Fiduciary duty
If you haven't served the mandatory 50,000 hours needed to develop investment skill or don't have time for the 100+ hours per week necessary to stay competent, find someone that has. Consistent success takes rare talent and dedication so most "professionals" and all amateurs must underperform. Don't confuse luck with a bull market or for skill. Why risk ANY MONEY on the unskilled market?
Forget about "investment grade bonds" and focus on finding investment grade fund managers. Unlike "cheap" passive strategies that do no security analysis and buy everything no matter how risky or expensive, I prefer rigorous portfolio construction and manager selection. Fortunately profitable opportunities can be found if you work hard and are good enough. Bond benchmarks are size weighted: don't permit your wealth to be lent to the world's most indebted borrowers.
YOUR money deserves to be invested with the best but talent is rare. Out of the 10,000 "hedge funds" I've looked at and hundreds visited globally that made the first cut, I have found less than 100 worth investing in after due diligence. Industry averages for active long only managers and hedge funds are downward biased by hordes of unskilled. Security and manager selection drive 100% of returns. Asset allocation has little to do with it. Conventional wisdom failed as it didn't hedge risk or control drawdowns.
Risk parity is just jargon for leveraging bonds. At such low yields? Bond prices went up so risk parity made money. If fixed-income goes down they will lose. Investing in SKILL allows investors to meet goals. Avoid "new" spins on old beta. If 60/40 can't deliver required risk adjusted returns why should 60/80 or 60/120? Don't risk poverty on risk parity.
Low volatility equity is just the age-old strategy of buying defensive stocks. Low volatility isn't low risk. Generic copycat strategies and hedge fund wannabes guarantee poor "industry" returns. Less than T-bills after stripping out factor dependencies. "Risk parity" and "low vol" are as bad as prior "solutions" like portable alpha and 130/30. Remember them?
Smart money invests in skill. Sadly "modern" portfolio theory still has believers and trillions are still bet on "efficient" betas. Gold made absolute returns every year SO FAR this century; as has a carefully constructed, skillfully diversified portfolio of the world's greatest fund managers. Does gold itself have skill or was it the decision to buy gold? As with luck, gold's rise will end but skill marches on. Alpha is much more useful than gold.
Long term investors must survive many short terms. I'm only interested in managers that work hard, have exceptional focused expertise and are incentivized to deliver consistent absolute returns. If a client asks "Should we invest in China?" I interpret that to mean "Do Chinese markets offer short selling/long opportunities that a highly experienced Mandarin reading and speaking security selection specialist can generate alpha from?" to which the answer is of course YES. Some think it just means "Do we buy China beta?".
John Bogle claims there is no such thing as skill! Adoring cap-weighted indices, he gambles Mom and Pop's retirement on lists of big companies and most indebted borrowers. But he thinks Jim Simons and Warren Buffett were just lucky. Can you really afford to avoid active expertise and bet on "cheap" passive? Reliable returns take hard work and dedication not naive asset allocation. Special forces always outwit benchmark hugging conscripts over time. Most do-it-yourself investors get as painful results as do-it-yourself dentists.
Why limit allocation to 0% - 100% range when -100% to +100% is safer? Every QUALITY portfolio manager makes use of short selling. It's IMPOSSIBLE to properly diversify or manage risk without it. Long only is wrong only and only appropriate for speculators. In recent years stocks AND bonds have risen. If they can both go up, they can both go down! Risk parity uses a short history during which bonds mostly only rose. After 30 years with a brief correction in 1994, risk parity is unlikely to be robust to a sustained bond bear market.
Why hope unskilled asset classes might deliver? People want top quality portfolio management and advice not "equity benchmarks (should) be higher if you wait a few decades". Regardless of the economy, we need absolute returns to grow capital or pay liabilities in RELEVANT time frames. Most equities underperform over time and don't compensate for risk while bonds pay insufficient real income for default and inflation. Hire brilliant people to buy good securities and short sell bad ones; limit "the market" effect on your wealth.
