Seeking alpha

Absolute return? Investors need alpha because beta is too risky. Skill is the best investment for the long term. It would be good if beta does eventually perform but we need the "hedge" of alpha if it doesn't. Diversify away volatility with return sources that don't depend on the economy to make money for you. History is a powerful persuader but pathetic predictor. The performance of your country's stock index will be MINUS 100% in the long term. Hedging and short sales are essential.

For some countries last century was "triumph of the optimists" particularly in Australia and South Africa, stock market superstars. Beware of survivorship bias of the RARE countries with continuous track records. As the past decade showed, 21st century might or might not be "revenge of the pessimists". There is no FORWARD-LOOKING evidence "buy and hold" works. Just old data erroneously extrapolated to the "fabulous" future passive pundits expect. Some even say we can ignore volatility due to the "long term" economic utopia coming!

They seem to "know" all will be fine decades from now but my clients can't wait that long. According to the fortune tellers the stock market will be much higher one day. Optimism is good but overoptimism is dangerous as we have seen. Hindsight driven "buy and hope" is the biggest risk most investors take. Reduce unhedged bets on "passive" index and relative return funds. Too volatile and very EXPENSIVE considering the lack of skill. Unnecessary now that financial innovation delivers LOWER risk investment products that people actually need - absolute return. You can't eat relative returns in bear markets.

Listed hedge fund Berkshire Hathaway's annual letter to shareholders is written by Warren Buffett and this year's was as insightful as ever. The salient quote was "You can occasionally find markets that are ridiculously inefficient or at least you can find them anywhere except the finance departments of some leading business schools". There are even some who say Warren's returns are from luck or reward for taking higher risk! Absurd. The FACT is that he takes LESS risk than "the market" and his investment skill is the reason why his hedge fund has produced copious alpha.

Warren says to avoid the 2 and 20 crowd. I agree. It is the elite teams NOT the crowd you want. Warren Buffett, the junk bond and derivatives trader - "derivative contracts that I manage" - runs a multistrategy hedge fund that has adapted to fluctuating alpha capture opportunities for decades. The Oracle of Omaha goes long the Brazilian Real, various commodities, trades Chinese oil stocks and short sells stock index options. Naked put selling seems at odds with his core value investing ethos and similar trades have sent many to the poorhouse. His bizarre long date options gamble is a nasty case of style drift for which BRKA shareholders will pay dearly but the rest of his portfolio looks to be in line with his "margin of safety" moat philosophy.

Just like Benjamin Graham and several Nebraskan doctors spotted Warren's talents BEFORE he went on to great things, it is possible to identify other good fund managers with the skills to perform over the long term, even if their investment strategy itself is short term. Fees are irrelevant if the AFTER fee performance meets required reward/risk targets. Those 1950s Nebraskans have had no complaints about Warren keeping 25% of "their" profits because he worked hard to find absolute alpha for them and charged a fair fee for his abilities.

The Economist magazine recently ran another advertorial for "passive" funds, emphasizing the "high" fees of active management. Beating the market is difficult, requires rare aptitude and expensive expertise. Most fund managers will fail at such a task as a skill MUST be scarce, by definition. But why try to beat the market when finding a NEW source of absolute alpha is so much more important for portfolio diversification? Investors would be better off with reliable ABSOLUTE returns that outpace inflation EVERY year rather than just relative outperformance of some equity index. What is the value of relative alpha in a bear market? Why have beta swamp the alpha?

The article predictably quotes John Bogle saying that the S&P 500 returned 12.3% annually from 1980-2005 but makes no mention of the MINUS 70% after inflation that investors "received" prior to that from 1965-1980. And it writes of a hedge fund that dares to charge 5% and 44% fees but ignores the 38% CAGR since 1990 AFTER fees that the fund generated. Such data snooping is typical of the long only beta brigade. John Bogle assumes that the world's best stock pickers must work at index construction firms while Buffett is a fluke since the market "cannot" be beaten. Curious considering the number of other "lucky" absolute return managers around. Investment skill doesn't exist?

Professor Kenneth French has even made the absurd attempt to count the cost of active investing but fails to note the obnoxious opportunity costs, vicious volatility and ludicrous losses exhibited by the "passive" funds he adores but his employer shrewdly avoids. 2 and 20 for hedged absolute alpha is a great deal compared to 0.20 for unhedged beta. Penny wise but dollar foolish capital "preservation".

