Best hedge fund?
Best hedge fund? Recently I visited the best ever hedge fund's office. On the way I saw some black swans and ate at a restaurant that had run out of rice. Sometimes minor events can signal major opportunities. Many commodities have risen but wide fluctuations do not bode well for financial stability. Economic decoupling was always a crazy concept; volatility is never "contained" and reverberates across every asset class.
How to define "top fund manager"? Best past performance? Highest risk-adjusted returns? Below is the chart of a popular fund I analyzed a while back.
Seems good. Over 20% compound annual return after fees. The fund is still open and you could, if you want, invest in it. The returns have been independently verified many times. Heavily regulated and available to all investors globally. Zero leverage, no lockup and no valuation issues. The manager keeps it simple by investing in equities listed on the world's highest market value stock exchange. No arcane assets, malicious models, specious SPACs or dubious derivatives so it must be "safe"?
But after thorough analysis I concluded the fund was not a suitable candidate for investment. Too risky. I decided to figure out who was the best manager ever. The criteria for an investable fund are complex but necessary to identify the "best". If we define the top hedge fund as that which achieved the best returns over several decades, the wealth accumulated by the manager from his trading acumen, the consistency and repeatability of that performance from protectable edges and a legacy of investment thought-leadership then the world's best ever hedge fund manager is obvious.
That person was of course the legendary Munehisa Honma, the “god of the markets”, who ran a managed futures CTA hedge fund in 18th century Japan. He generated outstanding amounts of alpha for over 50 years. His main book, the "Fountain of Gold", is brilliant. Probably the greatest investment book ever written. His trading ability enabled the Honma family 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 mostly mountainous country. There is a fountain in the main garden of the house as a reminder of the source of wealth - Honma's trading profits. As befits many successful hedge fund managers, Honma was also an avid art collector. He also advised the world's first sovereign wealth fund.
In today's money, Honma's net worth was over $100 billion. Some years he "took home" more than the equivalent of $10 billion so it is curious those pundits excited about the "news" that John Paulson received "record" pay of $3.7 billion; fair "salary" for the over $12 billion he and his team generated for clients that they would not OTHERWISE have. REAL hedge fund managers focus on achieving good performance to monetize their talents and build wealth. Shorting subprime was NOT the greatest trade ever. Good but not greatest. "All time" means since 2002? Recency bias...again. Honma's short sale of rice futures in 1789 was far more profitable than Paulson's trade in 2007.
AW Jones did not "invent" hedge funds. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that it was psychology and the IRRATIONAL actions of participants NOT economic logic that drove markets. Behavioral finance isn't new, it's 253 years old. He didn't buy and hold rice and wait around to be compensated for its higher risk. He did not "expect" a risk premium or "assume" that rice would go up over time.
And though rice was heavily traded and followed even in those days, such liquidity did NOT produce an efficient market. Like most good traders, he figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether rice prices themselves were rising or falling. That is a TRUE hedge fund.
Munehisa Honma paved the way for the absolute return 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 today. 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 the efficient, equilibrium economists still hold onto as they continue their futile search for a rational, perfectly priced market.
Since Honma's era there have been many hedge fund obituaries. We are on yet 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 options and hoping a black swan won't show up to reveal their fund as a lemon is very OLD news.
Ten years ago Long-Term Capital Management short sold options and bet the house on convergence and then 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 such risks.
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 prognosticators spend valuable time on Bank of Japan and Fed watching when they could INSTEAD be listening to 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 crop 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 was the original black box algorithmic trader. 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 the previous 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 single 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 surely the output has memory. If no memory is assumed, prices might indeed follow a random walk. Professor 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.
Since stock, bond, currency, real estate and commodities prices are determined by participants with memory, prices MUST themselves also have memory. Honma ALONE accumulated more personal 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 in the real world. 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. I've seen more than a few "star" bund or treasury traders get blown up by JGB futures. 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. And of course there are "strategists" and some Japan long/short equity focused "hedge funds" have been claiming "Japan is cheap" since the Nikkei was at 17,000. As Honma wrote, the cheap can get MUCH cheaper. Value traps many value investors.
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 DOES believe in such things as Doji, Harami, Kagi, Renko and ichimoku kinko hyo then that trading may impact the Japanese markets and lose money for those who do not keep up with such methods. If you don't know your edge then you don't have an edge but also that edge must be enough to overcome other traders' edges. I haven't come across many people able to consistently make money trading the yen, JGBs or Japan equities without a thorough understanding of Japanese charting interpretation.
