Hedge fund crisis
Hope for the best but hedge for the worst. First rule of risk management - if it can happen, it will happen. Market crashes are no problem for investors that diversify PROPERLY. I've been saying, writing and doing for so many years now but to repeat: only invest in alpha and hedge beta factor sensitivities away. NO ASSET ALLOCATION. Zero naive equity or credit exposure. Only short/long SKILL. Skill strategies are the ONLY suitable, prudent investment.
We have seen excellent returns from great hedge funds, hard times for lower quality managers but much worse from "cheap" risk craving index funds. Skilled investors don't always make money but they do have fewer, milder and shorter drawdowns than passive funds that don't try to manage risk, reduce exposures or preserve capital. As a risk averse investor I'll stick with 100% in skill strategies. 2 and 20 for alpha is a fantastic bargain as far as my experience has shown.
Total losses of MINUS 3,700 basis points doesn't strike me as cheap. But that is how much Bogle cost his retail clients this year. I wrote back in January 2008, when both were above 13,000, that the Dow and Nikkei would collapse far below 10,000 as a result of the OBVIOUS credit bubble and, as predicted, my allocations to long volatility strategies, managed futures, short biased and out of the money SPY put, VIX call options have all been very profitable in achieving excellent absolute returns in this supposedly difficult year. A great year for alpha, terrible year for beta.
Even the "average" hedge fund, an epitome of mediocrity, outperformed the S&P500 by 2,000 basis points. That's TWO THOUSAND, after fees. Contrary to common wisdom, the performance of risky asset classes proves the need for investors to have substantial allocations to skill-based return sources and true strategy diversification. Losses of 50% twice in a decade are unacceptable so why endure "low fee", high cost funds?
You won't read it in the media but several hedge fund strategies have NOT been affected by imploding prime brokers, changes in short selling rules or the leverage lockup. The best managed futures CTAs, global macro, high frequency trading and volatility arbitrage hedge funds have been generating outstanding absolute returns throughout the meltdown. October was a nice up month for my clients but risk assets did not.
The outlook for cheap stocks, distressed debt and CB arbitrage going into 2009 is very positive for focused managers with the necessary expertise. Short biased equity, credit and commodity funds have delivered that so important negative correlation for portfolios. Strategy and manager diversification is crucial.
Crash or capitulation? For those predicting a Great Depression, it is worth recalling that hedge fund managers like Benjamin Graham, John Maynard Keynes, Karl Karsten and Gerald Loeb performed very well during the 1930s. And when the 1960s boom ended, even the Buffett Partnership closed down despite good returns but Warren has extracted plenty of alpha subsequently. Dislocated markets create inefficiencies for traders with the rare expertise to exploit them. If the world really is entering depression, investors need to rapidly move MORE of their money into quality hedge funds. Government bonds and cash will not be yielding enough.
Hedge funds are dead? Long live hedge funds. I am long/short optimistic/pessimistic for different strategies. Even in ideal conditions only 20% of hedge funds are "buys" and 80% are "sells". If we lose the bottom quartile, it is a POSITIVE for the industry. It is survival of the fittest, not biggest, so good riddance to the growing economy dependent, beta bundling asset gatherers. The crowd is usually wrong and seeking alpha requires going against the crowd.
Severe losses for stock markets have occurred many times in the past. Plenty of "hedge funds" unable to manage risk or cope with chaos disappeared in 1970, 1974, 1994 and 1998. The more hedge funds that shut down, the better the opportunity set for talented managers. Redemptions? Sure but the money will simply be reinvested with firms that know how to generate alpha INSTEAD of the many weaker funds that were just repackaging beta.
There is NOTHING unprecedented about recent volatility. Many long biased "hedge funds" closed as a result of the hard times for hedge funds back in 1969 but that had no impact on REAL hedge funds that didn't need a bull market to make money. The current problems are impacting the unhedged funds rather than the hedged ones.