Doesn't economic theory require investment capital to flow to where it can best be put to work rather than into every company in an index regardless of fundamental outlook? Perhaps in his next paper Ken French should try to calculate the absolute alpha that hedge funds generate out of index reconstitutions. Yes index funds "passively" tracking a beta benchmark can generate alpha...for good active funds. Either way his advocacy of worthless "passive" products that sit idly by while bear markets decimate client capital is mistaken and WILL cost investors a lot more.

There are low cost goods in any industry but that does not cause the highest quality manufacturers to lower their fees. Did Lamborghini panic about their pricing structure because Tata Motors TTM just launched a $2,500 car? Of course not. Performance comes at a price. I shall watch out for an academic paper on the money we apparently "waste" on cars just like all the cash investors supposedly squander on active fees. Buy the Tata Nano because it is irrational to drive any car that costs more? No proper hedge fund manager worries about "cheaper" unskilled funds. I'll happily pay 2 and 20 for consistent performance from a blend of skilled investment strategies than endure decades wasting time and losing money with "bargain" beta.

Performance attribution between market and skill-based returns is the idea behind alpha and beta separation but there is less attention to the fact that beta itself splits into PRICE beta and DIVIDEND beta. Alpha comes from the RELATIVE alpha of good traditional funds and the more valuable ABSOLUTE alpha produced by quality hedge funds running genuine absolute return strategies. Equity beta ALONE is unlikely to provide the performance of the past. Bond beta cannot due to low interest rates. Perhaps some day in the future, beta may again contribute but in the meantime investors need SUBSTANTIAL allocations to managers who can reliably deliver.

Some say alpha doesn't even exist. But a zero sum game does not mean zero gains for every participant. Some win, some lose and talent is the differentiator. Profits migrate from bad fund managers to good fund managers. Index growth will NOT be like the previous "wonderful" century; beta is not going to be sufficient to meet assumed target returns. Yet despite the 10% returns at 20% volatility - only half the reward for the risk! - many years spent below high water marks, a 90% implosion and several 50% drawdowns, we are STILL urged by the random walkers and efficient market hypothesizers to risk so much of our hard earned cash on equity beta!! Even with the performance of the PAST what kind of return-on-risk was that? Good hedge funds would be laughed out of the room with such dire risk-adjusted returns but not the beta bandits.

In aggregate the entire group of active managers WILL underperform their benchmarks. "Hedge funds" consisting of the whole set of fund products that say they are hedge funds won't, on average, be any good. I can't think of any reason why an investor would want to invest in a hedge fund index of "all" funds any more than an "all" stock index. Why tie up capital in sinking securities, archaic assets or mediocre managers? Seems VERY inefficient to me. Risk tolerance? I am too risk averse and conservative to tolerate the absolute risk of an long only equity. That particular "free" lunch is looking pretty expensive.

The long only luddites conveniently choose examples biased by their frame of reference. Instead of relying on their questionable conjectures I have looked at the full data set and the FACT is that SECURITY, STRATEGY and MANAGER SELECTION not ASSET ALLOCATION have done AND will continue to drive portfolio performance. Most hedge funds are run by unskilled wannabes but some in the top decile provide great value to investors. EVERY hedge fund manager can have losing periods, even Warren Buffett and James Simons, but when alpha returns drop below their high water marks they are shallower and shorter than the deep and extended drawdowns exhibited by beta. Of course proper manager due diligence, portfolio construction and diversification are ESSENTIAL for identifying investment skill.

Stock market PAST returns provide little indication of FUTURE performance. Now we are 8.20 years into the new century and a negative TOTAL return from many developed market betas. How long should we wait and how poor must investors become before the "equity markets go up over time" or "stocks outperform bonds" mantra materialises? No-one I know is prepared to wait around to find out if "stocks" WILL rise. Despite his buy and hold persona Warren Buffett expects his holdings to perform in a REASONABLE time frame or he dumps them and rightly so. Many investors can't afford to tie up capital in steeply declining asset classes and why should they endure such drawdowns in the first place? Be impatient for absolute returns from ANY fund manager.

