Biz Direct MarketKnowing When To Make A Good Decision

Emerging market for alpha? Good hedge funds had a great decade as usual and many emerging markets also did well. Ten years ago most investors avoided developing countries and loved developed because of the Asia crisis, Russia default and 1990s bubble. When will the crowd learn to buy the unpopular and short sell the trendy? Not yet judging by the money swarming into long only emerging market debt and equity funds. Like developed markets, emerging countries offer alpha capture opportunities from long/short security selection, arbitrage and timing NOT buy and hold beta.

Lost decade? I ended up with an +18.59% CAGR after fees for the 2000s. Not bad considering the high manager diversification and low market risk. I choose alpha vendors for most strategies but manage some special situations myself if I have an edge. I use macro black boxes and micro risk metrics that seem to have predictive value. Emerging markets alpha is a favorite strategy. One year ago AND ten years ago many experts said avoid “risky” emerging markets and “dangerous” hedge funds! Financial science is not rocket science; it’s more complicated than that. I focus on robust models and geographic FACTS not economic THEORIES. I just strive to be long only of alpha.

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Emerging market for alpha? Good hedge funds had a great decade as usual and many emerging markets also did well. Ten years ago most investors avoided developing countries and loved developed because of the 1990s bubble, the Asia crisis and Russia default. When will the crowd learn to buy the unpopular and short sell the trendy? Not yet judging by all the new institutional RFPs for long only emerging market mandates and the retail money swarming into similar mutual funds. Even more so than developed markets, emerging markets offer alpha opportunities from long/short security selection, timing and hedging NOT buy and hold beta.

Lost decade? I ended up with an +18.59% CAGR after fees for the 2000s. Some did better but not bad considering the high level of diversification and limited risk. I select alpha vendors for most strategies but manage some special situations myself if I have an analytical advantage. I use macro black boxes and micro risk metrics that seem to have predictive value. Emerging markets alpha has been a favorite strategy. One year ago AND ten years ago many experts said to avoid “risky” emerging markets and “dangerous” hedge funds! Financial science is not rocket science; it’s more complicated than that. I focus on robust mathematical models and geographic FACTS not economic THEORIES. I always strive to be long only of alpha.

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Alpha beta separation? Can’t beat beta? Beta based asset allocation is supposedly the driver of returns. Many papers claim that it is almost all that matters. That mistake has dominated conventional wisdom for too long. They reached that sample biased conclusion because asset allocation is what the selected investors focused on. Setting a stock/bond/alternatives mix determines variability of returns ONLY if you emphasize it. It is easy to debunk this portfolio construction “axiom” if you seek reliable performance.

Suppose corporate pensions were required to invest 100% in the plan sponsor’s equity. Then we would conclude that security selection drove returns. If investors flipped coins each month to be 100% stocks or bonds then market timing would be the factor. You only have to look at the underfunded liability status of many institutions to see that conventional “choose your betas” asset allocation needs NEW thinking. Some say that those with long term outlooks should have more in risky assets due to the alleged higher “expected” return. Instead investors would be wise to focus on the alpha/beta weights. For anyone with lower risk tolerances and dislike of deep drawdowns, alpha gets the vote.

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Alpha beta separation? Beta based asset allocation is supposedly the main driver of returns. Many papers claim that it is almost all that matters. They reached that conclusion because asset allocation is what the chosen investors focused on. Despite many errors, that biased sample has dominated conventional wisdom for too long. Setting a stock/bond/alternatives mix may determine variability of returns for investors that emphasize it. It is easy to debunk the portfolio construction “axiom” if you seek reliable performance.

Suppose corporate pensions were required to invest 100% in its plan sponsor’s stock. Then we would conclude that security selection drove returns. Or assume investors flipped coins each month to determine whether to be 100% stocks or bonds. Tactical timing would be the only performance factor. In reality the best determinant of superior risk-adjusted returns is investment SKILL not the percentage in different UNSKILLED asset classes. If the “seminal” studies had confined their analysis to high frequency portfolios obviously they would find that ability at high frequency trading drives performance! Is it valuable information to “discover” that asset allocators’ returns largely depend on their asset allocation?

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Asset allocation? The “endowment model” was once seen as the “solution” for how to invest for the long term. Sadly as some universities have found out to their cost, the model was flawed and overexposed to a bad economy. It was heavily long biased, higher risk and not hedged. Despite being asset diversified, it was insufficiently strategy diversified. The ONLY thing to overweight in any portfolio is alpha; not beta and certainly not illiquid “alternative” betas. A dynamic investment universe cannot be optimally navigated with a static or occasionally rebalanced asset allocation. A bad economy increases the need for a good portfolio.