Invest in skills not asset classes. Sadly most investors are urged to bet on long term index "performance". Strategy and manager selection are critical for diversification because asset class dependent funds ALWAYS lose in down periods. How to find major league alpha and avoid hordes of beta repackagers in the minor leagues? The market "average" is no place for YOUR money and neither is the "average" fund manager
Everyone has risk budgets, spending policies and retirement liabilities to prepare for. I need absolute returns at low risk not relative returns at high risk. Such fund managers are scarce and don't run beta-based funds. Beta is dependence on an index but alpha is profitably finding securities to short sell or buy. I choose rare funds that can do skilled security selection and manage risk. Index funds ignore risk and do zero security analysis! Such expensive toxic waste is unsuitable for all investors.
Quality absolute return strategies are the solution. It's much easier to become a movie star or sports legend than to be a good fund manager. Beating the market isn't useful and doesn't require skill. Cash has performed better than most developed equity markets over 15 years. Does that mean cash and bonds have alpha? No. Are they worth investing in at current yields? Long only is wrong only.
Risk and return are unconnected. It's no longer a question of whether to invest in alternatives. Alpha is the ability to produce higher returns than the risk taken. Passive pundits say you must have X% in stocks and (100-X)% in bonds for all scenarios changing only as a function of "risk aversion"! If "risk free" bonds yielded 10% perhaps "age in bonds" might have made sense but not at these yields. It's no surprise many investors feel discombobulated.
Most portfolios are overexposed to stock or bond market drawdowns. Ignore asset class labels and focus on the best unconstrained funds. Let them decide the what, where, when and how of making money for you. Identifying them is itself a form of alpha. Anyone managing their own portfolio should compare themselves to the best not the average and make sure their capital is being put to work optimally.
I separate manager returns into market dependence and value added. Most define an index fund as designed to track indices but I broaden it to funds whose returns are mostly driven by underlying benchmarks or factors. In the last three years the MSCI World and HFR Fund Weighted Composite had +0.91 correlation! Most so-called absolute return funds lose money in down markets. Any product whose performance is dominated by a benchmark is more an index fund than a hedge fund. Many "hedge funds" are simply beta repackagers. Typically I can screen out 90% of the universe very quickly.
Of the remaining 10% of managers, I then calculate what percentage of alpha was due to skill and what from luck. I use hidden Markov models to uncover hidden factor dependencies. After further qualitative and quantitative analysis 90% of that 10% is also eliminated. Starting from thousands of funds I end up with less than 10% of the 10%. The cream of the cream of the crop. Those who refer to "hedge funds" as an asset class know NOTHING about hedge funds. Ignore people that say they can't forecast the short term but claim to be able to predict the long term!
1. Buy GOOD funds in drawdowns. All genuine hedge funds lose money sometimes. No matter how brilliant, even the best managers only have small competitive edges. I doubt there is anyone that gets even 60% of investment decisions correct over time which is why great defense is more important than good offense. Every true hedge fund is CERTAIN to have drawdowns. "Hot money" amateurs usually redeem often creating great entry points for new clients. Famous drawdowns include those by Ken Griffin 2008, Jim Simons 1989, Warren Buffett 1974 and Munehisa Honma 1769. Buying into those drawdowns resulted in great wealth. Skill is persistent, luck runs out.
2. Don't avoid proven strategies. Only invest in what you understand? If you don't understand a strategy, find someone that does. Many times I look at the - losing - portfolio of a "diversified" fund of funds and see no black box quant, no managed futures, no short biased, no volatility arbitrage and no frontier markets funds. No surprise such FOHFs are losing assets while the good ones that look at all strategies are thriving. High frequency trading is a reliable source of returns but no institution globally has issued an RFP for a HFT allocation. Yet. A strategy's holding period is irrelevant. For the past 250 years the best performing funds have been quant.
3. Do proper due diligence but don't take too long. Many investors take months and months, often years, to decide whether to invest in a fund. There is no evidence that such a slow process adds any value or avoids incredibly rare frauds. We live in a high frequency world. It takes me a few minutes to decide to avoid or exit a fund. Deciding to invest in a fund takes a few days provided I have visited all its offices and interviewed the most senior and most junior decision-making staff. And if someone I trust is happy with the operational, back office side and I am familiar with the administrator and prime brokers.
4. Never invest in a fund that is often mentioned in the mass media. Ideally you want funds the mainstream has never heard of. It is very hard to produce returns when a manager's every move is followed and scrutinized. Beware of overly transparent funds. Transparency to ACTUAL investors is important but not to anyone else. I have daily position level detail for most invested funds. I receive over a thousand monthly performance letters and commentaries each month but you won't see any here. Secrecy is the edge.