Pundits forecasting the end for hedge funds (again!) should check into how much money was made by investors that INCREASED allocations to GOOD hedge funds at the end of 1998. Or invested with George Soros and Michael Steinhardt, among others, at the end of 1969. Meanwhile the experts' beloved "passive" funds are still in a deep drawdown over a DECADE later. Some financial professionals never let the FACTS get in the way of their THEORIES. Long only equity funds are much too risky for conservative investors like me. Hedge away that systemic risk.
Flight to quality? I focus on managers that preserve capital, control drawdowns and can generate alpha no matter what. Many quality hedge funds are POSITIVE for the year even if the aggregate returns for the industry are negative. Performance dispersion is enormous in such a diverse universe especially when all it takes to be considered a "hedge fund" is to claim to be one! While 3,000 hedge funds are up for 2008, all long only equity funds are down. Many unleveraged, heavily "regulated" but unhedged funds have lost trillions by speculating on rising stock markets. During this decade those who saw the value of bona fide hedge funds have more than doubled their money unlike long only equity products which have underperformed T-bills. What compensation for risk?
Creative destruction is the inevitable result of free markets and there have been several hedge fund shake outs previously. I don't know the etiology of the market meltdown and credit crisis or intend to guess government policy initiatives or regulatory solutions. I do know good hedge fund managers are able to evolve in WHATEVER market conditions occur. When business magazines use words like hedge fund extinction, absolute return armageddon or hedge fund apocalypse then capitulation is near. All I can say in response is that out of the hedge funds that I follow or invest in, they range from up a lot to down but much less than long only equity, credit or commodity funds.
The FUTURE prospects may be negative for some strategies but the outlook is attractive for many other strategies. The manager universe is so varied and investment skill so wide ranging that the "average" return is not informative. Of course the "typical" manager will be down especially with the largest hedge fund category being long biased equity. The independence of a return source and the low covariance of that performance with underlying risk factors is what separates the alpha managers from the beta repackagers. Keep the powder dry since buying good securities and good hedge funds in a drawdown is usually a good decision.
Turbulence and turmoil permit talented traders to make money. The purpose of REAL hedge funds is to REDUCE total portfolio volatility. The previous bear period a few years ago when stock markets also dropped 50%, money flowed INTO hedge funds for that very reason. Quality hedge funds offer a SMOOTHER ride, lower volatility and less severe drawdowns than long only. Despite the current hysteria on redemptions, the percentage asset allocation to absolute return strategies actually ROSE recently because much more was lost gambling on the stock market. When a strategy gets crowded and AUM too large, it makes sense to do the OPPOSITE. The negative carry trade that worked best in 2008: borrow Icelandic króna to BUY the Japanese yen. Shorting the mythical "upward drift" of equities and REVERSE arbitrage of popular "market neutral" strategies also did well.
Markets fluctuate. The revenge of the pessimists has triumphed over the optimists for 12 years in many major markets and 26 years in Japan. How many decades are investors supposed to wait for the alleged "stocks go up over time" wish to come true? Long only has provided no growth for so long unlike the capital appreciation that good hedge funds have delivered. Hedging means expecting and preparing for the unexpected. Reducing risk and PROPERLY diversifying BEFORE bad times occur. The beta bubble has burst so the need INCREASES for absolute return strategies that can make money or preserve capital.
Some might have the patience and fortitude to grow old riding out ANOTHER damaging stock market drawdown but I don't bet on beta myself. I realise some still think stocks will go up over time but I have yet to be shown ANY robust evidence for that dubious assertion. Instead of waiting decades hoping for some stock market magic to eventually show up, I prefer receiving absolute returns in time horizons that match my requirements and conservative risk tolerance. So I find managers with genuine skills in risk management and security selection. Then I overlay that with my own edges in strategy allocation and portfolio construction. Consistent portfolio returns requires identifying managers with rare talent and a robust strategy.
Neither hedge funds nor capitalism are facing judgment day. Overly pessimistic economic eschatology has been misinformed and counterproductive. The pundits could note that some very SOPHISTICATED investors are planning to INCREASE hedge fund allocation in 2009 because they recognize the alpha opportunities that will be available. Most redemptions from losing hedge funds will simply be reinvested in better strategies run by superior managers. If anything the equity and debt meltdown CONFIRMS the case for genuine alpha generators. Beta is simply too unreliable. That's traditional beta AND alternative beta.
