Stock market volatility

Smart money hedges but many investors STILL take too much risk on the stock market. Most equities don't compensate for their volatility and most bonds have insufficient REAL yield for default and inflation risks. There's been a vast brain drain to skill-based strategies in recent decades. Sophisticated investors want quality portfolio management not the usual "stocks (might) go up over time" mantra. Strategy selection is crucial when asset class dependent funds don't deliver. How to identify major league funds and avoid the minors? Risk-adjusted, long only ALWAYS loses to skilled long short strategies.

Invest in skills not assets. If a fund needs the market to go up to make money then it's unskilled and NOT A HEDGE FUND. Long term returns needs short term focus. Consistent success requires rare talent so "average" managers underperform. Unlike "cheap" funds that naively buy the dartboard and subsequently decimate client capital, I prefer carefully targeted security selection to gambling on benchmarks. Fortunately for retirees, pensions, foundations, endowments and sovereign wealth funds, short and long mispricings can be identified if you have the work ethic and expertise.

Generic copycat strategies, alternative beta and hedge fund clones GUARANTEE poor returns. Less than T-bills after stripping out factor dependencies. Almost as dire as portable alpha and 130/30. Remember them? The hot things today are risk parity - jargon for leveraging up bond beta - and minimum variance. Low volatility isn't low risk. Variance is a USELESS measure of dispersion and not indicative of future danger. Amazing "modern" Markowitz Sharpe kool-aid has believers. Sadly for EVERYONE, trillions are mis-allocated due to asset allocation nonsense. Revoke that "Nobel".

Luck or skill? Everyone has retirement liabilities to fund. I need absolute returns at low risk not relative returns at high risk. Such managers are scarce and don't run beta-based funds. Long only stock or bond funds are risky so I won't consider products whose returns come mainly from beta. Beta is dependence on an index but alpha is profitably finding securities to short sell or buy. All "hedge funds" aren't worth investing in. I choose RARE funds that can do security selection and manage risk. Index funds ignore risk and do NO security analysis! Look for managers making an avocation their vocation. Don't risk poverty on risk parity.

Quality absolute return strategies are the solution. Forget about new spins on beta. It's much easier to become a movie star or sports legend than to be a fund manager worth investing in. Beating the market isn't useful and doesn't require skill. Cash has performed better than most developed equity markets over 15 years, Japan for much longer and bonds have beaten stocks for 30 years. Does that mean cash and bonds have alpha? No. Are they worth investing in at current yields?

Gold has risen EVERY year so far this century. The MLP index ^AMZ has crushed the S&P 500 for twelve years in a row. Do gold and MLPs have skill? Should you rush into gold and MLPs now? It takes a minimum 50,000 hours to get good at investing. Even then most won't succeed. But some will and those can be identified in advance. Great managers produce consistent alpha INDEPENDENTLY of beta. It does take focus and dedication. Usually do-it-yourself investors get similarly painful results as do-it-yourself dentists.

Risk and return are unconnected. Investment grade bonds or investment grade funds? It's no longer a question of whether to invest in alternatives. Alpha is the ability to produce higher returns than the risk taken. Bombastic 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. Quality funds are for those seeking alpha regardless of the economy.

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.

Index products are unsuitable for cost sensitive, risk averse people like me. Prudent investors avoid "cheap" funds that don't bother to analyze securities and hold any toxic waste included in benchmarks. I'm only interested in managers that work hard 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/long opportunities that a highly experienced specialist can generate alpha from?" to which the answer is of course YES. Some think it just means "Do we buy China beta?".

Incentives are necessary for a functioning economy and incentives are critical to a successful portfolio. The best managers don't run funds without 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 estimation of alpha is non-trivial but if beta > alpha then it's too risky else if alpha > beta then it's worth further due diligence as it could be a real hedge fund.

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 index direction 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 also 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. Bad drawdowns include those by John Paulson 2011, Ken Griffin 2008, James Simons 1989, Warren Buffett 1974 and Munehisa Honma 1769. Avoid funds with infinite Sortino ratios because the crowd loves them. To their ultimate cost. Skill is persistent, luck runs out. Bad luck also ends.

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 always 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 receive and read 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.

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. The long term investor must negotiate many short terms.