5. Ignore pedigree. Many investors place great emphasis on managers' previous firms or education. Practical experience is important but track records are rarely fungible or relevant. More importantly it is not a predictive indicator. Even more dangerous is paying any attention to universities attended. Common sense is not so common and no-one has a PhD in it. Avoid any fund advised by Nobel prize "winners".
6. Always redeem from funds announcing their intention to IPO. Every hedge fund firm in the world that went public hasn't made a cent for clients since it went public! Serving two CONFLICTING masters - LPs and shareholders - does not work and shareholders haven't been served well either. Check out hedge fund IPO prices and the value today. Price is what IPO buyers paid, value is what shareholders received.
7. Every investment in a hedge fund is venture capital. It makes no difference if it was set up yesterday or 60 years ago like BRKB. People worry a lot about capacity and AUM. Some strategies only have room for $200 million, others $200 billion. A good manager closes his fund long before returns reduce. Never fall for the old "closing soon" trick. Don't believe the "We are closed but for you we are open" nonsense. Beware of the "endowment" effect and holding onto funds past their prime. Every fund has to justify itself every month. Otherwise it's time to upgrade to a better one.
8. Incentives are necessary for a functioning economy and incentives are critical to a successful portfolio. The best managers charge incentive fees. Investing in hedge funds is about replacing market risk with manager risk. Constructing a portfolio of good funds is as difficult as selecting securities so I use similar processes. You need powerful metal detectors to find alpha needles in beta haystacks. Few people have the combination of talent, expertise and work ethic to produce absolute returns in excess of absolute risk on a consistent basis. The FORWARD-LOOKING detection and estimation of alpha is non-trivial.
The great thing about hedge funds is there are always new ones to look at. As great funds close, successful managers retire and unsuccessful ones go out of business, better strategies are developed. Like everything it's a dynamic active selection process unsuitable for policy asset allocation. The average hides funds in the far right tail of the talent distribution. The stock market is a market of stocks. Who lives in a passive world? Who wants average portfolios with average performance? Whether it is trading stocks or choosing funds, the aim is to maximize use of capital and minimize opportunity cost.
Forget about "investment grade bonds" and focus on finding investment grade fund managers. Unlike "cheap" passive strategies that do no security analysis and buy everything no matter how risky or expensive, I prefer rigorous portfolio construction and manager selection. Fortunately profitable opportunities can be found if you work hard and are good enough. Bond benchmarks are size weighted: don't permit your wealth to be lent to the world's most indebted borrowers.
YOUR money deserves to be invested with the best but talent is rare. Out of the 10,000 "hedge funds" I've looked at and hundreds visited globally that made the first cut, I have found less than 100 worth investing in after due diligence. Industry averages for active long only managers and hedge funds are downward biased by hordes of unskilled. Security and manager selection drive 100% of returns. Asset allocation has little to do with it. Conventional wisdom failed as it didn't hedge risk or control drawdowns.
Risk parity is just jargon for leveraging bonds. At such low yields? Bond prices went up so risk parity made money. If fixed-income goes down they will lose. Investing in SKILL allows investors to meet goals. Avoid "new" spins on old beta. If 60/40 can't deliver required risk adjusted returns why should 60/80 or 60/120? Don't risk poverty on risk parity.
Low volatility equity is just the age-old strategy of buying defensive stocks. Low volatility isn't low risk. Generic copycat strategies and hedge fund wannabes guarantee poor "industry" returns. Less than T-bills after stripping out factor dependencies. "Risk parity" and "low vol" are as bad as prior "solutions" like portable alpha and 130/30. Remember them?
Smart money invests in skill. Sadly "modern" portfolio theory still has believers and trillions are still bet on "efficient" betas. Gold made absolute returns every year SO FAR this century; as has a carefully constructed, skillfully diversified portfolio of the world's greatest fund managers. Does gold itself have skill or was it the decision to buy gold? As with luck, gold's rise will end but skill marches on. Alpha is much more useful than gold.
