Team Hedge Fund

Archive for the ‘Hedge Fund’ Category

Hedge Fund Blog began five years ago. It’s been great meeting and dialoging with people I might never have connected with. Initially I posted daily but away from the blogosphere I was quite busy helping investors make money and reduce risk. Developing pension liability solutions and portfolio rescue strategies takes a lot of time. Despite superior performance, hedge funds continue to be controversial and misunderstood. The five years have been good for alpha but not for beta.

Risky but some still bet on beta – the unskilled returns from asset classes. I prefer alpha – absolute returns from market skill. There is no need for retirement savings and personal net worth to suffer the unreliability and volatility of long only stocks and bonds. Could individual and institutional investors afford another severe bear market? Safer alternatives and better uses of capital are available. The ONLY financial certainty over the next five years is a substantial increase in investment in hedge funds. Don’t let the beta behemoths crush your portfolio, again.

Since inception here are the 10 most popular Hedge Fund Blog posts.

Hedge fund blog? I wrote this just after arriving in New Zealand for some meetings. While long only passive and active funds extol their virtues, investors should remember the ONLY reason to hire any manager is for absolute returns. Relative return funds emerged out of “Modern” Portfolio Theory. Managers were asked to beat a benchmark NOT make money! To add insult to injury, managers became obliged to fully invest regardless of market conditions or valuation. Asset allocation meant risk management was “unnecessary”! Evaluate products for their return on risk and alignment of SHARED interests with clients. Don’t get caught out by tail risk. Hedge black swan and purple sheep “rare” events.

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

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

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

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

Hedge fund arbitrage? Those dollar bills are still being dropped on streets all over the world and being scooped up by the quick and nimble. Why take unhedged directional risk when the markets offer up so many inefficiencies and arbitrages. The experts hate this notion because it goes against the house of cards theory that no securities are ever mispriced and arbitrages cannot appear. Risk and return have no connection. Some arbitrages offer a good return for very low risk. Meanwhile long only funds in major stock markets have delivered negative returns on very high risk. Finding lucrative arbitrages does take talent and expertise. Fortunately this is available for the LOW fees of 2 and 20.

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

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

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

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

Writing a blog on investing defensively rather than conventional “wisdom” has been interesting. Hopeless hypotheses and industry inertia stop many investors from being allowed to access better risk-adjusted returns. Hedging, strategy evaluation and manager due diligence require specialist expertise but it’s cheaper than the damage wrought by “simple” portfolio construction. I don’t know how much longer ideas like “strategic asset allocation” and “time in the market” will exist. I do know that sophisticated investors accept that radical surgery and portfolio triage are required if performance is to be achieved over the long term, irrespective of the economy.

The tipping point from beta-centric to alpha-centric portfolios is here. Most mainstream commentary on hedge funds is uninformed and therefore negative. Those who criticise hedge funds have never invested in one. Few that take the time to understand skill-based absolute return strategies revert back to long only. Other industries embrace innovation but improvements in investment technology are still fiercely and often successfully resisted. Sad for those that urgently need access to new sources of return. Whether the Dow is on its way to 50,000 or 500, the future growth of the hedge fund industry is guaranteed.

by Veryan Allen. Copyright

Go to Source

Hedge Fund Blog began five years ago. It’s been great meeting and corresponding with people I might never have connected with. Initially I was intending to post daily but outside the blogosphere I’ve been busy helping investors make money, developing pension liability solutions and implementing portfolio rescue strategies. Despite vastly superior performance, hedge funds continue to be controversial and misunderstood. The past five years have been great for alpha but not for beta.

Some investors still bet on beta – the unskilled returns from asset classes. I prefer alpha – absolute returns from market skill. There is no need for retirement savings and personal net worth to suffer the unreliability and volatility of long only stocks and bonds. Could individual and institutional investors afford another severe bear market? Safer alternatives and better uses of capital are available. The ONLY financial certainty over the next five years is a substantial increase in investment in hedge funds. Slay the beta behemoth.

Since inception in 2005 here are the top 10 most read Hedge Fund Blog posts.

1. Hedge fund blog? I wrote this just after arriving in New Zealand for some meetings. While long only passive and active funds extol their virtues, investors should remember the ONLY reason to hire any manager is for absolute returns. Relative return funds emerged out of “Modern” Portfolio Theory. Managers were asked to beat a benchmark NOT make money! To add insult to injury, managers became obliged to fully invest regardless of market conditions or valuation. Asset allocation meant hedging and risk management were “unnecessary”. Evaluate products for their return on risk and alignment of interests with clients. Don’t get caught out by tail risk. Hedge black swan and purple sheep “rare” events.

2. Hedge fund test? In the REAL investment world, passing paper tests doesn’t help much. Spend 50 years theorising in the Ivy League but 50 minutes on a trading floor delivers the true education. Economics Nobel prize winners are famously negatively correlated with investment success. Efficient markets, mean-variance “optimization” and CAPM have not aided investors that desire consistent returns. Check out the performance of traditional portfolios following ivory tower “advice” and groupthink policy asset allocation. It hasn’t worked and it won’t work. Short FNGN and ENV?