From 1900-1949 the Dow rose from 66 to 200 for a 2.25% annual return from price appreciation. Dividends added a lot in those days. From 1950-1999 the rise from 200-11,497 equated to a much higher 8.45% annually. Index appreciation over even very long periods is not stable and very temporally dependent. This century the Dow has "grown" a little from 11,497 but dividends are much lower nowadays. If there were some inherent "expected" price appreciation in stock markets would not the two fifty year periods' price appreciation be more similar? Shouldn't we have already seen more sustained gains this century by now? With such long term variability and derisory dividends beta does not look good going forward. Seek absolute alpha because beta might not be there for us. Performance is what you keep NOT what you make and then give back.

Let's look closer at this alleged "expected return" from "stocks". Warren calculates that the Dow only grew 5.3% per year in price appreciation last century. We have been treading water since so I updated Warren's numbers to include the "growth" this century. The Dow closed at 65.73 on 29 Dec 1899 and 12,266.39 on 29 Feb 2008 so we are down to a miserable 4.95% annually over the last 1,298 months. The Dow does not include dividends which is unfortunate considering dividends WERE such an important contributor to the total return.

AVERAGE dividends over the 108 1/6 year period were as high as 5% which gets us to a 10% total return CAGR so the Dow is NOW around 2,000,000 if it had included dividends. So for those "shocked" by 100-200 point swings, the total return Dow is ACTUALLY experiencing 25,000 to 50,000 point fluctuations each day. That's what 65.73 invested at 10% compounds to over the period. But that figure contains no information on what $65.73 TODAY will be in 108.20 years if you were to invest it in the stock market index NOW. We don't know that data point YET.

Did anyone actually put $65.73 into the Dow on the last trading day of 1899 and now has $2 million? Of course not. It is just a historical artifact and TOO long term to be useful. Most investors need real returns quicker than beta alone can be assumed to deliver. 39,510 days ago there were no economists ranting on about "expected returns from risky asset classes" - a classic case of outcome bias and hindsight hype. Those who claim "stocks" rise over time only "know" that because they are looking at the result. No-one in 1900 recommended buying and holding the DJIA because they had no idea it would perform so well. Knowing the past doesn't mean you know the future. All I KNOW is that some stocks go up and some go down and skilled experts can do so in advance.

HISTORICAL performance was indeed quite good for passive assuming someone endured or could afford the non-growth from 1900-1932, 1929-1954, 1965-1982 and 2000-...? Of course that is also restricting analysis to stock markets that DID survive the entire period. Just like many individual equities go to zero, several large countries' stock AND bond markets went to what was effectively zero during last century. I am not being apocalyptic, just reiterating that risk management, diversification and hedging for ANY scenario are necessary. Let's hope world wars and depressions are gone forever. A year ago some said inflation and real estate crashes were gone "forever". The credit crisis was also "contained". No-one knows the long term but the short term is sometimes partially predictable if you have the right fundamental and technical tools.

If you had invested in 1900 then 33 years later you would STILL have been waiting for that fabled equity risk premium to kick in. High dividends and the post war baby-boom bull market meant that by the 1960s it seemed like "stocks" had an inherent upward drift especially if you only used data starting from 1926 which led to the fallible financial theories of the mid-late 60s and early 70s. Forget about alpha(!) because the market is efficiently random and beta will arbitrage away any incoming information! Get that strategic asset allocation right, sit back and watch those absolute returns roll in over time?

Later the 1980s/1990s mega bull market "confirmed" the 10% from beta baloney and "justified" larger equity allocations back then but which now suffer from the ongoing bear market that BEGAN in 2000. Few real scientists would have fallen for such a spurious conclusion or make such a non-predictive data mining error but many orthodox economists still believe it. The "expected" return from stock markets is lower than they would have you believe. The Dow price return from 1900-1982 was 3.20% but inflation from 1900-1982 was also 3.20%. The real return over those 82 years came from DIVIDENDS which were high THEN but are now low. Listen to what Warren is saying NOT the Nobel prize "winners".