Long term investors must survive many short terms. I'm only interested in managers that work hard, have exceptional focused expertise and are incentivized to deliver consistent absolute returns. If a client asks "Should we invest in China?" I interpret that to mean "Do Chinese markets offer short selling/long opportunities that a highly experienced Mandarin reading and speaking security selection specialist can generate alpha from?" to which the answer is of course YES. Some think it just means "Do we buy China beta?".
John Bogle claims there is no such thing as skill! Adoring cap-weighted indices, he gambles Mom and Pop's retirement on lists of big companies and most indebted borrowers. But he thinks Jim Simons and Warren Buffett were just lucky. Can you really afford to avoid active expertise and bet on "cheap" passive? Reliable returns take hard work and dedication not naive asset allocation. Special forces always outwit benchmark hugging conscripts over time. Most do-it-yourself investors get as painful results as do-it-yourself dentists.
Why limit allocation to 0% - 100% range when -100% to +100% is safer? Every QUALITY portfolio manager makes use of short selling. It's IMPOSSIBLE to properly diversify or manage risk without it. Long only is wrong only and only appropriate for speculators. In recent years stocks AND bonds have risen. If they can both go up, they can both go down! Risk parity uses a short history during which bonds mostly only rose. After 30 years with a brief correction in 1994, risk parity is unlikely to be robust to a sustained bond bear market.
Why hope unskilled asset classes might deliver? People want top quality portfolio management and advice not "equity benchmarks (should) be higher if you wait a few decades". Regardless of the economy, we need absolute returns to grow capital or pay liabilities in RELEVANT time frames. Most equities underperform over time and don't compensate for risk while bonds pay insufficient real income for default and inflation. Hire brilliant people to buy good securities and short sell bad ones; limit "the market" effect on your wealth.
Invest in skills not asset classes. Sadly most investors are urged to bet on long term index "performance". Strategy and manager selection are critical for diversification because asset class dependent funds ALWAYS lose in down periods. How to find major league alpha and avoid hordes of beta repackagers in the minor leagues? The market "average" is no place for YOUR money and neither is the "average" fund manager
Everyone has risk budgets, spending policies and retirement liabilities to prepare for. I need absolute returns at low risk not relative returns at high risk. Such fund managers are scarce and don't run beta-based funds. Beta is dependence on an index but alpha is profitably finding securities to short sell or buy. I choose rare funds that can do skilled security selection and manage risk. Index funds ignore risk and do zero security analysis! Such expensive toxic waste is unsuitable for all investors.
Quality absolute return strategies are the solution. It's much easier to become a movie star or sports legend than to be a good fund manager. Beating the market isn't useful and doesn't require skill. Cash has performed better than most developed equity markets over 15 years. Does that mean cash and bonds have alpha? No. Are they worth investing in at current yields? Long only is wrong only.
Risk and return are unconnected. It's no longer a question of whether to invest in alternatives. Alpha is the ability to produce higher returns than the risk taken. Passive pundits say you must have X% in stocks and (100-X)% in bonds for all scenarios changing only as a function of "risk aversion"! If "risk free" bonds yielded 10% perhaps "age in bonds" might have made sense but not at these yields. It's no surprise many investors feel discombobulated.
Most portfolios are overexposed to stock or bond market drawdowns. Ignore asset class labels and focus on the best unconstrained funds. Let them decide the what, where, when and how of making money for you. Identifying them is itself a form of alpha. Anyone managing their own portfolio should compare themselves to the best not the average and make sure their capital is being put to work optimally.
I separate manager returns into market dependence and value added. Most define an index fund as designed to track indices but I broaden it to funds whose returns are mostly driven by underlying benchmarks or factors. In the last three years the MSCI World and HFR Fund Weighted Composite had +0.91 correlation! Most so-called absolute return funds lose money in down markets. Any product whose performance is dominated by a benchmark is more an index fund than a hedge fund. Many "hedge funds" are simply beta repackagers. Typically I can screen out 90% of the universe very quickly.
Of the remaining 10% of managers, I then calculate what percentage of alpha was due to skill and what from luck. I use hidden Markov models to uncover hidden factor dependencies. After further qualitative and quantitative analysis 90% of that 10% is also eliminated. Starting from thousands of funds I end up with less than 10% of the 10%. The cream of the cream of the crop. Those who refer to "hedge funds" as an asset class know NOTHING about hedge funds. Ignore people that say they can't forecast the short term but claim to be able to predict the long term!