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

4. Jack Bogle versus hedge funds? Jack Bogle is brilliant. A brilliant salesman of BELIEFS but the index crowd doesn’t like being confronted with the FACTS of humble arithmetic. Today, another 3 years on, stock benchmarks are even lower and “passive” bond funds don’t pay enough yield. While the S&P 500 has lost money, some component stocks dropped -100% but others have risen massively like AAPL, GOOG, PCLN, ISRG and CRM. Equities are opportunity sets for long/short alpha NOT buy and hope beta. Security selection can’t be done? Market timing is impossible so hold all stocks regardless of prospects? George Soros, Warren Buffett and Jim Simons were just lucky flukes? 3,000 hedge funds making money in 2008 wouldn’t have helped cushion the crash for Boglehead portfolios?

5. Hedge fund arbitrage? Those dollar bills are still being dropped on streets all over the world and being scooped up. Why take unhedged directional risk when the markets offer up so many inefficiencies and arbitrages. The experts hate this notion because it goes against the whole house of cards theory that no securities are ever mispriced and arbitrages cannot appear. Risk and return have no connection. Some arbitrages offer a good return for very low risk. Meanwhile index funds in major stock markets have delivered negative returns on very high risk. Finding lucrative arbitrages does take talent and expertise. Fortunately this is available for the fee of 2 and 20.

6. 2 and 20? Skill costs in all business sectors. With good hedge funds, the after fee return to investors is higher than competing products. Paying a few basis points for -50% losses isn’t cheap. Many long only funds have 90% of performance explained by the benchmark. So the residual 10% explained by active management “justifies” a 1% expense fee? The IMPLIED expense fee for many traditional funds is nearly 10% even during negative returns since index tracking costs almost nothing. The 2% management fee and 20% of new profits for a good hedge fund is a bargain by comparison. All alpha strategies are capacity constrained and in most cases the 2% is NOT a profit center. The more clients make the better “pay” for the manager. Incentives work. Check out the returns of funds that DON’T charge incentive fees.

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

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

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

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

Writing a blog on investing defensively rather than conventional “wisdom” has been interesting. Hopeless hypotheses and industry inertia stop many investors from being allowed to access better risk-adjusted returns. Hedging, strategy evaluation and manager due diligence require specialist expertise but it’s cheaper than the damage wrought by “simple” portfolio construction. I don’t know how much longer ideas like “strategic asset allocation” and “time in the market” will exist. I do know that sophisticated investors accept that radical surgery and portfolio triage are required if performance is to be achieved over the long term, irrespective of the economy. The tipping point from beta-centric to alpha-centric portfolios is here.

Most mainstream commentary on hedge funds is uninformed and therefore negative. Those who criticise hedge funds have never invested in one. Few that take the time to understand skill-based absolute return strategies revert back to long only. Other industries embrace innovation but improvements in investment technology are still fiercely and often successfully resisted. Sad for those that urgently need access to new sources of return. Whether the Dow is on its way to 50,000 or 500, the future growth of the hedge fund industry is guaranteed.

by Veryan Allen. Copyright

Go to Source

Long or short? A flight to “safety” so “rational” investors BUY government bonds and the yen? Congratulations to “emerging market” South Africa for holding a successful soccer tournament and for winning the stock market World Cup over the long term, 110.5 years. We are all long term investors, right? I guess index zealots are loading up on EZA since past is prologue or is “passive” home bias still wrecking their portfolios? Long or short alternative strategies, not long only traditional assets, is the way to go.

France are out of the World Cup and it’s Warren Buffett’s fault? He shorted Les Bleus to profit from their demise. Negative bets “cause” failure according to those who blame short sellers. Do things fail because of fundamental problems or shorts? Have sovereign debt spreads widened due to some belatedly realizing there are no risk free bonds or use of credit derivatives? Anyone not shorting is not hedging. The fact is that markets where short selling and derivatives are not allowed have WORSE crises.

A portfolio without shorts or derivatives is like a soccer team with no defenders or goalkeeper. The unhedged, unskilled crowd has underperformed CASH since France won back in 1998; so far my best ever year but commonly regarded as “bad” for alternative strategies due to the blow up of one incompetent fund staffed with Nobel Prize “winners”. Absolute return funds have demolished traditional managers since England won back in 1966; the year when the flexibility and lower risk of long/short was first widely publicized and shown conclusively to be a vastly superior and safer strategy for portfolios.

After 44 years of vicious volatility, insidious inflation, debt defaults and failed financial dogma, how much longer must most investors wait to be allowed to properly diversify and allocate to genuine skill? That “long term” stock market upward drift doesn’t seem to be working and “risk free” bonds carry yields woefully inadequate to compensate for their numerous RISKS. Even worse is that bond index funds force investors to lend the most to those that borrow the most regardless of yield! Not what a prudent man would do and a clear breach of fiduciary duty. Why invest in such toxic waste as capital-weighted passive fixed-income?

Some say short selling is a drag on returns, derivatives must be banned while security analysis and active manager selection are a waste of time. Diversification is “Don’t put all your eggs in one basket”; surely it makes MORE sense to bet that some or most of the eggs will indeed get broken. Shorting and hedging are the way to REDUCE risk. If there is no such thing as investment skill, there is no such thing as sporting skill?

Anyone competent knows FUTURE talent is detectable in any field. It just takes hard work, due diligence and experience to find the top performers in advance. Skill must be unconstrained which is why mandating good active managers to be long only gets similar results to blindfolding good football players. For those who still prefer human decisions to computer driven strategies, check out the results of world cup referees not using modern technology. Then check out the total portfolio performance of investors that avoid BETTER ways of making money – skill-based strategies.