Warren Buffett says buy SOME "foreign" equities? Bottom up stock picking may be a fine strategy but geopolitics and the macro situation can NEVER be ignored. Since history is supposedly helpful let's not forget what happened to investments in several major countries in the first half of last century. Some markets suffered a 100% drawdown while the USA "only" lost 90% in the 1930s but earlier had to shut down for several months in 1914. Perhaps things are different(!) today but a simple ukase to "buy foreign" is wrong. It is ALWAYS time to buy good foreign securities and short sell bad foreign securities. Ditto for domestic securities.

Recently some have even started saying "commodities" or "currencies" have an expected return. An asset class that deserves an asset allocation. UNLIKE stocks or bonds, commodities cannot go to zero and everyone needs them. Gold, silver, wheat and corn have a track record since 10,000BC unlike those new fangled financial products called equities. Stocks for the long run or commodities for the REALLY long run? But the opportunities in commodities are long/short tactical trading and very cyclical. The return comes from knowing WHAT to buy and WHEN to sell and vice versa. Commodities are an alpha source NOT beta.

Many commodities have been in a bull market in recent years so the long term return NOW does indeed look good but there is no "expected return" from "commodities" any more than "equities". Successfully trading oil or natural gas is an alpha process that requires high skill, an informational advantage and domain expertise. With "currencies" the returns are relative to WHERE you are. Risky asset classes like equities, credit, commodities and currencies are for security selection NOT buy and hold. Choose managers who can figure out what and when to trade and best leverage the opportunities.

Investors need REAL returns AFTER inflation. Inflation rates vary but inevitably take their toll so most portfolios CANNOT afford a deep drawdown especially during stagflation. The CPI is underestimating REAL inflation, that is the inflation you and I observe at the supermarket and gas station. TIPS won't help as much as expected since they track what the CPI says inflation is NOT what it actually is so there is significant basis risk with TIPS. Investors cannot be expected to ride out an extended bear market WHILE inflation erodes their purchasing power. Inflation-linkled derivatives like inflation caps also suffer from how "inflation" is measured; what the index says it is or what people are REALLY experiencing. The absolute returns from good hedge funds are a better inflation hedge.

Markets, risks and liabilities change so return sources and portfolio construction must also change. Why are investors urged to keep to a static asset class split when markets and economies fluctuate so widely? Don't the opportunities and dangers move over time? Trying to apply a static "solution" to a dynamic system must lead to errors? Warren is right that 8% probably can't be achieved with traditional beta but it IS possible with a properly constructed portfolio of beta AND absolute alpha that adapts as conditions require. Derivatives are indeed weapons of financial destruction in the wrong hands but there are many risk reduction benefits from the competent use of derivatives. Hedging and strategy diversification is the safer more risk averse route to the minimum acceptable return.

Worrying for shareholders in Berkshire Hathaway is the short sales of credit default options and long dated puts on various stock market indices. Warren is hoping that investing the premiums will exceed any potential liabilities at expiration. He says Dexter shoes was a bad trade but the option trades are potentially MUCH worse. Surely Warren is aware that 33 years into last century on 29 Dec 1932 the Dow closed at 59.12. No gain in the bellwether index for a third of a century but don't worry because equities will EVENTUALLY compensate you for their risk! Could you wait until after 2032 for beta to start working its "magic"? BRKA might end up owing plenty of cash to those who purchased the options.

High downside but limited upside doesn't look like a typical BRKA trade. Has Warren stress tested or Monte Carlo simulated for the S&P 500 being below 500 at expiration? AIG also short sold credit default options on securities that someone thought deserved to be "rated" AAA and recently had to mark them to what there currently is of a market. Japanese insurance companies short sold similar derivatives in the 1990s and also thought they could invest the premium and wouldn't have to pay out. They were wrong. There is much to learn from the Japan experience. It was driven by an internecine network of credit crossholdings backed by wrongly priced real estate "collateral". Mark to market is a cruel BUT necessary discipline.

The performance of ALL alpha seekers will sum to zero as fees and execution costs undermine the neophyte's attempt at something that is so difficult. An index of "all" hedge funds is like an index of "all" stocks; why invest when they are CERTAIN to include so many underperformers? Some securities are good but others are bad. Some fund managers are good but investment talent is rare. Equity indices are unhedged, have no skill, lose money too often for long periods with unacceptable volatility. Reinvestment of the relatively high dividends paid in earlier decades were a key contributor to long term compounded returns. Prior to 1982 dividends were the largest component of the total return in many stock markets. You can do a dividend swap to bet on rising or falling dividends. Portable dividend beta to overlay on the absolute alpha.