Many equity or credit risk premium managers masquerading as hedge funds have been revealed in the past 15 months. Thorough due diligence can detect such bull market reliance in advance. If a fund needs fine conditions to make money there is little point in having it in a portfolio. We can get "good economy" return sources from traditional funds. A TRUE hedge fund should offer something different. That's why they are called ALTERNATIVE investments. If it is dependent on underlying risk factors it is NOT a hedge fund.
Capital should flow to quality strategies as much as quality assets. A PROPERLY diversified portfolio can eliminate major drawdowns. Volatility is vicious if a manager is not nimble or too constrained by mandate or large AUM to capture the market anomalies it creates. Commentators try to impose a homogeneity on hedge funds but it is the heterogeneity of strategies and managers that is the value proposition. A good fund below its high water mark is an investment opportunity but a good manager up for the year is even better. Natural selection and thorough research reveals who those funds will be.
I've never found empirical support for the so-called "equity risk premium" despite analyzing 100 countries and 300 years of history but "skill-based alpha" is persistent in the REAL hedge fund performance data. The "average" hedge fund has lost money but would anyone seriously expect an AVERAGE fund manager to have made money in 2008? Recent events simply emphasize the rarity of skill and the MANDATORY need for portfolio strategies that are able protect capital in DOWN markets. Alpha is the ability to extract absolute returns out of other market participants. 2 and 20 is worth paying for uncorrelated sources of return but NOT to funds that need conducive markets and risk premia to make money.
Great Depression - no, Great Delusion - yes. In bull markets the best trade is to short sell arrogance and ignorance of risk but in bear markets it can be optimal to buy into pessimism and negativity. With the widespread predictions of an economic cataclysm, we are likely nearing the end of the panic. Ironically my own long term macro model switched to bullish this week after over 18 months of bearishness. The beauty of computational intelligence is that it is the complete opposite of computational finance. Those looking to apportion "blame" for current economic woes might like to check out the demented credit pricing and rating "models" the computational finance crowd cooked up.
My own unorthodox black box is often early and the stock markets could still fall further. An edge does not mean correct all the time. But since it has been short stocks and long volatility for such an extended period the risk/reward now favor the bull case. Not that I have ever put money in a long only fund; there are so many arbitrages and mispricings available that it is BETTER to invest with hedge funds running lower risk strategies.
I have no doubt managers with genuine edges will be back at high water marks MANY years before major equity benchmarks. Sure there are issues affecting particular strategies but the best investors and traders adapt and ultimately thrive in new economic paradigms. Transitions from one market regime to another usually requires a financial revolution.
Why are so few aware that those who invested in the stock market in the late 1890s were still losing money over 30 years later? Or that fixed-income outperformed equities from the late 1790s to 1870s. Could the late 1990s be similarly prescient? Over what time frame are stock markets supposed to deliver a real return? I'd rather keep the PROFITS that talented, unconstrained managers make than worry about the "long haul". 2 and 20 for reliable absolute returns is a bargain. Long only "passive" and closet index active funds have deep drawdowns and have an egregiously expensive negative effect on portfolios. "Cheap" fees beget cheap risk-adjusted "performance". Unhedged equity has been an underperforming asset class for a long time.
Some good hedge funds have made money while others have had limited drawdowns in the market meltdown. Many have reduced exposures and moved substantially to cash. Good defence is more important than good offence. A bear market for stocks and credit is the SCENARIO that proves the need for strategy diversification. Of course beta dependent unskilled managers are shutting down and being redeemed but that is the Darwinian nature of the business. It is excellent news for the industry.
Real hedge funds have CORRECTLY functioned as a portfolio hedge during difficult times for traditional risky assets. Despite temporary problems for some strategies, GOOD hedge funds offer outstanding long term prospects for consistent risk-adjusted absolute returns. That was true 1929-2008 and WILL be the case for 2009-2088. The best product for long term conservative investors are good absolute return funds. Begin due diligence NOW as 2009 WILL be a fantastic year for hedge fund performance just like 1999. Avoid unskilled assets and buy skilled managers in drawdowns.