As Honma knew and John Maynard Keynes succinctly implied, the key is working out what others will do and how they value securities NOT necessarily 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 and their unfortunate clients heavy cost. Equity analysts visiting companies may be useful in some countries but I have seen zero evidence of its utility in Japan.
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 somewhat less predictable. It is interesting how today more scientific method and new math are being applied to the markets. But, to put it mildly, OLD math and dubious "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 very useful in finance but even today many still use it because stochastic calculus is easy, unlike the quant methods that actually work.
ALL assets are connected. The equity long/short crowd will be keeping a close eye on credit traders from now on and vice versa but they should have been doing that all along. You also have little hope of picking the right stocks or bonds without closely following the commodity and currency markets. 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 more sophisticated methods to win the zero-sum game. The Central Limit Theorem has little applicability to the REAL statistical distribution of prices.
Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic was a popular trend in Japan for a while though it was first developed in the USA. It is routinely disdained by those who think we live in an orderly, bivalent world of true/false, right/wrong, yes/no and 0/1. Many years ago I 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 fx. Given the inappropriate Ito stochastic integral for pricing derivatives, I also tried adapting 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 looks vague to me 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 trading strategies managed from the 1740s to the 1790s - but also, and quite surprisingly, the world's best performing stock market index over the LONG TERM remains Japan. The chart above is a Japan "passive" index fund's performance from 1980-1989 but below is the ENTIRE performance chart from 1980-2008. Past perfomance was not indicative for future performance.
The risk and volatility since 1990 have failed to compensated investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy andhold hope. A good heuristic for assessing investment strategies - if it is simple then it likely won't work. Easy "solutions" cause difficult problems, as we have seen this year.
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, 18 years into the bear market, the TOPIX remains the BEST 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 magnificant past. But for those who like the "cheapness" of long only equity funds and historical data dredging, it is interesting they don't overweight Japan considering its enormous HISTORICAL outperformance of ALL other stock markets! As for me I am staying long yen, long JGBs and short the Nikkei.
I prefer the manager risk of TODAY's superstar traders and investors NOT the risk of equities. Honma-sensei would have thrived in current market conditions. Recession will make the absolute returns generated by quality 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.
How to define "top fund manager"? Best past performance? Highest risk-adjusted returns? Below is the chart of a popular fund I analyzed a while back.
Seems good. Over 20% compound annual return after fees. The fund is still open and you could, if you want, invest in it. The returns have been independently verified many times. Heavily regulated and available to all investors globally. Zero leverage, no lockup and no valuation issues. The manager keeps it simple by investing in equities listed on the world's highest market value stock exchange. No arcane assets, malicious models, specious SPACs or dubious derivatives so it must be "safe"?
But after thorough analysis I concluded the fund was not a suitable candidate for investment. Too risky. I decided to figure out who was the best manager ever. The criteria for an investable fund are complex but necessary to identify the "best". If we define the top hedge fund as that which achieved the best returns over several decades, the wealth accumulated by the manager from his trading acumen, the consistency and repeatability of that performance from protectable edges and a legacy of investment thought-leadership then the world's best ever hedge fund manager is obvious.
That person was of course the legendary Munehisa Honma, the “god of the markets”, who ran a managed futures CTA hedge fund in 18th century Japan. He generated outstanding amounts of alpha for over 50 years. His main book, the "Fountain of Gold", is brilliant. Probably the greatest investment book ever written. His trading ability enabled the Honma family 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 mostly mountainous country. There is a fountain in the main garden of the house as a reminder of the source of wealth - Honma's trading profits. As befits many successful hedge fund managers, Honma was also an avid art collector. He also advised the world's first sovereign wealth fund.
In today's money, Honma's net worth was over $100 billion. Some years he "took home" more than the equivalent of $10 billion so it is curious those pundits excited about the "news" that John Paulson received "record" pay of $3.7 billion; fair "salary" for the over $12 billion he and his team generated for clients that they would not OTHERWISE have. REAL hedge fund managers focus on achieving good performance to monetize their talents and build wealth. Shorting subprime was NOT the greatest trade ever. Good but not greatest. "All time" means since 2002? Recency bias...again. Honma's short sale of rice futures in 1789 was far more profitable than Paulson's trade in 2007.
