Biz Direct MarketKnowing When To Make A Good Decision

The social impact and economic benefit of hedge funds? Foundations heavily invested in skilled strategies have higher returns on capital for good causes. Endowments properly invested in absolute return have more for students and spending policies. Pension plans with substantial hedge fund allocations have better funded liabilities than solely long only. Family offices have more for donations, grants and charitable trusts. Sovereign wealth funds gain sovereign wealth. Individual investors an earlier retirement. Hedge funds also provide liquidity and act as a buyer of last resort. Making money in a recession? That is when alpha is most needed and clients hired managers to do.

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

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Hedge fund pay? Money manager “salaries” vary widely. It’s a kurtotic world where fat tails render means almost meaningless. Necessity is the mother of invention and we all need innovative alpha sources. Hedge fund rich lists likely overstate “income”. The 20% incentive fee only applies to NEW profits. Those delivering absolute alpha deserve a fair percentage with clients making far more. Funds below high water marks aren’t paid much during drawdowns. Clawback clauses and other changes are coming.

Some good managers that lost money in 2008 worked nearly gratis last year with the 2% going to staff and infrastructure costs. Many “paychecks” were capital gains on own cash in the fund: shared upside AND downside in alignment with investors. AVERAGE hedge fund returns are often mentioned but not AVERAGE hedge fund pay. In finance the average is usually not indicative. Some CDO structurers mixed 800 FICO and 400 FICO scores for “average” default rates and a few managers figured out the probable result years beforehand.

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High frequency trading? Ironic the best long term returns came from short term strategies. Like most people my favorite holding period is forever. In reality it is rarely feasible and never optimal when economic volatility, creative destruction, business innovation and global instability are permanent market phenomena. The emerging markets post was on SPACE - people should invest in good opportunities anywhere. This is about TIME - buy and hold and low frequency trading do not diversify enough so investors also need higher frequency strategies in their portfolios. Different holding period alphas REDUCE total risk.

Best manager for the new decade? The chances are that fund is not yet in existence though I have visited some interesting startups recently. What about the best strategy? That strategy has likely yet to be invented. However some future trends are certain like the growth of alpha vendor industry AUM from the current tiny $2 trillion to over $10 trillion by 2020. Some $100 billion funds will appear, many not established today. High frequency trading was the best hedge fund category in the 2000s but it will NOT be the winner again with so many entering the field dragging down “aggregate” returns. The obscure is now mainstream but the top funds will thrive extracting alpha out of high frequency has-beens and wannabes.

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High frequency trading? Ironic that the best long term returns came from short term strategies. Like most people my favorite holding period in theory is forever. In reality it is rarely feasible and never optimal when economic volatility, creative destruction, business innovation and global instability are permanent market phenomena. The previous post was on SPACE - people should invest in good alpha opportunities anywhere. This post is about TIME - buy and hold and low frequency trading do not diversify enough so investors also need higher frequency strategies in their portfolios. Different holding period alphas REDUCE total risk.

Best fund manager for this new decade? The chances are that fund is not yet in existence though I have visited some interesting start ups recently. What about the best strategy? That strategy has likely yet to be invented. However some future trends are certain like the growth of the alpha vendor industry AUM from the currently tiny $2 trillion to at least $10 trillion by 2020. Some $100 billion funds will appear, many not established today. High frequency trading was the best hedge fund category in the 2000s and it will NOT be the winner again with so many entering the field dragging down “aggregate” returns. The obscure field is now mainstream but the top exponents will thrive extracting alpha out of the many more high frequency wannabes.

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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 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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