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

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

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

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

Much hope for the future relies on dubious assumptions that “stocks” eventually rise. Sorry but there is NO expected return. Long only credit is bad, long only equity is worse, long only commodities is crazy. Over time most equities FALL as any thorough empirical examination of buy and hold confirms. Short selling permits absolute returns from the majority of stocks that go DOWN over time. In my experience bear markets create increased alpha opportunities. As with the World Cup there are always more losers than winners which makes it OPTIMAL to have more shorts than longs and benefit from the natural selection and creative destruction of the markets. 130/30 or 30/130 since MOST stocks are sells not buys over that infamous long term.

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

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

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

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

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

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

Socrates said “I am not an Athenian or a Greek, but a citizen of the world” – invest in alpha opportunities anywhere not the country you happen to be in. “The only good is knowledge and the only evil is ignorance” – financial ignorance is abundant but there have been great returns by the knowledgeable. Small losses are a cost of doing business whereas large losses stem from ignorance.

by Veryan Allen. Copyright

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Buyers, sellers and users beware of opposite scenarios and opposing forces. Alpha capture is war and victors don’t take prisoners. What if the Abacus and Timberwolf synthetic CDO deals had NOT blown up? Brilliant buyers now gurus for their perspicacious positioning? Goldman Sachs excoriated for failing to disclose to loser shorts that winning longs bet against them? Would there be a case? Rely on deal arrangers or do your own analysis? While others figure out if laws were broken, the message for investors remains: caveat emptor, caveat venditor, caveat utilitor. Be grateful to those betting against you. How else can alpha be found?

Assume and expect others have different opinions. We need them. But would Michael Lewis have still written “The Big Long” on credit experts picking off bears that wandered into the doomsday machine? Or Gregory Zuckerman on the “The Worst Trade Ever” how an obscure merger arbitrage trader, John Paulson, went out of business style drifting into subprime? Magnetar sucked into a black hole? Dr. Michael Burry back on double shifts at the hospital? What if Paulson HAD bought and the next day reversed to the short side. Would it have changed the loan portfolio selection or the bond “rating”?

Wary of negligent misrepresention, financial weapons of mass destruction and non-disclosure of agents of asset class armageddon, I fled to the relative safety of stocks. I selected 500 dodgy, in my humble opinion at the time, reference securities to bet against. Luckily a broker’s quantitative geeks had already assembled a listed structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary failed to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the salestrader herself confided in an email that she was bearish at that time but her function was facilitating CLIENT transactions regardless of personal or her firm’s market views. Anyone long that SPY ETF asset backed security and not made aware of shorts has recourse to regulators?

Harry Hindsight? The first casualty of war is truth and the first casualty of finance is memory. Casual emails gain overweighted prominence when LDL conversations aren’t recorded. I wonder about that fateful meeting in January 2007 between Goldman Sachs, ACA and Paulson. Would buyers have walked away if the marketing materials had stated on the front page in bold red ink “A merger arbitrage fund you likely haven’t heard of with no known expertise or track record in credit helped choose the underlying loans and will likely bet against them”. Or “Fabulous Fab and some of the other Goldman Sachs proprietary traders at this moment in time happen to be bearish on subprime but they have been right AND wrong in the past”. How might this have changed investor appetite? Lists of heavily shorted stocks are published daily but does this make every long get out? Never buy IPOs since the insiders are selling?

Deception? Designed to fail? There are ALWAYS bears on anything. If there are no bears get short immediately! If then unknown Paolo Pellegrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an outlier opinion ignored by the street. Even I wrote several bearish posts in early 2007 and investors that followed that advice made very high returns but most ignored those too. To make money out of the credit meltdown you didn’t have to specifically short subprime as it would obviously negatively impact most risk assets. Was Fabrice Tourre wrong in his “smoking gun” email to express his then view that shorts were more likely to win than longs? There have been many securities constructed on reverse enquiry from hedge funds where that client ended up being very wrong. I also know of IPOs for “overvalued” companies considered “bound to fail” that subsequently went up 1,000% after listing. Everyone gets it wrong sometimes.

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

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

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

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

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

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

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

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

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

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

by Veryan Allen. Copyright

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Long or short? France are out of the soccer world cup and it’s Warren Buffett’s fault? Berkshire Hathaway short sold Les Bleus to profit from their demise. Negative bets “cause” failure according to those who blame short sellers for the credit crisis. Did the team fail from fundamental problems or shorts? Have sovereign debt spreads widened due to some belatedly realizing there are no risk free bonds or use of credit derivatives? The fact is that markets where short selling and derivatives are not allowed have worse volatility and drawdowns. Anyone not shorting is not hedging. A flight to “quality” so BUY bonds and the yen? Long/short is the way to go.

A portfolio without shorts or derivatives is like a soccer team with no defenders or goalkeeper. Winning funds and teams also require strong management, teamwork and tactical adjustments to nimbly react to changing opportunities. The unhedged, unskilled crowd has underperformed CASH since France won back in 1998; so far my best ever year but commonly regarded as “bad” for hedge funds due to the blow up of one. Hedge funds have demolished long only managers since England won back in 1966; the year long/short was first widely publicized and shown conclusively to be a vastly superior alternative for portfolios. After 44 years how much longer must most investors wait to be allowed to properly diversify and allocate to genuine skill?

