Friday

Downside risk

I rarely write about my work for clients but here's one proprietary equation that has served well over many years of highly profitable investing in skill strategies. Good manager + bad period = buying opportunity. Sadly most investors do the opposite so their dollar weighted returns are poor compared to time weighted returns they would have achieved. I've increased allocations to quality funds in EXPECTED drawdowns many times. A great alpha driver is getting in when dumb money is redeeming. Some models actually do work.



As I wrote in late 2008, itself a FANTASTIC up year for many GOOD managers, most hedge funds went on to perform very well in 2009. Some MADE MONEY both in 2008 and 2009. Experts claim 2008 was a bad year but it was actually the greatest year for GOOD hedge funds. Risk management and skill are EVERYTHING. Most generic fund of hedge funds haven't a clue how to select managers. MOST INVESTMENT CAPITAL IS DUMB MONEY.

Trends end quickly and violently. Do the opposite of the dumb money that buys high and sells low. Since most phenomena are non-linear it stands to reason that linear equations are of no use. The simplest pear-shaped formula is y^2=x^3-x^4 which only has solutions in the real world for inputs between 0 and 1. Remarkably the area under that curve above comes to pi/4. Yet another example of pi showing up unexpectedly.

Are you managing your future by hiring skilled people to invest YOUR money? Or just hoping unskilled indices get lucky? We can define the beginning of anything at zero and ending at one to transform any data set into that range. Identifying and jumping onto a trend is relatively easy. Lots of people make money in bull markets. Only the best figure out how to make money in bear markets or when to short sell an ending bull market.

Smart investors are increasing allocations to hedge funds. It's no surprise that market dislocations, misvaluations and panic-selling hysteria created fantastic alpha capture opportunities for skilled managers. Performance was certain to be strong when so many "professionals" even recommended to avoid all hedge funds. Bear that in mind next time they offer you more absurd investment "advice". Redemptions by those who didn't understand true diversification benefited investors that REDUCED risk by having more alpha in their portfolios.

All trends end. Inconsistent those who argue trend following has no value but advocate long only equity because of a historical up trend last century that can supposedly be extrapolated into this one. Their insouciant belief in past being prologue is pathetic. The volatility of recent years has shown "difficult" times provide the best risk management stress test.

The more long lasting the trend, the more violent the end. The trend is your friend until it ends. The last two centuries were positive equity markets in some countries so this one will be too? A logic that far too many STILL believe. On a long enough time scale the survival rate of ANYTHING tends to zero. Bear that in mind next time your hear the "value" of buy and hold!

Definition of a trend: “What the wise man does in the beginning, the fool does in the end.” Even more impressive are the hedge funds that made money in both 2008 and 2009. Proper hedging and market timing is difficult but some have the talent. A way to evaluate any investment strategy is its return on risk. Even with the recent stock and credit market rally, the return on risk of long only funds has been terrible. Is the mythical equity risk premium positive or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve capital. Invest in managers with the skills to MAKE MONEY when things go pear-shaped - ie markets or economies go bad.

The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fans sell a rosy view of a DISTANT future that we can apparently all look forward to...eventually. I hope they are right but CONSISTENT CAPITAL GROWTH requires mitigating the downside. Few investors can afford to ignore deep drawdowns or vicious volatility. Follow the trend? Into the abyss? Thousands of equities have dropped to zero but NONE has ever gone to infinity. Portfolios need to be structured for ANY possibility including a dystopian long term. If your portfolio is not stress tested and hedged for a 90% stock market and real estate crash and all "risk free" government bonds defaulting then you have the wrong portfolio.

Unfortunately the crowd STILL uses normal assumptions which is fine UNTIL things cease to be normal. Pear-shaped situations require pear-shaped analysis. I prefer non-linear pear-shaped equations since they capture the initial quasi-linear uptrend and then nicely model the nasty end game. WE DON'T KNOW THE FUTURE but we do know that there are always securities to short sell and others to buy. Linear mathematics is easy which is why too many financial "professionals" rely on it to their clients' heavy cost.

Many things are pear-shaped. The universe is pear-shaped. Time is certainly pear-shaped. Just ask Professor Stephen Hawking. Atoms are too. If the largest and smallest physical systems are pear-shaped, it seems possible that financial structures also exhibit a similar form. Bonds and loans are great assets till the borrower defaults. Mortgage backed securities are fine unless real estate or interest rates go pear-shaped. Bull markets last longer and have low volatility while bear markets (pear markets?) often eviscerate years of growth. Beta climbs the wall of worry and then speedily descends into the dungeon of delusion.

Recently I read some books on the economic shape of the world. One was The
World is Flat
by Thomas Friedman. While interesting, the premise is incomplete. The world is actually pear-shaped and only gives the illusion of flatness during easy times. Protectionism may slow the globalization trend. While David Smick's book The
World is Curved
is more insightful, we need techniques to prepare for the different scenarios beyond the curve. Perhaps I should write a book called The World is Pear-Shaped.

Invention eliminates the obsolete. The life-cycle for businesses shortens all the time. Corporate and even country hegemony is not as long term as it used to be. Typewriters and slide rules had rising sales for decades but have not had much "growth" recently. Innovative investment strategies that seep into the public domain and crowded trades are prone to end with a meltdown. Bubbles take a long time to form but a short time to end. The best alpha generators are those managers equipped to navigate difficult markets. Successful trend following requires good entries AND exits.

Some absolute return strategies went pear-shaped in 2008 like CB arbitrage and long biased equity. The returns have stormed back this year by those managers with the skills to achieve them. Meanwhile good managed futures CTAs and short biased funds continue to deliver ESSENTIAL negative correlation to their clients despite experts worrying about their TEMPORARY losses. Fiduciary duty REQUIRES portfolio construction for optimistic AND pessimistic scenarios. Bear markets or bull markets are irrelevant in a robust strategy allocation.

By Veryan Allen Creative Commons License

This work is licensed under the Creative Commons Full Attribution, Non-Commercial, No Derivative Works 3.0 License

Hedge Fund Hedge fund

ヘッジファンド

F u n d §©®±¼½¾µßαβγδσ€∂√∞≠♠♣♥♦ΣΦΨΩ Follow Me on Pinterest