1. Buy GOOD funds in drawdowns. All genuine hedge funds lose money sometimes. No matter how brilliant, even the best managers only have small competitive edges. I doubt there is anyone that gets even 60% of investment decisions correct over time which is why great defense is more important than good offense. Every true hedge fund is CERTAIN to have drawdowns. "Hot money" amateurs usually redeem often creating great entry points for new clients. Famous drawdowns include those by Ken Griffin 2008, Jim Simons 1989, Warren Buffett 1974 and Munehisa Honma 1769. Buying into those drawdowns resulted in great wealth. Skill is persistent, luck runs out.
2. Don't avoid proven strategies. Only invest in what you understand? If you don't understand a strategy, find someone that does. Many times I look at the - losing - portfolio of a "diversified" fund of funds and see no black box quant, no managed futures, no short biased, no volatility arbitrage and no frontier markets funds. No surprise such FOHFs are losing assets while the good ones that look at all strategies are thriving. High frequency trading is a reliable source of returns but no institution globally has issued an RFP for a HFT allocation. Yet. A strategy's holding period is irrelevant. For the past 250 years the best performing funds have been quant.
3. Do proper due diligence but don't take too long. Many investors take months and months, often years, to decide whether to invest in a fund. There is no evidence that such a slow process adds any value or avoids incredibly rare frauds. We live in a high frequency world. It takes me a few minutes to decide to avoid or exit a fund. Deciding to invest in a fund takes a few days provided I have visited all its offices and interviewed the most senior and most junior decision-making staff. And if someone I trust is happy with the operational, back office side and I am familiar with the administrator and prime brokers.
4. Never invest in a fund that is often mentioned in the mass media. Ideally you want funds the mainstream has never heard of. It is very hard to produce returns when a manager's every move is followed and scrutinized. Beware of overly transparent funds. Transparency to ACTUAL investors is important but not to anyone else. I have daily position level detail for most invested funds. I receive over a thousand monthly performance letters and commentaries each month but you won't see any here. Secrecy is the edge.
5. Ignore pedigree. Many investors place great emphasis on managers' previous firms or education. Practical experience is important but track records are rarely fungible or relevant. More importantly it is not a predictive indicator. Even more dangerous is paying any attention to universities attended. Common sense is not so common and no-one has a PhD in it. Avoid any fund advised by Nobel prize "winners".
6. Always redeem from funds announcing their intention to IPO. Every hedge fund firm in the world that went public hasn't made a cent for clients since it went public! Serving two CONFLICTING masters - LPs and shareholders - does not work and shareholders haven't been served well either. Check out hedge fund IPO prices and the value today. Price is what IPO buyers paid, value is what shareholders received.
7. Every investment in a hedge fund is venture capital. It makes no difference if it was set up yesterday or 60 years ago like BRKB. People worry a lot about capacity and AUM. Some strategies only have room for $200 million, others $200 billion. A good manager closes his fund long before returns reduce. Never fall for the old "closing soon" trick. Don't believe the "We are closed but for you we are open" nonsense. Beware of the "endowment" effect and holding onto funds past their prime. Every fund has to justify itself every month. Otherwise it's time to upgrade to a better one.
8. Incentives are necessary for a functioning economy and incentives are critical to a successful portfolio. The best managers charge incentive fees. Investing in hedge funds is about replacing market risk with manager risk. Constructing a portfolio of good funds is as difficult as selecting securities so I use similar processes. You need powerful metal detectors to find alpha needles in beta haystacks. Few people have the combination of talent, expertise and work ethic to produce absolute returns in excess of absolute risk on a consistent basis. The FORWARD-LOOKING detection and estimation of alpha is non-trivial.
The great thing about hedge funds is there are always new ones to look at. As great funds close, successful managers retire and unsuccessful ones go out of business, better strategies are developed. Like everything it's a dynamic active selection process unsuitable for policy asset allocation. The average hides funds in the far right tail of the talent distribution. The stock market is a market of stocks. Who lives in a passive world? Who wants average portfolios with average performance? Whether it is trading stocks or choosing funds, the aim is to maximize use of capital and minimize opportunity cost.
© posted by Hedge Fund on 6:11 PM
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