Some say short selling is a drag on returns, derivatives must be banned while security analysis and active manager selection are a waste of time. Diversification is “Don’t put all your eggs in one basket” so surely it makes sense to bet that some or most of the eggs will indeed get broken. Shorting and hedging are the way to REDUCE risk. If there is no such thing as investment skill, there is no such thing as sporting skill? Anyone competent knows FUTURE talent is detectable in any field. It just takes hard work, due diligence and experience to find the top performers in advance. Skill must be unconstrained which is why mandating good managers to be long only gets similar results to blindfolding good soccer players. For those who prefer human decisions to computer driven strategies, check out the results of world cup referees not using modern technology.

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

Avoid all bonds because of Greece? I recently met with a famous fund that blamed the “unprecedented” Greece situation for why they lost money! Proud of their terabytes of “historical” data, amazingly they were unaware Greece had many defaults in the past starting with Solon financial regulatory reform in 600BC and for over 100 of the past 200 years. Investors can learn a lot from the greeks. On trial for daring to challenge conventional wisdom, Socrates’ prophetic last words were “Please don’t forget to pay the debt”. Archimedes invented leverage and was prescient in saying “Give me enough leverage and I will move the world” considering how borrowers have moved world markets recently. It always puzzled me how experts worried about leveraged hedge funds but treated government bonds as risk free. The only risk free rate is zero. Every country is a great place for seeking alpha from long/short NOT long only beta.

Aristotle also offered investment advice. “The aim of the wise is not to secure pleasure but to avoid pain” – the wise short sell and hedge downside risk to avoid portfolio pain. “Hope is the dream of the waking man” – if you hope a losing position will turn into a profit or a long only stock and bond portfolio will fund retirement liabilities you are dreaming. “A great city is not to be confounded with a populous one” – invest with great funds not necessarily the biggest managers. “The greatest virtue is those which are useful to other people” – absolute returns are ALWAYS very useful to clients but they can’t eat relative returns in down markets. Socrates said “I am not an Athenian or a Greek, but a citizen of the world” – invest in alpha opportunities anywhere not the country you happen to be in. “The only good is knowledge and the only evil is ignorance” – financial ignorance is abundant but there have been great returns by the knowledgeable. Small losses are a cost of doing business whereas large losses stem from ignorance.

Too much hope for the future relies on dubious assumptions that “stocks” rise eventually. Long only credit is bad, long only equity is worse, long only commodities is crazy. Over time most equities FALL as any thorough empirical examination of buy and hold confirms. Short selling permits absolute returns from the majority of stocks that go DOWN over time. In my experience bear markets create increased alpha opportunities. As with the world cup there are always more losers than winners which makes it OPTIMAL to have more shorts than longs and benefit from the natural selection and creative destruction of the markets. 130/30 or 30/130 since MOST stocks are sells not buys over the famous long term.

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

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

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

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

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

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

by Veryan Allen. Copyright

Go to Source

France are out of the world cup and it’s Warren Buffett’s fault? Berkshire Hathaway short sold Les Bleus to profit from their demise. Negative bets “cause” failure according to those that blame short sellers for similar financial implosions. Did the team fail due to fundamental problems or short sales? Did the Euro fall in recent months because of structural defects or shorts? Have sovereign debt spreads widened due to amateurs belatedly realizing there are no risk free bonds or professionals using credit derivatives? Some say short selling is a drag on returns, derivatives and shorting should be outlawed while security analysis and active manager selection are a waste of time. If there is no such thing as investment skill, is there also no such thing as sporting skill? Anyone competent knows FUTURE talent is detectable in any field. As any good coach will confirm it just takes hard work, due diligence and experience to find the top performers in advance. Skill also must not be constrained which is why mandating good managers to be long only gets similar results to blindfolding soccer players. And for those who prefer human decisions to quant strategies I suggest they take a close look at world cup referees “accuracy”.

A portfolio without shorts and derivatives is like a soccer team without defenders and goalkeepers. A winning fund requires strong management, teamwork and tactical adjustments to nimbly react to changing opportunities. The unhedged, unskilled crowd has underperformed CASH since France won back in 1998; so far my best ever year but commonly regarded as “bad” for hedge funds due to the blow up of one. Good hedge funds have demolished most long only managers since England won in 1966; the year long/short was first widely publicized and shown conclusively to be superior. For long term investors, long/short is much safer and better aligned with actual economic reality than long only. Those seeking consistent performance invest in skilled managers not asset managers. For funds that hold the largest stocks to minimize tracking “error”, BP is yet another reminder that there are no blue chip, buy and hold “securities”. BP stock crashed due to poor management or short sellers? If one hedge fund drops a few billion some urge avoiding all hedge funds but when a stock loses $100 billion they don’t say avoid all stocks. Why?

Avoid all bonds because of Greece? Like every country Greece is a great place for alpha. I recently met with a manager that blamed the “unprecedented” Greece situation for why they lost money! Proud of their petabytes of “historical” data to analyze, amazingly they were unaware Greece had many defaults in the past starting with Solon trying to sort out the debt situation in 600BC and for over 100 of the past 200 years. Investors can learn a lot from the greeks. On trial for daring to challenge conventional wisdom, Socrates’ prophetic last words were “Please don’t forget to pay the debt”. Archimedes invented leverage and was prescient in saying “Give me enough leverage and I will move the world” considering how large borrowers have moved world markets recently. It always puzzled me how experts worried about leveraged hedge funds but regarded government bonds as risk free.

