Team Hedge Fund

Archive for May, 2009

British Virgin Islands based hedge fund manager Tranen Capital took the lead in the Fixed Income – Asset-Backed Lending category for March 2009 with a return of 2.49%.

In addition to the March performance, the fund, ‘Tranen Capital Alternative Investment Fund Ltd.’ posted a YTD (through April) change in NAV of 11.5%.

“Investors are keenly aware of the dismal and unstable returns from the major financial markets. They are demanding alternatives and absolute returns. The Barclay ranking certainly highlights the strategy’s excellent returns but more importantly, it demonstrates that the funds’ performance is non-correlated to financial markets. The Fund’s NAV has increased 27% since July 2008, which has been independently determined by our actuaries, Data Life, and confirmed by our Administrator Commonwealth Fund Services. Additionally, we have also recently delivered our first independent audit to investors, “says Kenneth Landgaard, Portfolio Manager.

Tranen Capital’s strategy is to trade life insurance policies in the Life Markets Space, more commonly referred to as the Life Settlements Market. The Life Markets Space enables seniors to sell their life insurance contracts for more than the cash surrender value than they would otherwise receive from the Insurance Company. The credit crisis has helped create more supply as Seniors (65 or older) are looking for other ways to generate cash. In fact, the life settlements market is expected to grow to over $160 billion over the next several years, according to a Sanford Bernstein report.

Arthur Bowen, Director and in-house counsel explained, “The growth in the life settlement market confirms the validity of this asset class and we continue to see great interest from institutional investors. These sophisticated investors understand the strategy and they appreciate that Tranen has gone to great lengths to provide an institutional quality product with a great level of transparency.”

Tranen Capital offers qualified offshore investors access to the Tranen Capital Alternative Investment Fund Ltd. with a 1% acquisition fee and a 20% incentive fee. The minimum investment is $100k USD.

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Hedge fund manager, Majid Al Futtaim Asset Management, is launching its first Middle East and North Africa (MENA) equity fund, the Luxembourg domiciled ‘Elite MENA Equity Fund’.

Investors can invest alongside the family office of Majid Al Futtaim and gain access to the services of the portfolio management team responsible for the MENA equity investments. The Majid Al Futtaim family office has seeded the fund with Dh550 million ($150 million), making it one of the largest MENA equity funds available to investors.

“Investors deserve to have the best home for their money in both turbulent and stable investment environments.” Iyad Malas, Chief Executive, Majid Al Futtaim Asset Management, said, “By opening the doors to the services of the portfolio management team responsible for Majid Al Futtaim’s family office, we offer investors a tried and tested place to invest. The Elite MENA Equity Fund offers investors an opportunity to invest with a team whose performance speaks for itself.”

The new ‘long-only’ open-ended fund aims to achieve long-term asset growth and capital preservation through a ‘Risk-Managed Growth’ approach to MENA investments.

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Principal at Rothstein Kass, Charles F. Plaveczky will be speaking at a webinar for hedge fund managers interested in meeting the growing demands for increased reporting transparency and control, according to fund manager and host Confluence.

“As the April 30 hedge fund financial reporting cycle clearly demonstrated, prevailing error-prone manual processes for hedge fund reporting are far too brittle and inflexible—and they lack the scalability to meet increasingly complex reporting requirements,” said Plaveczky. “The pressure for greater flexibility and control will only increase with the adoption of additional reporting rules, and challenge current processes even more.”

The webinar entitled “The Change Imperative for Hedge Fund Reporting” and will take place on Friday, May 29 at 11:00 am EDT.

Kirk Botula, Chief Operating Officer of Confluence, will also provide information on new hedge fund reporting trends and challenges, discussing processes to maximize accuracy, efficiency and control in the reporting process as hedge funds deal with a variety of reporting requirements—such as FAS 157 fair market reporting, FAS 161 disclosures about derivative instruments and hedging activities, and how new International Financial Accounting Standards from IASB will challenge prevailing back-office reporting processes.

“Multiple stakeholders are demanding greater reporting diligence from hedge funds and their administrators. Regulators are clearly focused on greater transparency, investors are demanding additional disclosures and more frequent reporting, and accounting and auditor firms are mandating improved process control and documentation,” said Botula. “Hedge funds must consider how technology and automation can improve their reporting processes in order to provide the speed, control and flexibility needed to weather a new era of reporting transparency and control.”

Hedge fund companies and their fund administration service providers can register for this complimentary webinar at www.confluence.com/GETCONTROL. Individuals who register will also receive Confluence’s new whitepaper, Hedge Fund Reporting: The Change Imperative.

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Hedge fund research provider, Guidepoint Global, LLC, has acquired tech and media company, Vista Research, Inc. from Standard & Poor’s.

