Best hedge fund?

Best hedge fund? When do past returns predict future performance? Defining "best" as highest risk adjusted alpha after deducting all style premia and beta factors, the greatest ever hedge fund manager is obvious.

Skill is predictive, luck is not. Alpha yes, beta no. It's better to select jockeys, rather than horses, as I wish to avoid the vexatious volatility and devastating drawdowns of smart/dumb beta. Invest with great managers before they are famous. Despite outstanding performance, hedge fund managers like George Soros, Warren Buffett and Jim Simons were unknown for decades.

Your money is too important to be risked on "averages". I prefer strategies that deliver independently of market direction. Though rare, skill can be detected with detailed analysis. Bet on horses and lose years of gains in bear markets. No "average" for me or clients. Passive always fails, eventually. Time in drawdowns is never recovered.

Below is the chart of a famous fund. The fund is open and you can, if interested, invest in it. Experts say it's great but pathetic returns for the risk taken.



Seems good. +20% CAGR after fees for 10 consecutive positive years. The returns have been independently audited many times. Transparent, heavily regulated and available to all investors. No leverage, lockups, gates or valuation issues. The manager keeps it simple by investing long only in liquid equities on the largest market value stock exchange. It must be good, right?

After analysis I concluded the fund was too risky despite being recommended by rearview mirror loving "Nobel" geniuses. I decided to figure out who was the best manager ever. The criteria for a good fund are complex but necessary to find the best. Defining a top fund as that which achieved the highest risk-adjusted alpha over several decades, the wealth accumulated by the manager from his investment acumen, the consistency and repeatability of performance from protectable edges, then the best ever investor is obvious.

The “god of the markets”, 本間宗久 Munehisa Honma long/short hedge fund performed outstandingly for over 50 years. His main work, "Fountain of Gold", is the best finance book ever written. His trading ability enabled his family office to become the largest land owner in Japan. They later diversified into the Honma golf business which makes sense if you own vast tracts of flat land in a mountainous region.

A set of Honma clubs has "high" fees but like hedge funds versus index funds, you get what you pay for. Destroy your golf score with "cheap" clubs? Wreck your portfolio with 0.02 for passive or grow and preserve wealth by paying 2 and 20 for skill?

Munehisa Honma's net worth was over US$100 billion in today's money. Some years he "took home" more than the equivalent of US$10 billion so it's curious why pundits are excited on "news" John Paulson received "record" pay of just $3.7 billion. Fair "salary" for the over $12 billion he generated for clients that they would not OTHERWISE have.

Like Honma, Paulson hedged client portfolios. REAL hedge fund managers focus on achieving returns to monetize talent and build wealth. Shorting subprime was NOT the greatest trade ever. Good but not greatest. "Ever" means since 2002? Recency bias yet again. Honma's short sale of rice futures in 1789 was far more profitable than Paulson's "big" credit short.

There's a fountain in the main garden of Honma's house as a reminder of the source of wealth. As befits many successful hedge fund managers, Honma was an avid art collector. He also advised the world's first sovereign wealth fund. Though rice was heavily traded and analyzed in those days, such liquidity did NOT produce an efficient market. He figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether futures brokers themselves were bullish or bearish or prices were rising or falling. That's a TRUE hedge fund. Any firm needing a bull market to make money is NOT a hedge fund.

Note for the long only luddites: the GREATEST trades tend to be shorts. Hedge fund "pioneer" Alfred Winslow Jones did not "invent" hedge funds. He invented the term but not the philosophy. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that psychology and the IRRATIONAL actions of participants NOT economic logic drove markets. Behavioral finance isn't new, it's 253 years old. He didn't buy and hold rice and wait to be compensated for its higher risk. He did not "expect" a risk premium or "assume" that rice prices would rise over time. Index fans regard those as axiomatic for "stocks". Neither equities nor credit carry a risk premium. Trade them but NEVER hold them.

Munehisa Honma paved the way for the hedge fund managers of today. Translated adages from his main book - "Market action is more important than news". "Prices do not reflect actual value". "Buys and sells are decided on emotion not logic". He discovered the truth all that time ago and without the computers, analytics and communication systems we have. He also knew the dangers of transparency: "Never tell others your positions or strategies". His performance speaks for itself. They should retrospectively award him one of those "Nobel" prizes that economists still hold onto as they continue their futile search for a rational market.

Honma wrote of the returns to be made buying when most are selling and shorting when everyone else is buying. Consult the market about the market! Even today many spend valuable time on Fed watching when they could INSTEAD be seeing what the MARKET is saying. The Market told us we were entering a recession several months ago and the credit crisis was NOT "contained". The Market is not efficient but it forecasts better than any economist. As befits the samurai trader he was, the time between making a decision and implementing that decision must be minimized. Delayed execution and transparency are the enemies of performance.

Though primarily a statistical trader, Honma also spent time on fundamental analysis, talking to farmers and consumers about what moved rice prices, who was buying or selling and why. He had detailed historical weather data and analyzed it to predict a key factor driving rice yields. His strategies required low latency trading so, despite the pre-electronic era, he established a signaling system all the way from Sakata to the Dojima Exchange in Osaka to get orders done and price data as quickly as possible. He developed many quantitative techniques to maintain his competitive advantage; some simple ones, like candlestick analysis, have entered the public domain but other more sophisticated methods he rightly kept to himself.

Honma invented black box algorithmic trading. As his impact on the markets grew he evolved from market-taker to market-maker. He leveraged his informational advantages and adapted to the situation as needed. Those quants who download a decade of security prices and then overoptimize and curve-fit to the patterns of recent history might remind themselves that Honma analyzed 1,500 years of rice data BEFORE doing a trade. He focused on finding robust and persistent phenomena NOT spurious patterns containing zero PREDICTIVE information.