Aristotle also had some investment advice. “The aim of the wise is not to secure pleasure but to avoid pain” – the wise short sell, buy puts and hedge downside risk to avoid portfolio pain. “Hope is the dream of the waking man” – if you hope a losing position will turn into a profit or a traditional portfolio will fund retirement you are dreaming. “A great city is not to be confounded with a populous one” – invest with great funds not necessarily the biggest asset gatherers. “The greatest virtue is those which are useful to other people” – absolute returns are very useful to clients but they can’t eat relative returns in down markets. Socrates said “I am not an Athenian or a Greek, but a citizen of the world” – invest in global alpha opportunities anywhere not the country you happen to be in. “The only good is knowledge and the only evil is ignorance”. Sadly for investors ignorance in finance is plentiful but there has been good performance by the knowledgeable. Don’t let the evil of down markets damage portfolios. Small losses are the cost of doing business; large losses are evidence of ignorance.

While some still believe that shorts and derivatives fuel down markets, the fact is there is not enough use of them to diversify, hedge and make money. Stock market drawdowns and volatility need not negatively impact any investor’s portfolio. With so many aspects of people’s lives affected by the economy, their savings and retirement plans ought to be immune to the unreliability of long biased equity and credit. The bull market tide went out recently revealing many naked, overly risky, poorly constructed portfolios. Too much hope for the future relies on dubious assumptions that “stocks” rise over time and “bonds” will repay you. Long only bonds is bad, long only stocks is worse, long only commodities is crazy. Over time most equities FALL as any thorough
empirical examination confirms. Short selling permits absolute returns from the majority of stocks that will go DOWN over time. In my experience bear markets create MORE alpha opportunities. Just like in the soccer world cup there are aways more losers than winners which means it is better to have more shorts than longs to keep aligned with the natural selection property and creative destruction phenomena of the markets.

The weakest prey are the easiest. There are more longs than shorts out there. Lack of performance incentives means many long decisions aren’t made for legitimate reasons. Some stocks are bought because they are in an index NOT because they are good investments. Many bonds are held because of investment grade “ratings” regardless of yield. Analysts issue far more “buys” than “sells”. Long only fund management has much larger AUM while weaker hedge funds tend to be LONG/short rather than long/short. Low returns and high correlation in May 2010 shows little has been learnt from 2008 in terms of proper risk management, reducing market dependence or focusing on truly uncorrelated strategies. The congenital long bias means shorting attracts a higher percentage of people who know what they are doing. In general the PROPORTION of smart money in shorts is higher than the smart money in longs. Since alpha is generated by the skilled out of the unskilled, position against where the most unskilled money is. Despite what some still(!) say, there is no evidence that risky assets rise over time or compensate for risk. Alpha is zero sum – smart money makes alpha out of dumb money. Identifying dumb money usually means looking for weak longs and taking the other side. There is usually more dumb money on the long side than the short side.

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

Most of the greatest trades ever have been shorts. Whether it was John Paulson shorting subprime CDOs in 2007, George Soros the British Pound in 1992, Jesse Livermore USA stocks in 1929, the Munehisa Honma’s rice short in 1789 or Isaac Le Maire famous short of VOC in 1609. The only way to truly diversify or hedge a long is with a short. Why does conventional asset allocation range from 0% to 100% when investors could use -100% to +100%? Even better would be to acknowledge the failure of static asset allocation and put it in SKILLED long/short strategies. Every investor needs short positions including during BULL markets. It is called hedging. Few managers have the capability and skills to make money in bear markets. Sadly too many fail in due diligence to show they have the quality of risk management, strategy testing and expertise to deliver positive performance in negative market periods. Despite the lessons of the thousands of years little has been learnt about decorrelating a portfolio to underlying risk factors and immunizing against market volatility. But the fact remains that long short is better for conservative investors than long only.

by Veryan Allen. Copyright

Go to Source

Buyers, sellers and users beware of opposite outcomes and opposing forces. What if the Abacus and Timberwolf synthetic CDO deals had not blown up? Brilliant buyers now gurus for their perspicacious positioning? Goldman Sachs excoriated for not disclosing to shorts that winning longs bet against them? Would there be a case? Would it be on front pages? Rely on dealmakers or do your own homework? The lawyers can figure out if any securities laws were broken but for investors the message remains as always: caveat emptor, caveat venditor, caveat utilitor.

Would Michael Lewis have written “The Big Long” on credit experts picking off bears wandering into the doomsday machine? Or Gregory Zuckerman with the “The Worst Trade Ever” how an obscure merger arbitrage specialist, John Paulson, went out of business style drifting with subprime CDOs? Magnetar sucked into a black hole? Dr. Michael Burry back on double shifts at the hospital? What if Paulson HAD bought and the next day reversed to the other side. Would it have changed ACA’s loan portfolio selection choices or the bond “rating”?