“In the current economic climate, investors and business decision makers are increasingly seeking on-demand knowledge and insights through expert networks,” said Albert Sebag, CEO of Guidepoint Global. “Guidepoint’s acquisition of Vista, a pioneer in the expert network field, gives our clients access to one of the most comprehensive primary research networks in the world, delivered with the single-minded focus on customized service that they have come to expect.”

Guidepoint has over 130,000 global experts and a compliance framework supported by a proprietary IT platform, as well as one of the most advanced online client interfaces.

With the acquisition of Vista Research, Guidepoint Global said it will expand its team of client service professionals and recruiters to support a client base that includes many of the world’s leading private equity firms, mutual funds, hedge funds, strategy consultancies and multinational companies.

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West Palm Beach (HedgeCo.net) – The organizing committee of The International Organization of Securities Commissions (IOSCO) is to host more than 500 of the leading securities regulators and economic experts from more than 65 countries at this year’s conference in Tel Aviv, Israel, June 8-11.

“We are honored to host the world’s leading regulatory experts, from Albania to Zambia, in Israel for this important event,” said Spokeswoman Yael Almog. “Israel ‘s sophisticated local market regulation and high levels of investor protection make it a great setting for this historical event. We believe that IOSCO 2009 will not only help restore strength in the world’s regulatory system, but more importantly, it will foster renewed confidence among the international investment community.”

Conference participants include SEC Chairwoman Mary Schapiro, Goldman Sachs CEO Lloyd Blankfein, S&P President Deven Sharma and UK FSA Chairman Lord Adair Turner and Mario Draghi, Governor of Banca d’talia and Chairman of the Financial Stability Forum.

The conference provides the opportunity, IOSCO said, for regulators from both emerging and developed markets to address the global effects of the financial crisis on the financial and securities system and the stability of the world economy. In addition, it will emphasize the role emerging markets will play in the global recovery process and will outline the need and importance for new partnerships between developed and developing markets.

The conference will be hosted by the Israel Securities Authority (ISA) and the Tel Aviv Stock Exchange (TASE).

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Bull market? Time to buy? Over 3,000 absolute return managers made money in the last 12 months but few long only equity funds have in 12 years. Financial services is about achieving CLIENT objectives and good hedge funds have delivered superb performance. Every sophisticated institution I know is increasing allocation to absolute return. It’s always time to invest in quality so I’ll be staying in the SAFE HAVEN of skill-based strategies. Speculating on unhedged equity funds is not for me or those I advise.

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

Recessions are bad for beta but advantageous for alpha. ROBUST hedge fund portfolios beat stock benchmarks on a risk-adjusted basis over every time horizon. Unhedged equity funds squandered a disasterous -40% in 2008 and remain negative for the decade. Despite a drawdown last year, even the index of “all” hedge funds produced +22% alpha compared to the stock market. The rare “hedge fund” that imploded received 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.

I suppose stock markets might eventually get back to where they once were. But even if I was certain that in 2029 the Dow, Nikkei, Dax and FTSE will be above 100,000, I still won’t be gambling on risky long only equity. I know good hedge funds will have HIGHER risk-adjusted returns. And if those benchmarks turn out to be LOWER than today, good hedge funds will also have outperformed. The demand for absolute return is growing unlike that unrequited love affair with stocks that has jilted so many investors. The long only crowd 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 risk.

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 hedge funds and bothers to look closely at the data concludes that the more conservative an investor’s risk tolerance, the MORE of their portfolio they need in quality hedge funds. Long only 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 holdings. Individual investors would be prudent to follow.

80% of alpha is made by 20% of managers. Yes the Pareto principle governs hedge funds. 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 to capture it. Back in 1970, 2 out of 3 “hedge funds” shut down but the following 40 years saw PLENTY of investor acceptance. 1994 and 1998 were also supposedly the “end” of hedge funds. Few business sectors grow in a straight line. The blip is another temporary timeout in the ongoing expansion of the hedge fund industry. Any money withdrawn simply creates space for smarter investors.

Not investing in any stock or corporate bond because of Bernie Ebbers would be dumb so why are some experts arguing for avoiding absolute return strategies because of some 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 bad use of leverage?

UNHEDGED 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 also 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 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 completely different strategies is critical to optimal portfolio construction for the long term.

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 so 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 hedge funds coming this year. 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 need access to that alpha. A substantial allocation to diversified skill based absolute return strategies is essential for long term risk averse investors.

by Veryan Allen. Copyright 2009

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Bernard Madoff did NOT run a hedge fund. He was a stockbroker “managing” customer accounts. His firm was “regulated” and fraud is already illegal. REAL due diligence ITSELF is an alpha source. Few sophisticated investors had cash with Madoff since he failed basic checks. PROPER diversification with GENUINELY uncorrelated strategies and managers is MANDATORY for risk averse investors.