AW Jones did not "invent" hedge funds. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that it was psychology and the IRRATIONAL actions of participants NOT economic logic that drove markets. Behavioral finance isn't new, it's 253 years old. He didn't buy and hold rice and wait around to be compensated for its higher risk. He did not "expect" a risk premium or "assume" that rice would go up over time.
And though rice was heavily traded and followed even in those days, such liquidity did NOT produce an efficient market. Like most good traders, he figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether rice prices themselves were rising or falling. That is a TRUE hedge fund.
Munehisa Honma paved the way for the absolute return 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 today. 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 the efficient, equilibrium economists still hold onto as they continue their futile search for a rational, perfectly priced market.
Since Honma's era there have been many hedge fund obituaries. We are on yet 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 options and hoping a black swan won't show up to reveal their fund as a lemon is very OLD news.
Ten years ago Long-Term Capital Management short sold options and bet the house on convergence and then 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 such risks.
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 prognosticators spend valuable time on Bank of Japan and Fed watching when they could INSTEAD be listening to 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 crop 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 was the original black box algorithmic trader. 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 the previous 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 single 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 surely the output has memory. If no memory is assumed, prices might indeed follow a random walk. Professor 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.
Since stock, bond, currency, real estate and commodities prices are determined by participants with memory, prices MUST themselves also have memory. Honma ALONE accumulated more personal 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 in the real world. 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. I've seen more than a few "star" bund or treasury traders get blown up by JGB futures. 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. And of course there are "strategists" and some Japan long/short equity focused "hedge funds" have been claiming "Japan is cheap" since the Nikkei was at 17,000. As Honma wrote, the cheap can get MUCH cheaper. Value traps many value investors.
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 DOES believe in such things as Doji, Harami, Kagi, Renko and ichimoku kinko hyo then that trading may impact the Japanese markets and lose money for those who do not keep up with such methods. If you don't know your edge then you don't have an edge but also that edge must be enough to overcome other traders' edges. I haven't come across many people able to consistently make money trading the yen, JGBs or Japan equities without a thorough understanding of Japanese charting interpretation.
As Honma knew and John Maynard Keynes succinctly implied, the key is working out what others will do and how they value securities NOT necessarily 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 and their unfortunate clients heavy cost. Equity analysts visiting companies may be useful in some countries but I have seen zero evidence of its utility in Japan.
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 somewhat less predictable. It is interesting how today more scientific method and new math are being applied to the markets. But, to put it mildly, OLD math and dubious "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 very useful in finance but even today many still use it because stochastic calculus is easy, unlike the quant methods that actually work.
ALL assets are connected. The equity long/short crowd will be keeping a close eye on credit traders from now on and vice versa but they should have been doing that all along. You also have little hope of picking the right stocks or bonds without closely following the commodity and currency markets. 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 more sophisticated methods to win the zero-sum game. The Central Limit Theorem has little applicability to the REAL statistical distribution of prices.
Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic was a popular trend in Japan for a while though it was first developed in the USA. It is routinely disdained by those who think we live in an orderly, bivalent world of true/false, right/wrong, yes/no and 0/1. Many years ago I 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 fx. Given the inappropriate Ito stochastic integral for pricing derivatives, I also tried adapting 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 looks vague to me 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 trading strategies managed from the 1740s to the 1790s - but also, and quite surprisingly, the world's best performing stock market index over the LONG TERM remains Japan. The chart above is a Japan "passive" index fund's performance from 1980-1989 but below is the ENTIRE performance chart from 1980-2008. Past perfomance was not indicative for future performance.
The risk and volatility since 1990 have failed to compensated investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy and
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, 18 years into the bear market, the TOPIX remains the BEST 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 magnificant past. But for those who like the "cheapness" of long only equity funds and historical data dredging, it is interesting they don't overweight Japan considering its enormous HISTORICAL outperformance of ALL other stock markets! As for me I am staying long yen, long JGBs and short the Nikkei.
I prefer the manager risk of TODAY's superstar traders and investors NOT the risk of equities. Honma-sensei would have thrived in current market conditions. Recession will make the absolute returns generated by quality 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.
© posted by Veryan Allen on 15.4.08
by Veryan Allen 
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