We have seen excellent returns from great hedge funds, hard times for lower quality managers but much worse from "cheap" risk craving index funds. Skilled investors don't always make money but they do have fewer, milder and shorter drawdowns than passive funds that don't try to manage risk, reduce exposures or preserve capital. As a risk averse investor I'll stick with 100% in skill strategies. 2 and 20 for alpha is a fantastic bargain as far as my experience has shown.
Total losses of MINUS 3,700 basis points doesn't strike me as cheap. But that is how much Bogle cost his retail clients this year. I wrote back in January 2008, when both were above 13,000, that the Dow and Nikkei would collapse far below 10,000 as a result of the OBVIOUS credit bubble and, as predicted, my allocations to long volatility strategies, managed futures, short biased and out of the money SPY put, VIX call options have all been very profitable in achieving excellent absolute returns in this supposedly difficult year. A great year for alpha, terrible year for beta.
Even the "average" hedge fund, an epitome of mediocrity, outperformed the S&P500 by 2,000 basis points. That's TWO THOUSAND, after fees. Contrary to common wisdom, the performance of risky asset classes proves the need for investors to have substantial allocations to skill-based return sources and true strategy diversification. Losses of 50% twice in a decade are unacceptable so why endure "low fee", high cost funds?
You won't read it in the media but several hedge fund strategies have NOT been affected by imploding prime brokers, changes in short selling rules or the leverage lockup. The best managed futures CTAs, global macro, high frequency trading and volatility arbitrage hedge funds have been generating outstanding absolute returns throughout the meltdown. October was a nice up month for my clients but risk assets did not.
The outlook for cheap stocks, distressed debt and CB arbitrage going into 2009 is very positive for focused managers with the necessary expertise. Short biased equity, credit and commodity funds have delivered that so important negative correlation for portfolios. Strategy and manager diversification is crucial.
Crash or capitulation? For those predicting a Great Depression, it is worth recalling that hedge fund managers like Benjamin Graham, John Maynard Keynes, Karl Karsten and Gerald Loeb performed very well during the 1930s. And when the 1960s boom ended, even the Buffett Partnership closed down despite good returns but Warren has extracted plenty of alpha subsequently. Dislocated markets create inefficiencies for traders with the rare expertise to exploit them. If the world really is entering depression, investors need to rapidly move MORE of their money into quality hedge funds. Government bonds and cash will not be yielding enough.
Hedge funds are dead? Long live hedge funds. I am long/short optimistic/pessimistic for different strategies. Even in ideal conditions only 20% of hedge funds are "buys" and 80% are "sells". If we lose the bottom quartile, it is a POSITIVE for the industry. It is survival of the fittest, not biggest, so good riddance to the growing economy dependent, beta bundling asset gatherers. The crowd is usually wrong and seeking alpha requires going against the crowd.
Severe losses for stock markets have occurred many times in the past. Plenty of "hedge funds" unable to manage risk or cope with chaos disappeared in 1970, 1974, 1994 and 1998. The more hedge funds that shut down, the better the opportunity set for talented managers. Redemptions? Sure but the money will simply be reinvested with firms that know how to generate alpha INSTEAD of the many weaker funds that were just repackaging beta.
There is NOTHING unprecedented about recent volatility. Many long biased "hedge funds" closed as a result of the hard times for hedge funds back in 1969 but that had no impact on REAL hedge funds that didn't need a bull market to make money. The current problems are impacting the unhedged funds rather than the hedged ones.
Pundits forecasting the end for hedge funds (again!) should check into how much money was made by investors that INCREASED allocations to GOOD hedge funds at the end of 1998. Or invested with George Soros and Michael Steinhardt, among others, at the end of 1969. Meanwhile the experts' beloved "passive" funds are still in a deep drawdown over a DECADE later. Some financial professionals never let the FACTS get in the way of their THEORIES. Long only equity funds are much too risky for conservative investors like me. Hedge away that systemic risk.