The Madoff scandal has no connection to absolute return. No incentive fees, no prime broker, no proper auditor and no independent administrator. The chart below is Madoff feeder fund, Fairfield Sentry, versus Gateway GATEX, a fund with the SAME strategy. Suspicious numbers and serial correlation in the 1990s got worse in 2001.

Split strike conversion is a BASIC strategy for options traders. It is too simple and well-known to be an edge and does NOT protect against major stock market falls. It looks like Madoff was subsidizing losing months with brokerage commissions from early on. Then a watershed event occurred in 2001 from the potent combination of a sustained bear market, reduced payment for order flow and decimalization. The broking income 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 five minutes over 14 years ago to decide I had no interest in the Madoff “strategy”. Since then many feeders wholly or partially invested with him have crossed my desk, often without any disclosure as to who the underlying manager was. Even a few weeks ago two marketers approached me at separate institutional investor conferences with “15 years of double digit returns at under 3% vol, daily liquidity” pitches. Both times I replied “No Madoff” before I had heard the manager’s name. I look at REAL hedge funds and don’t have time to study obviously unsuitable investments any closer.

Bernie did not make the first cut with most professional investors. I didn’t know for sure that Madoff was a fraud until now. But I do know a little about options and stay away from funds with a big difference between what they should have made and what they did make. Back in Christmas 1994 I was simply looking around for some good funds that had navigated that challenging year successfully. The trouble with Madoff was that he performed too well for the split strike conversion strategy on the S&P 100 OEX he was supposedly running. I like good black box trading strategies but this was no black box. I’ve designed options pricing models and volatility arbitrage systems and it takes much heavier quantitative weaponry to generate consistent returns out of the options markets.

Despite his “performance”, Bernie wasn’t a billionaire. With those “returns” on that AUM he should have been a stalwart of the Forbes 400. Why did his clients not question his absence from the list? Going long some large cap equities, sell calls and buy puts for the collar does not protect capital in steeply down markets. Contrary to its “market neutral” claims, split strike conversion performs better in bullish conditions. 1994 was a flat year for the S&P 100 with several negative months but Madoff reported 12%. Gateway, returned 5.5% which is approximately what would be expected. Madoff should have had similar numbers to the mutual fund but somehow “made” double digits. That was impossible for his “claimed” strategy in 1994.

You can detect a lot by focusing on difficult periods. When Long-Term Capital Management imploded in summer 1998, volatility was itself very volatile and stocks dropped sharply. But Bernie produced a similar return as in quieter months despite the mayhem. In September 2001, 9/11, stocks gapped down and volatility gapped higher but no problem for Madoff. Almost every real hedge fund either lost a lot or made a lot in that terrible month. More recently Madoff seemed remarkably “immune” to the stock market meltdown that has unfolded over the last 18 months. The crash of October 2008 was the end. His undoing was that even funds 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 journalists looked into the story more than 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 domestic investors. Why did so few US university endowments and pension plans queue up at 53rd and 3rd in New York to gain direct “access” to the master?

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

It is sad to hear of investors who were told their money was in a diversified portfolio, only to be wiped out by one fraud. It confirms the essential need for informed advice and a wide spread of manager bets. I wonder whether Fairfield, Kingate, M-Invest, Rye, Herald, Gabriel, Frontbridge, Fix or Ascot really understood options collar strategies or questioned his positive performance in periods when it SHOULD have done poorly. short selling private equity by way of Fortress FIG, Blackstone BX and KKR KFN. Not often do such absolute returns offer themselves up so easily and generously. The implosion of big private equity was a rare example of an apodictic certainty in finance. The short positions are now so small they are hardly worth covering. That’s the trouble with successful shorts but I will buy to cover soon. Some specific emerging markets are looking good for next year.

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

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

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

by Veryan Allen. Copyright 2009

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Hedge fund drawdown? Risk management rule No.1: if it CAN happen then it WILL happen. Hope for the best but hedge for the worst. 2008 has provided EXCELLENT performance from thousands of hedge funds, hard times for other hedge funds but much worse from long only equity. Skilled absolute return managers don’t always make money but they do have fewer, milder and shorter drawdowns than traditional funds that don’t even attempt to manage risk, go to cash, reduce exposures or preserve capital. Personally I’ll stay with absolute return strategies. It’s more prudent.

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

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

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

Hedge funds are dead? Long live hedge funds. I am long/short optimistic/pessimistic for different strategies. Even in ideal conditions only 10% of hedge funds are “buys” and 90% are “sells”. If we lose the bottom two quartiles, it will be 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 in firms that know how to generate alpha INSTEAD of the many weaker names that were just repackaging beta.

