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Bear market?

scgadmin — Wed, 30 Nov 2011 18:29:41 +0000

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.

by Veryan Allen. Copyright

Hedge fund technology?

scgadmin — Wed, 30 Nov 2011 18:29:41 +0000

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.

by Veryan Allen. Copyright

Active versus passive?

scgadmin — Wed, 30 Nov 2011 18:29:40 +0000

Active versus passive? There are NO passive investment strategies. Active is the only choice in the REAL world since “passive” requires 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 think the best stockpickers work at Standard and Poor’s, invest in a “cheap” fund of the stocks they ACTIVELY select. If you don’t like that risk, 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.

by Veryan Allen. Copyright

Search for alpha?

scgadmin — Wed, 30 Nov 2011 18:29:40 +0000

Absolute return? Investors need alpha because beta isn’t reliable. A portfolio of long only relative return stock and bond funds can lose money over extended periods and is too risky anyway. Fortunately there is a solution – alpha from the skills of the world’s best fund managers. It would be good if beta does eventually perform but we need the “hedge” of alpha for when it doesn’t. Diversify away volatility and risk with return sources that don’t depend on the economy to make money.

History is a powerful persuader but poor predictor. The 20th century was the “triumph of the optimists” aided by the anomalous bubble of 1980s/90s and survivorship bias of rare markets with continuous track records. As the past decade showed, that doesn’t imply the 21st century won’t be the “revenge of the pessimists”. There is no FORWARD-LOOKING evidence “buy and hold” works. Just historical data erroneously extrapolated to the “fabulous” future the passive pundits expect. Some even say we can ignore volatility due to the economic utopia they predict!

They seem to “know” all will be fine decades from now. According to the fortune tellers the stock market will be much higher. 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.

by Veryan Allen. Copyright

Best hedge fund ever?

scgadmin — Wed, 30 Nov 2011 18:29:40 +0000

Best hedge fund? Just returned from a due diligence visit to the best ever hedge fund. On the way I saw some black swans 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 economic stability.

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

Seems good. A +20% CAGR after fees for ten positive years. The fund is open and YOU can, if interested, invest in it. The returns have been independently audited many times. It’s full 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? Perfect for “average” investors? Email me if you want manager’s contact details.

But I haven’t the slightest interest. After analysis I concluded the fund was unsuitable for investment. Too risky despite being adored by “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 trading acumen, the consistency and repeatability of performance from protectable edges and a legacy of thought-leadership then the best ever hedge fund manager is obvious.

The “god of the markets”, Munehisa Honma, ran a managed futures CTA hedge fund in the 18th century. His fund performed outstandingly for over 50 years. His main book, “Fountain of Gold”, is probably the best “how to invest” book ever written. 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 mostly mountainous country. A set of Honma clubs have “high” fees but like hedge funds versus index funds, you get what you pay for in superior results. Wreck your golf game with “cheap” clubs? Destroy 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 is a TRUE hedge fund. Any manager needing a bull market to make money is NOT running a hedge fund.

In today’s value Honma’s net worth was over $100 billion. Some years he “took home” more than the equivalent of $10 billion so it’s curious why pundits are 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 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 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 people able to consistently make money trading the yen, JGBs or Japan equities without a thorough understanding of Japanese charting interpretation.

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

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

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

by Veryan Allen. Copyright

Hedge fund drawdown?

scgadmin — Wed, 30 Nov 2011 18:29:40 +0000

Hedge fund drawdown? First rule of risk management – if it can happen it will happen. Recently we have seen 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 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.

by Veryan Allen. Copyright

Bernie Madoff hedge fund?

scgadmin — Wed, 30 Nov 2011 18:29:39 +0000

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 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. 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.

by Veryan Allen. Copyright

Bull market?

scgadmin — Wed, 30 Nov 2011 18:29:39 +0000

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 “target=_blank>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.

by Veryan Allen. Copyright

Trend following?

scgadmin — Wed, 30 Nov 2011 18:29:39 +0000

Some mathematical models actually do work. Here’s a proprietary black box equation that has served me very well over the years: 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. Remember the “experts” who said the hedge fund industry was “finished”! Those fools are welcome to their beloved, dangerous and “cheap” index funds.

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
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.

by Veryan Allen. Copyright

Asset allocation?

scgadmin — Wed, 30 Nov 2011 18:29:39 +0000

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 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.