risk-adjusted returns. Fund managers that sit idly by watching bear markets destroy capital are unsuitable for any portfolio. Index funds cost too much and YOUR money deserves better treatment. It is not what you pay but what you receive in VALUE.

Passive strategies are very expensive and damage portfolios. With skill based strategies, no risk averse investor needs to leave their cash in harm's way HOPING for a bull market over that infamous "long haul". "Passive" funds are too volatile for conservative investors like me with low risk tolerance. Quasi-active "index" funds market themselves as passive because it sells, backed up by "Nobel" economics nonsense. Acolytes fail to point out that passive funds' risk-adjusted returns have been dire even in bull markets. The deadly drawdowns and vicious volatility of index funds are unacceptable. Given their expense they have NO place in your or any prudently fiduciary portfolio.

Alpha is partly about knowing WHEN and HOW to change your beta exposures. Volatility and uncertainty mean portfolio management requires 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.

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 stockpicking 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 "passive" about market benchmarks. The editor of the Wall Street Journal actively picks and replaces the Dow components. How does he find the time to thoroughly analyze stocks?

The credit crisis malaise continues and will NOT be over soon. Those hedge funds that already bought distressed assets have yet to 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 problems grow but that is just the canary in the coal mine for other deals. Probably a sensible large private equity LBO last year was the Harrahs deal. On the left side of the Vegas strip after the Venetian there are several older casinos in prime locations 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 genuine business case could not raise sufficient debt shows how bad things are.

Elsewhere in the markets, Microsoft would like to buy Yahoo. Both ARE great companies but WERE good stocks once. I doubt Google 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 fickle business. Anyone still use 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 and Chevron. 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 seems harsh. Altria 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 do stock splits. Surely market capitalization or a fundamental metric would be appropriate. And why is illiquidity 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 accurate point in time and dividend data going back to 1896 and just looked 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 and IBM, deleted them a few years later and then re-added them after MISSING several decades of 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 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. 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 bizarre 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. 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 indices though since the equities change. Check out the Nasdaq components today compared to 1999. 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.

Hedge fund technology?

2008-01-31T08:48:00.056+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 invest and innovation impacts everything. Good hedge funds are inventing better ways to make money and disrupting the traditional world that has failed people so dismally. Successful investing requires flexibility so it makes sense to keep up with trends. NEW ideas 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 history 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 in Davos seemed rather subdued 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 forum provides an end-of-party short sale signal like private equity in 2007 or dotcom 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" meme 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 but are too crowded now. The arbitrage has long gone. The issues that bothered me in recent years was their dependence on cooperative credit buyers, the strategy being too well-known and too much money in the "taking public firms private" trade. Similarly CDOs are potentially 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" computers when sliderules have been 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 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?

2008-01-16T08:43:00.054+09:00

Bear markets for beta are bull markets for alpha. It's always an OPPORTUNITY MARKET for absolute return. Recently short selling has been 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 risk their retirement savings hoping for REALITY to catch up with dubious THEORY. The "panic of 2007" will worsen in 2008.

Though currently above 13,000, I would be amazed if the Dow and Nikkei are still above 10,000 by the time this MAJOR crisis and recession are played out. Few investors can waste time waiting 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. Buy puts.

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 false 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.