Today I naively took the risk of renting a car. After closing the deal I was shocked to find vehicles moving in the OPPOSITE direction. NO-ONE TOLD ME. The salesperson and documentation had NO disclosure about this risky two-way flow. More due diligence revealed that despite heavy regulation and licensing, these dubious inventions KILL over 1,000 people every day from such collisions! Again zero mention in the legal paperwork. Did the arranger commit fraud by failing to inform of the danger? CDOs can’t be traded by some individuals but calamitous CARs are widely available.

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

Wary of negligent misrepresention of risk and non-disclosure of agents of automobile armageddon, I fled to the relative safety of finance. I selected 500 dodgy, in my humble opinion at the time, reference securities to bet against. Luckily some broker’s quantitative geeks had already assembled a structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary failed to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the broker herself confided in an email that she was personally bearish but her function was facilitating CLIENT transactions regardless of private or her firm’s market views. Anyone long the SPY ETF asset-backed security and not made aware of this has recourse to regulators?

Alpha capture is war and battles have casualties. Finding alpha is a zero-sum ADVERSARIAL game of losers AND winners. Zero-skill, crowded beta is “cheap” but insightful analysis and variant perception costs 2 and 20 or more. Contrasting views make a market. It is dumb and suboptimal to presume a counterparty is on your side. The juxtaposition of ideas helps prick bubbles earlier than a one-way market. If I buy I want as many smart people as possible hoping I am wrong. If I short sell I am most comfortable and make the highest returns when sophisticated professionals are buying and A-list analysts regard it as a core long.

You can ONLY produce alpha when others lose. Therefore it is essential for others to oppose you. Longs need shorts and vice versa. The most alpha appears when most are wrong. A rating of “strong buy” on a stock or “AAA” for a bond is just someone else’s opinion. It is up to investors to do their own analysis or hire advisors working FOR them. Do your own due diligence or find someone to do it for YOU with rare investment expertise and whose interests and INCENTIVES are aligned with yours. Cheerleaders cheer the team that pays them not necessarily YOUR team.

Harry Hindsight lives. The first casualty of war is truth and the first casualty of finance is memory. Casual emails gain overweighted(?) prominence when LDL conversations aren’t recorded. I wonder about that fateful meeting in January 2007 between Goldman Sachs, ACA and Paulson. Would buyers have walked away if all deal materials had stated in bold red ink “A merger arbitrage manager you likely haven’t heard of with no known expertise or track record in credit may have helped choose the underlying loans and will likely bet against them”. Or “Fabulous Fab and some of the <a href="http://news.yahoo.com/s/nm/20100503/bs_nm/us_berkshire_buffett
“target=_blank>Goldman Sachs GS proprietary credit traders are at this moment in time bearish on subprime credit but they have been right AND wrong in the past”. How might this have changed things?

Deception? Designed to fail? There are always bears on anything. If then unknown Paolo Pelligrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an outlier opinion ignored by the street. Even I wrote several bearish posts in 2007 and investors that followed that advice made high returns but the general population ignored those too. To make money out of the credit meltdown you didnt have to specifically short subprime. Was Fabrice Tourre wrong in his “smoking gun” email to express his then view that shorts were more likely to win than the longs? There have been many securities constructed on reverse enquiry from hedge funds where the client ended up being very wrong. I also know of IPOs done for “overvalued” companies considered “bound to fail” that have subsequently gone up 1,000% after listing. Everyone including insiders gets it wrong sometimes.

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

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

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

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

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

If you need a friend get a dog. Full transparency: at this instant I am short the S&P 500 and numerous other asset-backed equity and credit structured products, however I might reverse and buy between 20 milliseconds and 20 years from now. Whatever or whenever an investor buys or sells, it is certain that others are betting the opposite way. To generate consistent alpha it is necessary to have counterparties with different opinions. It is obligatory for others to disagree with you. Their existence is mandatory for seeking alpha.

by Veryan Allen. Copyright

Go to Source

Buyers, sellers and users beware of opposite outcomes and opposing forces. What if the Abacus and Timberwolf synthetic CDO deals had not blown up? Brilliant buyers cited as gurus for their perspicacious positioning? Goldman Sachs called to testify for not disclosing to shorts that winning longs were betting against them? Would there be a case? Would it be on front pages? Rely on deal arrangers or do your own homework? Caveat emptor, caveat venditor, caveat utilitor.

Would Michael Lewis have written “The Big Long” on credit experts picking off bears wandering into the doomsday machine? Or Gregory Zuckerman on the “The Worst Trade Ever” how a merger arbitrage specialist, John Paulson, went out of business style drifting with subprime CDOs? Magnetar sucked into a black hole? Dr. Michael Burry back on double shifts at the hospital? What if Paulson HAD bought and the next day reversed to the other side. Would it have changed ACA’s loan portfolio selection choices or the bond “rating”?

Today I naively took the risk of renting a car. After closing the deal I was astonished to see some vehicles moving in the OPPOSITE direction. The salesperson and documentation made NO disclosure about this risky two-way flow. More due diligence revealed that despite heavy regulation and licensing, these dubious inventions KILL over 1,000 people every day from such collisions! Again zero mention in the legal paperwork of these hazards. Did they commit fraud by failing to inform of the danger? CDOs can’t be traded by some individuals but calamitous CARs are widely available.