Economic fluctuations ought not have a deleterious effect on portfolio growth or asset/liability matching whether you have $1,000 or $1 trillion to invest. Many long term investors forgot that they still need SHORT TERM cash and income. Having so much tied up in illiquid assets makes it difficult to be agile enough to capture and adapt to the changing inefficiencies that the market ALWAYS makes available. Why commit so much to 10 year lockups and ongoing capital calls when there is vast alpha available in liquid markets? The OPPORTUNITY cost from overweighting illiquidity was very expensive. And where was the scenario analysis and stress testing to construct a TRULY robust portfolio? When liquid assets sneeze, similar illiquid assets catch pneumonia.

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Some equations do work. Good hedge fund + rough quarter = buying opportunity. As expected many hedge funds have performed very well so far in 2009. It is no surprise that the market dislocations, misvaluations and panic-selling hysteria created fantastic opportunities for the best absolute return managers. Inevitably a repeat of 1998, 1994 and 1970 has occurred. Redemptions by some who didn’t understand proper strategy diversification have benefited those that knew they needed skill based funds in their portfolios.

Even more impressive are the hedge funds that made money in both 2008 and 2009. Market timing is hard but some have the ability to do it. The best way to evaluate an investment strategy is its return on risk. Even with the recent stock market rally, the return on risk of long only funds has been poor. As usual the mythical equity risk premium hasn’t worked. Is it zero? Is it negative? I don’t know but it is too unreliable for investors that seek to match institutional liabilities or individuals wanting to grow and preserve their retirement savings. Invest with managers that have the skills and resources to MAKE MONEY when things go
pear-shaped - ie when markets or economies go bad.

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Time to buy? Over 3000 absolute return funds made money in the last 12 months but how many long only equity managers? Money management is about achieving client objectives and QUALITY hedge funds HAVE delivered what investors want. Every smart investor I know intends to INCREASE their allocation to absolute return. Bonds have done better than stocks for 40 years and hedge funds have outperformed since 1970. The manager SKILL premium exists but the equity RISK premium? Unlike stocks, it’s always time to invest in good hedge funds. So while my zero beta, all alpha portfolio was up in 2008, I’ll be keeping those yen in the SAFE HAVEN of hedge funds.

The prospects for the REAL hedge fund industry are outstanding. Good hedge funds beat equity benchmarks on a risk-adjusted basis over EVERY time horizon. So far in 2009 most hedge funds that I follow are positive while unhedged equity funds have lost another -10% after a disasterous -40% in 2008 and most are negative for the decade. Despite a drawdown last year, even the index of “all” hedge funds delivered +22% alpha compared to the stock market. The very rare hedge fund that blows up gets saturated media coverage but there have not been many articles on the hedge funds that MADE +20%, some over +100%, in 2008.

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Bull market? Time to buy? It’s always time to invest in good hedge funds. Over 3,000 absolute return funds made money in the last 12 months but few long only equity managers did. Money management is about meeting client objectives and QUALITY hedge funds HAVE delivered the performance that investors require. The FACT is that the prospects for the REAL hedge fund industry are outstanding. Every large investor I know intends to INCREASE or maintain their allocations to absolute return.

The redemption of hot money creates more room for sophisticated investors who understand that smaller AUMs lead to larger alphas. Poor quality “hedge funds” that shut down will simply be replaced by better new ones. So while my zero beta, all alpha portfolio was nicely up in 2008, I’ll be keeping those yen in hedge fund strategies. The “free lunch” of “passive” index funds has cost investors too much for too long. Risky asset classes are volatile. The cult of equity and the credit cataclysm have devastated beta-centric portfolios. The way forward is to allocate to investment and risk management skill.

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Bernard Madoff did NOT run a hedge fund. He was a stockbroker “managing” customer accounts. The firm was “regulated” and fraud is already illegal. Few sophisticated investors put any money with Madoff. REAL due diligence ITSELF is an alpha source. PROPER diversification with GENUINE uncorrelated strategies and managers is MANDATORY for risk averse investors.

The Madoff scandal has NOTHING to do with hedge funds. No incentive fees, no prime broker, no proper auditor and no independent administrator. The chart is the Madoff feeder, Fairfield Sentry, versus Gateway, GATEX, a fund with the SAME strategy. Suspicious numbers in the 1990s got worse around 2001.

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

The Madoff scandal has nothing to do with hedge funds. No incentive fees, no prime broker, no proper auditor and no independent administrator. The chart is the Madoff feeder, Fairfield Sentry, versus Gateway, GATEX, a fund with the SAME strategy. Suspicious numbers in the 1990s got worse around 2001.

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