tag:blogger.com,1999:blog-54038572024-02-20T12:11:21.619-08:00Hedge fundHedge fund blogHedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comBlogger109125tag:blogger.com,1999:blog-5403857.post-1162398738867097222023-11-07T07:08:00.000-08:002023-11-15T18:25:12.471-08:00Hedge Fund TestHedge Fund Test. Could you pass? In the unlikely event you score six sigma above the Minkowski mean,
we might contact you. If not the examiners wish you all the best for
your plan B career in pirate equity.<br />
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1) Risk management: Today, if global thermonuclear war, a 100% fatal contagious coronavirus, several Richter 12 earthquakes, a new ice age, an alien invasion, yet another zombie apocalypse and a giant asteroid vaporizes this miserable tiny little planet, you:<br />
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A) I pick stocks by analyzing companies, studying income statements, balance sheets and cash flows to find value in a glorious vacuum immune from macro factors<br />
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B) I didn't expect my "event-driven" hedge fund to be driven by events<br />
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C) Ridiculous scenario so I haven't stress tested for that particular set of factors and the 95% VaR and cVar tells LPs and their clueless consultants all they need to know<br />
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D) Very profitable. I always have many shorts and puts. I run an absolute return fund. It's my job to anticipate and prepare for every possible scenario<br />
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E) Might take an initial hit but make it up trading subsequent turbulent markets. I've also been diversifying into Space. Planetary bias is almost as dumb as national bias. Almost.<br />
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2) Quantitative analysis: Today you were thinking about the turbulence and viscosity in the markets when you stumbled onto a complete solution to the Navier-Stokes equations. You<br />
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A) Publish to worldwide acclaim, another Fields medal and $1 million Clay mathematics prize<br />
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B) A day's pay? I'd prefer to keep it to myself and perhaps use the ideas to gain an edge<br />
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C) Viscosity? Navier-Stokes? What's that got to do with making money?<br />
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D) Intellectually satisfying but I already solved specific cases I needed numerically with large eddy simulations<br />
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E) Forget about it. Just not into quant/math geek stuff. If it looks cheap I buy, if not I short sell. Fundamental analysis and gut trading drive my work<br />
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3) You receive a term sheet for AAA rated 20% yield CLO cubed SPAC, SIV-lite, PIK-toggle, Venezuelan Bolivar quanto, digital Bermudan rainbow knockout spreadtion, synthetic mortgage-backed subprime CPDO, lumber correlated, rock-salt linked, orange juice variance swap, carbon credit, catastrophe reinsurance PRDC cliquet reverse floating callable convertible preferred Argentine Peso denominated Z-tranche. You:</div>
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A) Mentally price it up yourself and arbitrage the investment bank's derivative mis-pricing models<br />
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B) Take all they've got but ask them to restructure the coupon up to 30%, reminding them of the need for mark to - your idea of a - market<br />
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C) Pull the line, inform the SEC, change your fund's name, email address, Bloomberg ID and phone number</div>
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D) Call your favorite search firm recruiter and poach the bank's structured products team</div>
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E) Tell them to email "sophisticated" investors craving high yield toxic waste "securities" declared AAA by clueless ratings firms bribed to do so. Vanguard loves that kind of trash.<br />
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4) Deductive reasoning: Hint: Googol is 10^100, a tiny number. Googolplex, 10^googol, is also very small. 99.999...% of numbers are much, much bigger than TREE(3)<br />
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A) A googol of hedge fund managers are asked to choose a whole number between zero and googol. They are each told they will get to manage USD 1 googol for googol year lockup if the number they choose is half the arithmetic mean of all numbers that were selected. What number should you pick?</div>
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B) A googol of monkeys/Vanguard employees type at googol computers for googolplex years. What is the expected wait time until someone types out exact content of all hedge fund Berkshire Hathaway's annual letters to investors from 1957, in sequence?<br />
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5) Human resources: You need to recruit a performance rainmaker. Your shortlist comprises the following candidates. You can only hire one. Who?</div>
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A) "Nobel" prize laureate in Economic "Sciences", who can't/won't do capital raising/client relations<br />
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B) machine learning computer scientist with no financial knowledge</div>
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C) old private trader, uneducated, illiterate, non-team player, made over +100% return per year net of 5 and 50 fees in each of past 50 years with zero negative months, 600 profitable months<br /></div>
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D) psychologist with no financial knowledge</div>