Abolish CARs? I even saw a “rogue” employee knowingly bet against me driving north while I headed south. Such conflicts of interest and idiotic innovation needs to stop before even more people die in toxic tort products like cars. Ban derivatives trading so ban driving since it is much riskier? Subpoena to Congress those merchants of mayhem and dealers in destruction like car rental firms? The world thrived for a long time before “monstrousities” like C-D-Os and C-A-Rs were created. Get CDOs wrong and just lose money but outlawing CARs would save lives.

Wary of misrepresention of risk and non-disclosure of agents of automobile armageddon, I fled to the relative safety of finance. I chose 500 dodgy, in my humble opinion at the time, reference securities to bet against. Luckily some broker’s quantitative geeks had already assembled a structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary neglected to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the broker herself confided in an email that she was also personally bearish but her function was facilitating CLIENT transactions regardless of private or her firm’s market views. Anyone long the SPY ETF asset-backed security and not made aware of this has recourse to regulators?

Alpha capture is a war and battles have casualties. Finding alpha is a zero-sum ADVERSARIAL game of losers AND winners. Zero-skill, crowded beta is “cheap” but insightful analysis and variant perception costs 2 and 20 or more. Contrasting views make a market. It is dumb and suboptimal to presume a counterparty is on your side. The juxtaposition of ideas helps prick bubbles earlier than a one-way market. If I buy I want as many smart people as possible hoping I am wrong. If I short sell I am most comfortable when sophisticated professionals are buying and A-list analysts regard it as a core long.

You can ONLY produce alpha when others lose. The most alpha appears when most are wrong. A rating of “strong buy” on a stock or “AAA” for a bond is just someone else’s opinion. It is up to investors to do their own analysis or trust advisors working FOR them. Do your own due diligence or hire someone to do it for YOU with rare investment expertise and whose interests and INCENTIVES are aligned with yours. Cheerleaders cheer the team that pays them not necessarily YOUR team.

Harry Hindsight lives. The first casualty of war is truth and the first casualty of finance is memory. Casual emails gain overweighted(?) prominence when LDL conversations aren’t recorded. I wonder about that fateful meeting in January 2007 between Goldman Sachs, ACA and Paulson. Would buyers have walked away if all deal materials had stated in bold red ink “A merger arbitrage manager you likely haven’t heard of with no known expertise or track record in credit may have helped choose the underlying loans and will likely bet against them”. Or “Fabulous Fab and some of the <a href="http://news.yahoo.com/s/nm/20100503/bs_nm/us_berkshire_buffett
“target=_blank>Goldman Sachs GS proprietary credit traders are at this moment in time bearish on subprime credit but they have been right AND wrong in the past”. How might this have changed things?

Deception? Designed to fail? There are always bears on anything. If then unknown Paolo Pelligrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an outlier opinion ignored by the street. Even I wrote several bearish posts in 2007 and investors that followed that advice made high returns but the general population ignored those too. To make money out of the credit meltdown you didnt have to specifically short subprime. Was Fabrice Tourre wrong in his “smoking gun” email to express his then view that shorts were more likely to win than the longs? There have been many securities constructed on reverse enquiry from hedge funds where the client ended up being very wrong. I also know of IPOs done for “overvalued” companies considered “bound to fail” that have subsequently gone up 1,000% after listing. Everyone including insiders gets it wrong sometimes.

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

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

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

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

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

If you need a friend get a dog. Full transparency: at this instant I am short the S&P 500 and numerous other asset-backed equity and credit structured products, however I might reverse and buy between 20 milliseconds and 20 years from now. Whatever or whenever an investor buys or sells, it is certain that others are betting the opposite way. To generate consistent alpha it is necessary to have counterparties with different opinions. It is obligatory for others to disagree with you. Their existence is mandatory for seeking alpha.

by Veryan Allen. Copyright

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Hedge fund economic benefits? Foundations invested in skilled strategies have higher performance to support social causes. Endowments properly allocated to absolute return have more for faculty and students. Pension plans with substantial hedge fund allocations have better funded liabilities. Family offices more for donations and grants. Eleemosynary institutions greater cash for charity. Sovereign wealth funds gain sovereign wealth for citizens. Individual investors secure an earlier retirement. Hedge funds provide deeper liquidity and act as a buyer of last resort. Making money in a recession is when alpha is needed most and clients hired managers to do.

$5 slate & chalk = index fund -> $500 Apple iPad = hedge fund. Investors can choose old products or more powerful performance. The billions in “wages” go mostly to philanthropy. Hedge fund pay is a kurtotic variable where fat tails render means meaningless. Rich lists miscalculate “income” and customers ultimately sign all “paychecks”. Those delivering absolute returns deserve a share for making and saving clients far more. Funds below high water marks aren’t paid well in drawdowns as the 20% incentive fee only applies to new profits. Hedge fund clawbacks are coming. Necessity is the mother of invention and we need INNOVATIVE alpha sources and lower risk MODERN portfolios.

By style I’m a macro portfolio manager/value investor and very conservative. I started by purchasing emerging and frontier market debt, equity and real estate far cheaper that its true worth. Also I spent years buying deeply mispriced options, derivatives and hybrid securities in those “unpredictable” and “efficient” markets fantasized about by “Nobel” prize winners. Recently I’ve helped fiduciary organizations manage money and construct portfolios of managers and multimanagers whose fees are a bargain compared to their VALUE. The higher hedge fund manager pay, the MUCH more investors make.