Flight to quality? I focus on managers that preserve capital, control drawdowns and can generate alpha no matter what. Many quality hedge funds are POSITIVE for the year even if the aggregate returns for the industry are negative. Performance dispersion is enormous in such a diverse universe especially when all it takes to be considered a "hedge fund" is to claim to be one! While 3,000 hedge funds are up for 2008, all long only equity funds are down. Many unleveraged, heavily "regulated" but unhedged funds have lost trillions by speculating on rising stock markets. During this decade those who saw the value of bona fide hedge funds have more than doubled their money unlike long only equity products which have underperformed T-bills. What compensation for risk?
Creative destruction is the inevitable result of free markets and there have been several hedge fund shake outs previously. I don't know the etiology of the market meltdown and credit crisis or intend to guess government policy initiatives or regulatory solutions. I do know good hedge fund managers are able to evolve in WHATEVER market conditions occur. When business magazines use words like hedge fund extinction, absolute return armageddon or hedge fund apocalypse then capitulation is near. All I can say in response is that out of the hedge funds that I follow or invest in, they range from up a lot to down but much less than long only equity, credit or commodity funds.
The FUTURE prospects may be negative for some strategies but the outlook is attractive for many other strategies. The manager universe is so varied and investment skill so wide ranging that the "average" return is not informative. Of course the "typical" manager will be down especially with the largest hedge fund category being long biased equity. The independence of a return source and the low covariance of that performance with underlying risk factors is what separates the alpha managers from the beta repackagers. Keep the powder dry since buying good securities and good hedge funds in a drawdown is usually a good decision.
Turbulence and turmoil permit talented traders to make money. The purpose of REAL hedge funds is to REDUCE total portfolio volatility. The previous bear period a few years ago when stock markets also dropped 50%, money flowed INTO hedge funds for that very reason. Quality hedge funds offer a SMOOTHER ride, lower volatility and less severe drawdowns than long only. Despite the current hysteria on redemptions, the percentage asset allocation to absolute return strategies actually ROSE recently because much more was lost gambling on the stock market. When a strategy gets crowded and AUM too large, it makes sense to do the OPPOSITE. The negative carry trade that worked best in 2008: borrow Icelandic króna to BUY the Japanese yen. Shorting the mythical "upward drift" of equities and REVERSE arbitrage of popular "market neutral" strategies also did well.
Markets fluctuate. The revenge of the pessimists has triumphed over the optimists for 12 years in many major markets and 26 years in Japan. How many decades are investors supposed to wait for the alleged "stocks go up over time" wish to come true? Long only has provided no growth for so long unlike the capital appreciation that good hedge funds have delivered. Hedging means expecting and preparing for the unexpected. Reducing risk and PROPERLY diversifying BEFORE bad times occur. The beta bubble has burst so the need INCREASES for absolute return strategies that can make money or preserve capital.
Some might have the patience and fortitude to grow old riding out ANOTHER damaging stock market drawdown but I don't bet on beta myself. I realise some still think stocks will go up over time but I have yet to be shown ANY robust evidence for that dubious assertion. Instead of waiting decades hoping for some stock market magic to eventually show up, I prefer receiving absolute returns in time horizons that match my requirements and conservative risk tolerance. So I find managers with genuine skills in risk management and security selection. Then I overlay that with my own edges in strategy allocation and portfolio construction. Consistent portfolio returns requires identifying managers with rare talent and a robust strategy.
Neither hedge funds nor capitalism are facing judgment day. Overly pessimistic economic eschatology has been misinformed and counterproductive. The pundits could note that some very SOPHISTICATED investors are planning to INCREASE hedge fund allocation in 2009 because they recognize the alpha opportunities that will be available. Most redemptions from losing hedge funds will simply be reinvested in better strategies run by superior managers. If anything the equity and debt meltdown CONFIRMS the case for genuine alpha generators. Beta is simply too unreliable. That's traditional beta AND alternative beta.
