Team Hedge Fund

Archive for the ‘Hedge Fund’ Category

Buy bonds or stocks? A nice investment this year has been the bric versus BRIC trade. Since I disclosed it the long Colombia/short China position returned +50%, long Indonesia/short India +30%, Bangladesh bettered Brazil and Romania romped past Russia. Beta-neutral relative value strategies rarely make money on both sides. While economic expansion does not imply stock market growth, I’m more glad I didn’t tie up cash in “risk free” bonds.

Seek alpha or bet on beta? Why does so much financial advice fixate on the irrelevant topic of how much to allocate to asset classes? The more “risk averse” the more in bonds? Is it sensible to recommend the same allocation if they yield 2% as when they paid 10%? Can opportunity cost and default risk be ignored with coupons so low and borrowing so high? There are no risk free bonds but at least higher yields delivered the fixed-income on which so many individuals and institutions depend. Absolute return is the alternative.

Asset allocation varies by age? Big opportunity cost putting capital in low yield securities when higher returns are needed. There are no stable laws in finance. Conventional wisdom was to put one’s age in “bonds” and the rest in “stocks”. But the rapidly growing cohort of 100 year olds needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The switchover from stocks to bonds over time doesn’t cut it. More sensible is to have 100% of the portfolio in alpha opportunities. The bond bull market has persisted for 30 years. Deflation fears may fuel more. But higher returns are necessary.

I’ve researched many successful investors and one common factor is that none paid any attention to asset allocation. I also studied unsuccessful investors desperately trying to fund retirement liabilities and found they put asset allocation front and center. A clear pattern and conclusion. Cognitive error: asset allocation only drives returns if you DECIDE to emphasize it. Selecting which betas to track, then searching for managers to deliver it (and maybe a bit of alpha) hasn’t worked. What does work is to choose skilled unconstrained managers and let them figure out how to produce absolute returns.

How much to allocate to “emerging markets”? What kind of question is that? How much to “submerging markets”? So many countries, cultures and disparate outlooks for thousands of stocks, bonds, commodities and currencies. “Frontier markets” don’t have long track records but weren’t all countries “frontiers”? The China economy is larger than 3 years ago but is over 60% below its high water mark. The Japan economy is bigger than 20 years back but 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to “hedge funds”? The average hedge fund is as bad as the average long only stock or bond fund. But every investor needs 100% in skilled strategies.

Portfolio deadweight? High grade bonds are considered to be a liability match. They were once but now they are not. More a liability mismatch. If you need an +8% income you can bet on “high” yield junk bonds, hope the stock market will deliver that “expected” return or focus on SAFER alternatives. At such low yields, every cent in “risk free” bonds is a wasted chance for better risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises directly with bond prices.

A disease many investors suffer from is Anton’s syndrome. They think they can see but they can’t. Their mind confabulates a rosy vision for the market. Investment inertia and the endowment affect makes them favor what they own not what they should own. Bonds going up? Keep them or miss the rally. Market timing is “impossible” so buy and hold for the economic utopia they can see but blind people like me can’t. Security analysis is a waste of time so buy them all despite the FACT that 75% of stocks are long term lemons. Own bonds since the classic 60/40 portfolio is “optimized” for all yields, risks and default probabilities! Buy more bonds if you “see” yourself as “conservative”?

With 2008 rapidly being forgotten and falling off track records, asset class amnesia is dangerous but financial anosognosia is even worse. To have a defect is bad but to not know you have the defect is dangerous. The world divides into the few that know they don’t know and the many that don’t know they don’t know. Thankfully famous clairvoyants such as Eugene Fama, Ken French and John Bogle are able to see that everything will be fine in the end. Hopefully passive stock and bond portfolios won’t die before then though the last ten years do not bode well. How many planned retirements and retirement plans have been wrecked by long only “passive”? Too many.

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

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

Search for yield? Entering 2010, many experts said inflation was inevitable so short bonds but now deflation is the hot topic so buy? Go figure. There is a long list of gurus that lost big money short selling JGBs over the years so perhaps treasuries will do the same. Applied skillfully, long/short equity is safer than long only. And I’ll take fixed-income arbitrage, convertible bond and distressed debt strategies over “investment grade” bonds with yields this low.

Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent “flash crash” was a reminder of the ephemeral “value” in the markets. It came back, that time. I observed the wealth destruction delivered by long only equity funds in the 1990 Japan crash and 1987 Black Monday. Back in 1982 a Kuwaiti friend’s family office lost everything in the Middle East crash. Oil riches don’t automatically translate to stock market wealth. 2008 offered a valuable and expensive investment lesson but still some invest in losers like index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It’s the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes. Unskilled and unaware of it. The black hole of incompetence is scarier than a real black hole.

by Veryan Allen. Copyright

Go to Source

Buy bond or stock ETFs? A good alpha trade this year has been bric versus BRIC. Since I disclosed it my long Colombia/short China position returned +50%, long Indonesia/short India +30%, Bangladesh bettered Brazil and Romania romped past Russia. Beta-neutral relative value strategies rarely make money on both sides. While economic expansion does not imply stock market growth, I’m more glad I didn’t tie up cash in “risk free” bonds.

Seek alpha or bet on beta? Why does so much financial advice fixate on the irrelevant topic of how much to allocate to asset classes? The more “risk averse” the more in bonds? Is it sensible to recommend the same allocation when they yield 2% as when they paid 10%? Can opportunity cost and default risk be ignored with coupons so low and borrowing so high? There are no risk free bonds but at least higher yields delivered the fixed-income on which so many individuals and institutions depend. Absolute return is now the alternative.

Asset allocation varies by age? It’s an opportunity cost having capital in low yield securities when higher returns are needed. There are no stable laws in finance. Conventional wisdom was to put one’s age in “bonds” and the rest in “stocks”. But the rapidly growing cohort of 100 year olds needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The switchover from stocks to bonds over time doesn’t cut it. More sensible is to have 100% of the portfolio in alpha opportunities. The bond bull market has persisted almost 30 years. Deflation fears may fuel more. But higher returns are necessary.

I’ve researched many successful investors and one common factor is that none paid any attention to asset allocation. I also studied unsuccessful investors desperately trying to fund retirement liabilities and found they put asset allocation front and center. A clear pattern and conclusion. Cognitive error: asset allocation only drives returns if you DECIDE to emphasize it. Selecting which betas to track, then searching for managers to deliver it (and maybe a bit of alpha) hasn’t worked. What does work is to choose skilled unconstrained managers and let them figure out how to produce absolute returns.

How much to allocate to “emerging markets”? What kind of question is that? How much to “submerging markets”? So many countries, cultures and disparate outlooks for thousands of stocks, bonds, commodities and currencies. “Frontier markets” don’t have long track records but weren’t all countries “frontiers”? The China economy is larger than 3 years ago but is over 60% below its high water mark. The Japan economy is bigger than 20 years back but 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to “hedge funds”? The average hedge fund is as bad as the average long only stock or bond fund. But every investor needs 100% in skilled strategies.

Portfolio deadweight? High grade bonds are considered to be a liability match. They were once but now they are not. More a liability mismatch. If you need an +8% income you can bet on “high” yield junk bonds, hope the stock market will deliver that “expected” return or focus on SAFER alternatives. At such low yields, every cent in “risk free” bonds is a wasted chance for better risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises directly with bond prices.

A disease many investors suffer from is Anton’s syndrome. They think they can see but they can’t. Their mind confabulates a rosy vision for the market. Investment inertia and the endowment affect makes them favor what they own not what they should own. Bonds going up? Keep them or miss the rally. Market timing is “impossible” so buy and hold for the economic utopia they can see but blind people like me can’t. Security analysis is a waste of time so buy them all despite the FACT that 75% of stocks are long term lemons. Own bonds since the classic 60/40 portfolio is “optimized” for all yields, risks and default probabilities! Buy more bonds if you “see” yourself as “conservative”?

With 2008 rapidly being forgotten and falling off track records, asset class amnesia is dangerous but financial anosognosia is even worse. To have a defect is bad but to not know you have the defect is dangerous. The world divides into the few that know they don’t know and the many that don’t know they don’t know. Thankfully famous clairvoyants such as Eugene Fama, Ken French and John Bogle are able to see that everything will be fine in the end. Hopefully passive stock and bond portfolios won’t die before then though the last ten years do not bode well. How many planned retirements and retirement plans have been wrecked by long only “passive”? Too many.

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

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

Search for yield? Entering 2010, many experts said inflation was inevitable so short bonds but now deflation is the hot topic so buy? Go figure. There is a long list of gurus that lost big money short selling JGBs over the years so perhaps treasuries will do the same. Applied skillfully, long/short equity is safer than long only. And I’ll take fixed-income arbitrage, convertible bond and distressed debt strategies over “investment grade” bonds with yields this low.

Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent “flash crash” was a reminder of the ephemeral “value” in the markets. It came back, that time. I observed the wealth destruction delivered by long only equity funds in the 1990 Japan crash and 1987 Black Monday. Back in 1982 a Kuwaiti friend’s family office lost everything in the Middle East crash. Oil riches don’t automatically translate to stock market wealth. 2008 offered a valuable and expensive investment lesson but still some invest in losers like index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It’s the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes.

by Veryan Allen. Copyright

Go to Source

Hedge Fund began five years ago today. It’s been great meeting and dialoging with many interesting people I might never have connected with. Initially I posted daily but outside the blogosphere I was helping investors make money and reduce risk. Developing portfolio rescue strategies and pension liability solutions also takes time. Despite vastly superior performance, hedge funds continue to be misunderstood. Some still blame them for downturns. Causality is cloudy: did EWP have a good month due to “stress tests” or soccer success? Stocks might eventually go up (or down) but why wait decades to find out?

Could individual and institutional investors afford ANOTHER severe bear market or credit cataclysm? There is no need for retirement savings and personal net worth to suffer the unreliability and volatility of long only stocks and bonds. Better alternatives and uses of capital are available. Some still bet on risky beta – the unskilled returns from asset classes. I prefer alpha – absolute returns from market skill. The only financial certainty in the future is a substantial increase in investment in skill. Major stock markets are lower than 5 and 10 years ago. Good for alpha but bad for beta. Don’t let beta behemoths crush your portfolio, again, prudent man. Fiduciary duty implies attempting to preserve client capital.

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

Hedge fund blog? I wrote this after flying to New Zealand for a beauty parade. Investors should remember the sole reason to hire any manager is for REAL 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, “asset allocation” required funds to fully invest regardless of market conditions or valuation. Asset allocation even meant risk management was claimed to be “unnecessary”! Evaluate products for their return on risk and alignment with clients. Don’t get caught out by tail risk. Hedge for black swan and purple sheep “rare” events.

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

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

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% 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 over time.

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

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

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

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

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

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

The tipping point from beta-centric to alpha-centric portfolios is 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 growth of the hedge fund industry is guaranteed. Smart investors demand ACCEPTABLE risk-adjusted returns on capital. Long only stocks AND bonds don’t meet the standard.

by Veryan Allen. Copyright

Go to Source

Hedge Fund began five years ago today. It’s been great meeting and dialoging with many interesting people I might never have connected with. Initially I posted daily but outside the blogosphere I was helping investors make money and reduce risk. Developing pension liability solutions and portfolio rescue strategies also takes time. Despite vastly superior performance, hedge funds continue to be misunderstood. Equity benchmarks might eventually go up (or down) but why wait to find out? The five years were good for alpha but bad for beta.

Could individual and institutional investors afford ANOTHER severe bear market or credit cataclysm? Some bet on risky 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. Better alternatives and uses of capital are available. The only financial certainty in the future is a substantial increase in investment in hedge funds. Don’t let the beta behemoths crush your portfolio, again.

Major stock markets were higher 5 and 10 years ago. Industry inertia stops many from being allowed to access better risk-adjusted returns. Strategy evaluation and manager due diligence require specialist expertise but it’s cheaper than the damage wrought by “simple” portfolio construction. I don’t know how much longer ideas like “strategic asset allocation” and “time in the market” will exist. I do know that smart investors accept that safer strategies, radical surgery and portfolio triage are required if long term performance is to be achieved, irrespective of the economy. Below are the 10 most read Hedge Fund posts.

Hedge fund blog? I wrote this after flying to New Zealand for a beauty parade. Investors should remember the sole reason to hire any manager is for REAL 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, “asset allocation” required funds to fully invest regardless of market conditions or valuation. Asset allocation even meant risk management was “unnecessary”! Evaluate products for their return on risk and alignment of interests with clients. Don’t get caught out by tail risk. Hedge for black swan and purple sheep “rare” events.

Hedge fund test? In the real world, paper qualifications don’t help. 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 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 “asset allocation”. It hasn’t worked and it won’t work. Short FNGN.

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

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% 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.

Jack Bogle versus hedge funds? Jack Bogle is brilliant. A brilliant salesman of BELIEFS and specious argument but the index crowd didn’t like being confronted with 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 every stock regardless of price or prospects? George Soros, Warren Buffett and Jim Simons were just lucky flukes? 3,000 hedge funds making money in 2008 wouldn’t have helped cushion the crash for Bogleheads? There are no arbitrages?

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

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

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

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

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

The tipping point from beta-centric to alpha-centric portfolios is 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 growth of the hedge fund industry is guaranteed. Smart investors demand ACCEPTABLE risk-adjusted returns on capital.

by Veryan Allen. Copyright

Go to Source

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

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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

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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