Invest in the leaders not the followers. Pick the good funds or hire someone with the experience and analytical resources to identify alpha generators whose FUTURE risk adjusted returns will make any management and incentive fees trivial. I too wish it were still possible to achieve 8% per annum with a simple portfolio of "stocks" and "bonds" but unfortunately it isn't. Risky securities may indeed go up over time but I just don't want to take the chance MIGHT not. Every investor should be activist with their portfolio. Security and strategy triage are essential. The only things investment grade are those where the returns are higher than the risks. Conservative investors need their capital protected with hedging instruments AND hedge funds.

It is not so much the unknown unknowns that worry me as much as the known "knowns" that are in fact wrong. We don't need two quarters of negative "growth" to know we have entered a recession. Real estate and credit prices are stronger indicators of economic strength and have more effect on consumer sentiment than stock markets. Ben Bernanke is correct that there is no danger of 1970s stagflation. Instead we have 2000s style stagflation and the remedy won't be easy to find. Banks continue to report VaR as if such numbers were indicative of the risks and exposures they have on. You can have low Var but enormous risk and vice versa.

There will always be hedge funds that lose money and a few that implode. Some stocks go bankrupt so avoid ALL stocks? A house once burnt down somewhere so NEVER buy real estate? Cuba and North Korea defaulted on their government debt so don't buy treasuries and JGBs? Sounds facetious but that is what we hear whenever one specific hedge fund implodes. Avoid good hedge funds because a few bad ones lost 100%? Everyone accepts that a single security blowing up does not mean ignore all the opportunities available in the asset class. But skepticism of any investment strategy other than long only still reigns. In any economic scenario there are ALWAYS opportunities for alpha especially when beta disappoints.

An investment strategy should be robust to structural changes in the market and financial regime shifts. I am tired of fundamental stock pickers who claim reg FD or the recent change in the uptick rule made things more difficult or quant types who complain about decimalization or execution algorithm copycats. Good investors evolve to what the current conditions are and innovate their strategies. Market cycles are certain so an investment process must be fortified and robust. There will be many more changes in the future. The current situation provides an ideal environment to show who has skill and who was lucky.

Hedge fund blow ups and large losses from speculators marketing themselves as "hedge funds" are portayed as negatives when in fact shaking out the weak STRENGTHENS the industry and confirms the case for investing in the proper hedge funds. Lots of poor quality hedge funds shut down in the first oil crisis of the mid 70s but the quality ones thrived. Plenty of low standard funds closed or crashed and burnt in 1994 and 1998. It just emphasizes that skill is rare while thorough due diligence and manager AND strategy diversification is essential.

The hedge fund bubble is bursting? No. January was bad but February was good on "average". Trouble in a few specific areas of hedge fund land? Sure. Overdue volatility and a bear market were bound to catch out some overleveraged players. Carlyle Capital Corporation CCC craters, DB Zwirn has difficulties, Drake Management drowns, Sailfish implodes, Richmond Capital loses 50% and AQR suffers from the same model development DNA malaise as Goldman Sachs' Global Alpha. Losses and meltdowns for some poor funds transports alpha to the good funds. That is the great thing about real "portable alpha"; the weak funds and risk premium products package their negative alpha up and "port" it over as positive alpha to properly hedged funds.

Invest in the breakaway leadership group NOT the the peloton. The Peloton hedge fund founders apparently couldn't keep an eye on their own millions in a simple bank account so could never have been expected to be able to manage client billions. The trouble with a cycling peloton is that if the riders at the front of the pack fall they also trip up the followers. It's those superstars way out in front, the yellow jersey winners and kings of the mountains to invest your money with.

It is curious how when "hedge funds" have a generally rough month some say redeem and the "bubble" is over but when long only funds lose a few trillion those same experts urge investors to "stay in for the long haul". They disdain technical analysis but then draw a trendline on a long term chart and extrapolate it into the future! Some even have the effrontery to say don't pay attention to market declines! Just "ride out that volatility" and hope the market will make it back in the dim and distant future. Even if you hate derivatives and hedge funds I don't think anyone could say they haven't changed financial markets and consequently the assumptions that underlie many portfolio postulates and economic phenomena.