Feedback fuels future fluctuations. Honma would have scorned those economists that assert that markets have no memory. Securities are traded by humans and computers programmed by humans, both of whom DO have memory. If the input has memory then the output has memory. If no memory is assumed, prices might indeed follow a random walk. "Nobel" Prize "winner" Paul Samuelson supposedly "proved" that "Properly anticipated prices fluctuate randomly" which might have been relevant except for the INCONVENIENT TRUTH that prices are NEVER properly anticipated.

Stock, bond, currency, real estate and commodities prices are determined by participants with memory, so prices themselves also have memory. Honma accumulated more wealth exploiting security price memory than all the economists TOGETHER who have ever believed in memoryless markets. Not only is there NO efficiently priced security; it is impossible for an efficient market to exist. Amnesiac assets? Absurd. Rational agents? Really. The future state has no dependence on the present or past states? Preposterous.

Many trading techniques can be traced back to Honma. It is interesting how often Western investors get caught out trying to trade Japan. Some fixed-income arbitrage hedge funds got hurt by cash Japanese bonds recently. The yen carry trade has damaged many that didn't realise that a low interest rate does NOT imply a weak currency. As Honma wrote, the cheap can get MUCH cheaper.

Some might be skeptical of technical analysis and know nothing about Japanese-style technical analysis. Fair enough. There are plenty of fundamental ways to make money. But if a bigger investor with a few trillion yen to put to work believes in such things as candlesticks, Kagi, Renko, Heikin Ashi and Ichimoku then that may impact the markets and lose money for those who do not master such methods. If you don't know your edge then you don't have an edge but that edge must be enough to overcome other traders' edges. I haven't come across ANYONE able to consistently make money trading yen, JGBs or Japan equities without a thorough understanding of Japanese analytics.

I didn't trade any security in Japan until I knew ALL the above methods cold. Incredibly many rookies still try (and fail dismally) to trade Japan profitably. As Honma knew and John Maynard Keynes implied, the key is working out what others will do and how they value securities NOT one's own estimate. The market may NEVER value an asset "correctly" as some activist and value investors in Japan have recently found out to their cost.

Honma was the first successful quantitative trader. Isaac Newton's earlier trading forays weren't successful but then gravitational modeling is easier than financial modeling. The sun WILL rise tomorrow but the motion of the markets is less predictable. It is interesting how today more scientific method and new math are being applied to the markets. But OLD math and dubious economic "theory" have not coped well with modeling REALITY. Assets classes affect each other but the ways they interact change over time. Since no traded security moves randomly, the math of randomness is not useful in finance. Today many still use it because stochastic calculus is easy, unlike the quant methods that work.

ALL assets are connected. Honma monitored many things even if they had no apparent connection to rice prices. Everything is related and NOTHING is independent. Beware of ANY financial "model" that assumes independent, identically distributed prices. We have seen the dire results though it does allow alpha to be transported from those that use them to those who employ better methods to win the zero-sum game. The Central Limit Theorem has no applicability to the REAL statistical distribution of prices.

Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic is disdained by those who think we live in an orderly, bivalent world of true/false, right/wrong, yes/no and 0/1. I once developed a fuzzy model to calibrate the bullishness or bearishness of the Japanese market. It provided nice projections for the daily ranges for the JGB, Nikkei and yen. Given the inappropriate Ito stochastic integral for pricing derivatives, I also adapted the Sugeno fuzzy integral to derive a more accurate option replication and hedging model. Isn't the world itself FUZZY so fuzzy logic could be of use? The market is vague even at the best of times. The market is NEVER in a 1 or 0, bull or bear state; it is always somewhere between 0 and 1.

Japan therefore had the world's best ever hedge fund - Honma's long/short rice fund managed from the 1740s to the 1790s. The chart above is a Japan "passive" index fund performance from 1980-1989 but below is the ENTIRE performance chart since 1980. Past perfomance was not indicative for future performance in any country. The risk and volatility since 1990 have failed to compensate investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy and hope. A good heuristic for assessing investment strategies - if it is simple then it won't work. Easy "solutions" cause difficult problems, as we have seen.



Returns have not been good for the TOPIX since the high water mark set so long ago. The 1980s were NOT even the best decade; the 1950s compounded at a 25% CAGR and returned 10X investors' money. Even now, so many years into a bear market, the TOPIX remains the top returning stock index in the post war period. Would I therefore invest in it? Absolutely not. I want funds that WILL perform in the future not rely on a magnificent past. But for those who like "cheap" long only equity funds and historical data dredging, it is interesting they don't overweight Japan. As for me I am staying long yen, long JGBs and short the Nikkei for now.

I prefer the manager risk of TODAY's superstar traders and investors NOT the risk of long only funds. Honma-sensei thrived in volatile market conditions. Recession will make the absolute returns generated by top hedge fund managers important and they have the best ever, Munehisa Honma, also known as Sokyu Homma (本間宗久) and born Kosaku Kato, for inspiration.

Since Honma's era there have been many obituaries written for the hedge fund industry. We are on another iteration right now because a few beta dependent speculators masquerading as hedge funds recently blew up. That SOME hedge fund strategies are short volatility and can be modeled as effectively short sellers of put options and hoping a black swan won't show up to reveal their fund as a data snooping lemon is very OLD news.

Ten years ago Long-Term Capital Management short sold options and bet the house on convergence and got taken out by the "never happened before" Russia default. Fortunately there are many quality hedge funds run by managers who are fully aware of the dangers of being short gamma and convexity, potential "rare" event fat-tail risks, carefully hedge for those exposures or maintain a long volatility profile. Sure plenty of "hedge funds" are no good but there are many skilled hedge funds that do manage risk.