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

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

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

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

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

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

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

by Veryan Allen. Copyright

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Buyers, sellers and users beware of opposite outcomes and opposing forces. What if the Timberwolf and Abacus synthetic CDO deals had not blown up? Brilliant buyers cited as gurus for their perspicacious positioning? Goldman Sachs called to testify for not disclosing to loser shorts that winning longs were betting against them? Would there still be a case? Would it be on front pages? Rely on deal arrangers or do your own homework? Caveat emptor, caveat venditor, caveat utilitor.

Would Michael Lewis have written “The Big Long” on credit experts picking off sucker bears that wandered into the doomsday machine? Or Gregory Zuckerman on the “The Worst Trade Ever” how a merger arbitrage specialist, John Paulson, went out of business style drifting with subprime CDOs? Magnetar sucked into a black hole? Dr. Michael Burry back on double shifts at the hospital? What if Paulson HAD bought and the next day reversed to the other side. Would it have changed ACA’s loan portfolio selection choices or the bond “rating”?

Today I naively took the risk of renting a car. Soon I was astonished to see some vehicles moving in the OPPOSITE direction. The salesperson and deal documentation provided NO disclosure about this risky two-way flow. More due diligence revealed that despite heavy regulation and licensing, these dubious inventions KILL over 1,000 people every day from such collisions! Again zero mention in the legal paperwork of the hazards. Did they commit fraud by failing to inform of the dangers? CDOs can’t be traded by some individuals but calamitous CARs are STILL widely available.

Abolish CARs? I even saw a “rogue” employee knowingly bet against me driving north while I headed south. Such conflicts of interest and idiotic innovation needs to stop before even more people die in toxic tort products like cars. Ban derivatives trading so ban driving since it is much riskier? Subpoena to testify those merchants of mayhem and dealers in destruction like car-rental firms? The world thrived for a long time before “monstrousities” like C-D-Os and C-A-Rs were created. Get CDOs wrong and just lose money but restricting CARs would save lives.

Wary of misrepresention of risk and non-disclosure of antagonistic agents of malice, I fled to the relative safety of finance. I chose 500 dodgy (in my humble opinion, at the time) reference securities to bet against. Luckily a broker’s quantitative geeks had already assembled a structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary neglected to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the salesperson herself confided in an email that she was bearish but her function was facilitating CLIENT transactions regardless of personal or her firm’s market views. Anyone long the SPY ETF asset-backed security and not made aware of this has recourse to regulators? Next time you short QQQQ or EEM, take care: others are long.

Alpha capture is a war and battles have casualties. Finding alpha is a zero-sum ADVERSARIAL game of losers AND winners. Zero-skill, crowded beta is “cheap” but insightful analysis and variant perception costs 2 and 20 or more. Contrasting views make a market. It is dumb and suboptimal to presume a counterparty is on your side. The juxtaposition of ideas helps prick bubbles earlier than a one-way market. If I buy I want as many smart people as possible hoping I am wrong. If I short sell I am most comfortable when sophisticated professionals are buying and A-list analysts regard it as a core long.

You can ONLY produce alpha when others lose. The most alpha appears when most are wrong. A rating of “strong buy” on a stock or “AAA” for a bond is just someone else’s opinion. It is up to investors to do their own analysis or trust advisors working FOR them. Do your own due diligence or hire someone to do it for YOU with rare investment expertise and whose interests and INCENTIVES are aligned with yours. Cheerleaders cheer the team that pays them not necessarily YOUR team.

Harry Hindsight lives. The first casualty of war is truth and the first casualty of finance is memory. Casual emails gain overweighted(?) prominence when LDL conversations aren’t recorded. I wonder about that fateful meeting in January 2007 between Goldman Sachs, ACA and Paulson. Would buyers have walked away if all deal materials had stated in bold red ink “A merger arbitrage manager you likely haven’t heard of with no known expertise or track record in credit may have helped choose the underlying loans and will likely bet against them”. Or “Fabulous Fab and some of the <a href="http://news.yahoo.com/s/nm/20100503/bs_nm/us_berkshire_buffett
“target=_blank>Goldman Sachs GS proprietary credit traders are at this moment in time bearish on subprime credit but they have been right AND wrong in the past”. How might this have changed things?

Deception? Designed to fail? There are always bears on anything. If then unknown Paolo Pelligrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an outlier opinion ignored by the street. Even I wrote several bearish posts in 2007 and investors that followed that advice made high returns but the general population ignored those too. To make money out of the credit meltdown you didnt have to specifically short subprime. Was Fabrice Tourre wrong in his “smoking gun” email to express his then view that shorts were more likely to win than the longs? There have been many securities constructed on reverse enquiry from hedge funds where the client ended up being very wrong. I also know of IPOs done for “overvalued” companies considered “bound to fail” that have subsequently gone up 1,000% after listing. Everyone including insiders gets it wrong sometimes.

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

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

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

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

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

If you need a friend get a dog. Full transparency: at this instant I am short the S&P 500 and numerous other asset-backed equity and credit structured products, however I might reverse and buy between 20 milliseconds and 20 years from now. Whatever or whenever an investor buys or sells, it is certain that others are betting the opposite way. To generate consistent alpha it is necessary to have counterparties with different opinions. It is obligatory for others to disagree with you. Their existence is mandatory for seeking alpha.

by Veryan Allen. Copyright

Go to Source