That stock markets can be relied on to go up over time is a classic Type 1 statistical error. A false positive. Stocks generally went up therefore they will? History offers quite weak corroborative evidence. Investors need time in the market since "no-one" can time the market! A rare few can market time and those fund managers can often be identified in advance. Claiming the market can't be consistently timed is like saying no-one can run the hundred in under ten seconds, can't hit basketball three pointers or shoot under par on the golf course. Warren Buffett has been successfully seeking alpha for a long time and the 1,000-2,000 bona fide hedge funds will also be delivering for their clients as will the many good ones yet to be established.

There are many dilettantes in investing and, as in most industries, hedge funds obey the 80/20 rule. At least 8,000 of the products that say they are "hedge funds" are no good. Quantitative finance isn't rocket science; it is MUCH more complicated than that. Too many employ hubristic heuristics to make their miserable models tractable. Some solve PDEs or Pathetic Delusional Equations that allegedly "fully" describe market phenomena. These silly simplifications cause the problems in the first place. A complex question needs a complex answer. The trouble with so much investment "advice" to individual investors is that it is too simple to work. Reliable rule of thumb; if the math is easy then the model is wrong.

Proving a hypothesis is very difficult but disproving it requires just a single counterexample. Warren Buffett exists therefore financial markets are neither efficient nor random. Quod erat demonstrandum. Or was he just lucky like all the other successful hedge fund managers? A "bum on the street" that fluked the last 50 years? Economists set great store in the anatocism of the past. Compounded returns that were not anticipated in advance. Practitioners like Warren Buffett are pragmatists and adapt to current financial conditions as they see fit.

I realise many investors hope they will eventually be compensated for the risk of equities. And I sincerely hope they are right but I can't afford to hope. I might trust but I need to verify as well. I HAVE verified that alpha - investment skill - exists AND persists INTO the future beyond any statistical, reasonable or practical doubt. I HAVE not been able to verify the same for market beta. Stock market price appreciation AND dividends are unstable so we need alpha too, just in case. It is THE hedge.

Asset allocation is unlikely to be the main driver of performance over time. The primary factor will be security, strategy and manager selection. Fund managers that work hard to find securities that will go up and those that will go down and managing risk in case they are wrong. The VARIABILITY of portfolio performance is reduced by hedging, risk management and the appropriate use of derivatives. The path DOES matter for the long term achievement of investment objectives at the LOWEST volatility. As Benjamin Graham wrote many years ago "The essence of investment management is the management of risks". So choose managers who are trying to manage their absolute risk not just their active risk.

Diversification by holding many securities is not hedging. You can own 10,000 stocks and bonds and not be properly diversified. Alpha seeking strategies need to be FRONT and CENTER in EVERY portfolio. I don't know whether the Dow will be at 24 million or back down to 65.73 in 2099 but I can tell you for certain that a lot of absolute alpha will have been created along the way. Alpha returns are complementary to beta returns. I would rather chase skill than chase performance because investment talent is persistent.

Although I have been pessimistic about the markets for the past year or so, I am an optimist at least with respect to the ongoing existence of some humans with the ability to invest and trade successfully no matter how far the stock market drops. And they can charge whatever fees they want as long as they perform to demanding parameters. Produce 8% of absolute alpha above REAL inflation with careful control of risk will satisfy many investors' requirements.

There is $64 trillion in money management and ONLY $2 trillion in hedge funds. It is such an obscure little industry so far. The proportion is going to be a LOT higher and YES there will ALWAYS be a bottom decile that get into trouble. That does not change the optimistic outlook for the industry and a proper hedge fund manager should relish an equity or credit bear market. Even if you don't short sell much, it also creates long opportunities to buy value cheaper as Warren Buffett has done many times in his search for alpha.

It is a market of stocks NOT a stock market and some securities do go up and some go down. Why invest long only in them "all"? Warren doesn't and every investor would be wise to focus on security, strategy and manager selection NOT asset allocation. Future equity returns: lost decade...lost century? Buy and Hold has given way to Buy and Fold. Market timing outperforms buy and hold if you know what you are doing. The only thing to overweight in a portfolio is SKILL but most investors are underweight.