Many equity or credit risk premium managers masquerading as hedge funds have been revealed in the past 15 months. Thorough due diligence can detect such bull market reliance in advance. If a fund needs fine conditions to make money there is little point in having it in a portfolio. We can get "good economy" return sources from traditional funds. A TRUE hedge fund should offer something different. That's why they are called ALTERNATIVE investments. If it is dependent on underlying risk factors it is NOT a hedge fund.
Capital should flow to quality strategies as much as quality assets. A PROPERLY diversified portfolio can eliminate major drawdowns. Volatility is vicious if a manager is not nimble or too constrained by mandate or large AUM to capture the market anomalies it creates. Commentators try to impose a homogeneity on hedge funds but it is the heterogeneity of strategies and managers that is the value proposition. A good fund below its high water mark is an investment opportunity but a good manager up for the year is even better. Natural selection and thorough research reveals who those funds will be.
I've never found empirical support for the so-called "equity risk premium" despite analyzing 100 countries and 300 years of history but "skill-based alpha" is persistent in the REAL hedge fund performance data. The "average" hedge fund has lost money but would anyone seriously expect an AVERAGE fund manager to have made money in 2008? Recent events simply emphasize the rarity of skill and the MANDATORY need for portfolio strategies that are able protect capital in DOWN markets. Alpha is the ability to extract absolute returns out of other market participants. 2 and 20 is worth paying for uncorrelated sources of return but NOT to funds that need conducive markets and risk premia to make money.
Great Depression - no, Great Delusion - yes. In bull markets the best trade is to short sell arrogance and ignorance of risk but in bear markets it can be optimal to buy into pessimism and negativity. With the widespread predictions of an economic cataclysm, we are likely nearing the end of the panic. Ironically my own long term macro model switched to bullish this week after over 18 months of bearishness. The beauty of computational intelligence is that it is the complete opposite of computational finance. Those looking to apportion "blame" for current economic woes might like to check out the demented credit pricing and rating "models" the computational finance crowd cooked up.
My own unorthodox black box is often early and the stock markets could still fall further. An edge does not mean correct all the time. But since it has been short stocks and long volatility for such an extended period the risk/reward now favor the bull case. Not that I have ever put money in a long only fund; there are so many arbitrages and mispricings available that it is BETTER to invest with hedge funds running lower risk strategies.
I have no doubt managers with genuine edges will be back at high water marks MANY years before major equity benchmarks. Sure there are issues affecting particular strategies but the best investors and traders adapt and ultimately thrive in new economic paradigms. Transitions from one market regime to another usually requires a financial revolution.
Why are so few aware that those who invested in the stock market in the late 1890s were still losing money over 30 years later? Or that fixed-income outperformed equities from the late 1790s to 1870s. Could the late 1990s be similarly prescient? Over what time frame are stock markets supposed to deliver a real return? I'd rather keep the PROFITS that talented, unconstrained managers make than worry about the "long haul". 2 and 20 for reliable absolute returns is a bargain. Long only "passive" and closet index active funds have deep drawdowns and have an egregiously expensive negative effect on portfolios. "Cheap" fees beget cheap risk-adjusted "performance". Unhedged equity has been an underperforming asset class for a long time.
Some good hedge funds have made money while others have had limited drawdowns in the market meltdown. Many have reduced exposures and moved substantially to cash. Good defence is more important than good offence. A bear market for stocks and credit is the SCENARIO that proves the need for strategy diversification. Of course beta dependent unskilled managers are shutting down and being redeemed but that is the Darwinian nature of the business. It is excellent news for the industry.
Real hedge funds have CORRECTLY functioned as a portfolio hedge during difficult times for traditional risky assets. Despite temporary problems for some strategies, GOOD hedge funds offer outstanding long term prospects for consistent risk-adjusted absolute returns. That was true 1929-2008 and WILL be the case for 2009-2088. The best product for long term conservative investors are good absolute return funds. Begin due diligence NOW as 2009 WILL be a fantastic year for hedge fund performance just like 1999. Avoid unskilled assets and buy skilled managers in drawdowns.
© posted by Hedge Fund on 5:08 AM
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