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

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

Creative destruction is the inevitable result of free markets and there have been several hedge fund shake outs previously. I don’t know the etiology of the market meltdown and credit crisis or intend to guess government policy initiatives or regulatory solutions. I do know good hedge fund managers are able to evolve in WHATEVER market conditions occur. When business magazines use words like hedge fund extinction, absolute return armageddon or absolute return strategies actually ROSE recently because so MUCH more was lost gambling on the stock market. When a strategy gets crowded and AUM too large, it makes sense to do the OPPOSITE. The negative carry trade that worked best in 2008: borrow Icelandic króna to BUY the Japanese yen. Shorting the mythical “upward drift” of equities and REVERSE arbitrage of popular “market neutral” strategies also did well.

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

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

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

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

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

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

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

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

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

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

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

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

by Veryan Allen. Copyright 2009

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Best hedge fund? Recently I visited the best ever hedge fund manager’s home. On the way I saw a black swan, bought an expensive tank of gas and ate at a restaurant that had run out of rice. Sometimes minor data can signal major opportunities. Many commodities have gone up recently but wide rice and oil price fluctuations do not bode well for financial stability. Economic decoupling was always a crazy concept; volatility is NEVER “contained” and reverberates across all asset classes.

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

Seems good. Over 20% compound annual return after fees. The fund is open and you could, if you want, invest in it. The fund exists and returns have been independently audited many times. Heavily regulated and open to all investors. No leverage, no lockup and no valuation issues. The manager can accept ANY amount without damaging performance. The fund keeps it simple by investing in equities listed on the world’s largest market value stock exchange. No arcane assets, malicious models, specious SPACs or dubious derivatives so it must be “safe”?

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

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

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

Alfred Winslow Jones did not “invent” hedge funds. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that it was psychology and the IRRATIONAL actions of participants NOT economic logic that drove markets. Behavioral finance isn’t new, it’s 253 years old. He didn’t buy and hold rice and wait to be compensated for its higher volatility. He did not “expect” a risk premium or “assume” that rice would go up over time. And though rice was heavily traded and analyzed even in those days, such liquidity did NOT produce an efficient market. Like most good traders, he figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether rice prices themselves were rising or falling. That is a TRUE hedge fund.

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

Since Honma’s era there have been many hedge fund obituaries. We are on yet another iteration right now because a few beta dependent speculators masquerading as hedge funds recently blew up. That SOME hedge fund strategies are short volatility and can be modeled as effectively short sellers of options and hoping a black swan won’t show up to reveal their fund as a lemon is very OLD news. Ten years ago LTCM short sold options and bet the house on convergence and then got taken out by the “never happened before” Russia default. Fortunately there are many quality hedge funds run by managers who are fully aware of the dangers of being short gamma and convexity, potential “rare” event fat-tail risks, carefully hedge for those exposures or maintain a long volatility profile. Sure plenty of “hedge funds” are no good but there are many skilled hedge funds that DO manage such risks.

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

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

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

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

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

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

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

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

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

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

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

So Japan therefore had the world’s best ever hedge fund – Honma’s long/short rice trading strategies managed from the 1740s to the 1790s – but also, and quite surprisingly, the world’s best performing stock market index over the LONG TERM remains the Japanese TOPIX. The chart above is the fund performance from 1980-1989 but below is the ENTIRE performance chart from 1980-2008. Past perfomance was not indicative for future performance. The risk and volatility since 1990 have failed to compensated investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy and hold hope. A good heuristic for assessing investment strategies – if it is simple then it likely won’t work. Easy “solutions” cause difficult problems, as we have seen.

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

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

by Veryan Allen. Copyright 2009

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Absolute returns? Investors need alpha because beta does not deliver reliably. The traditional portfolio of 60/40 equities/fixed income can lose money over long periods and is too risky anyway. Fortunately there is a solution – alpha from the strategies and skills of the world’s best absolute return managers. It would be good if beta benchmarks do eventually perform but we need the “hedge” of alpha if they don’t. Diversify away SYSTEMIC risk with talent-based return sources that do NOT depend on a good economy to make money.

History is a great persuader but poor predictor. The 20th century was ultimately the “triumph of the optimists” aided and abetted by the highly anomalous bubble of the 1980s/1990s. A bubble for which the world economy will continue to pay HARSHLY for many years to come. Past returns do not guarantee that the 21st century won’t be the “revenge of the pessimists”. There is no FORWARD-LOOKING evidence that “buy and hold” WILL work. Just historical data erroneously extrapolated into the “fabulous” future. Some “experts” even have the effrontery to say we can ignore volatility along the way due to the economic utopia that we can apparently all look forward to…eventually.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It is a market of stocks NOT a stock market and some securities do go up but most go down over time. Why invest 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 2009

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