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E) proprietary trader with many years experience at bulge bracket Wall Street banks, front running client orders/deal flow, analyst upgrades and prime brokerage data flowing over "Chinese Walls" <br />
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6) Portfolio management: Today your ten biggest long positions all went bankrupt and your ten largest shorts were LBO'd at enormous premia by overcapitalized private equity funds. You<br />
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A) smash your phone, trash the Bloomberg and jump out of the window<br />
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B) write op-eds for the WSJ, Nikkei and FT on "broken markets", appear on CNBC and schedule several conference keynote gigs<br />
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C) some noise in the markets today - good thing my diversified hedge fund actually is diversified and properly hedged<br />
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D) move the "distressed" longs to the illiquid special situations side pocket and launch higher offers on all the LBOs<br />
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E) shut down fund, go on a month vacation, then start a new fund with a new name and new high water mark<br />
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7) Basic market knowledge:<br />
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A) What is your favorite stock on the Armenia Stock Exchange?<br />
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B) Is the Bhutan Ngultrum now overpriced or undervalued?<br />
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C) What price would you pay for Cuban yen-dominated sovereign debt?<br />
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D) Denmark's DONG issued a 1,000 year hybrid. At what price would you short?<br />
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E) Long Estonia/neutral Egypt/short Ecuador or vice versa?<br />
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8) Market outlook: Investors are urged to bet on equities for the long haul. Stock indices in some countries have even risen over time. In several others they fell to zero.<br />
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A) What is the likeliest price for the Dow Industrial index in one billion years? <br />
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B) What is your bid/offer today for a Dow 30,000 strike call option expiring in a billion years?<br />
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9) Forecasting: To make consistent absolute returns at low risk the one thing that is truly necessary is:<br />
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A) To be really, really intelligent. Really<br />
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B) To use common sense, since it is not very common<br />
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C) To be a brash, brilliant, street smart, genius star day trader who does "size"<br />
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D) To work harder and more effectively than 99.99% of "professionals"<br />
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E) To follow closely what the strategists, economists and sell-side analysts are saying<br />
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10) Investing experience</p><p>A) From memory what were your ten best and ten worst investments and the exact levels of entry and exit and precise ex ante reasons for the trade? Also </p><p>B) From memory what are your current ten largest short and ten largest long positions, their average entry price, percentage of portfolio, level of conviction on each trade and what hedges do you have in place?<br />
</p><p>If you do not currently have in excess of 10 short positions and 10 long positions then you have failed.<br />
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******** End of Test ********<br />
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<br /></p><div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-1125838708360146302022-09-01T05:07:00.000-07:002022-09-02T08:48:55.245-07:00Hedge fund jokeIndex fund idol, a long only genius and me are flying in to deliver investment presentations to an institutional client in New Zealand. As the plane comes in to land we see a purple sheep alone in a field.<br />
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Professor Passive says "Every kiwi sheep is purple! I must buy them ALL, now, at ANY price the owners ask, no matter how high or overvalued. It's not my money. No need to know ovine business or earnings. Forget about analysis or due diligence. Ignore risk! Prices are always correct as markets are efficient. I have academic tenure and Swedish taxpayers awarded me a fake 'Nobel' in economic 'sciences' which I've been using for asset gathering marketing ever since. Risk free...for me."<br />
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Beta Bandit says "Some kiwi sheep are purple but the professor says they all are. I am benchmarked to the index so I must also buy that purple sheep no matter how expensive. Can't risk tracking error and not being fully invested or the conflicted advisers/consultants I bribed to be on their "recommended" lists might try to remove me. It's not my money either. I get same fees whether muppet customers win or lose."<br />
<br /> I say "That sheep may seem purple but my machines have deep learnt that nothing should ever be sold short or bought without regard to value or price. My clients are retirees, widows, orphans, university endowments awarding student scholarships and foundations funding good causes so I MUST do much deeper analysis. Our interests are aligned as my wealth and family and friends savings are in the fund. I study potential investments very closely so that ABSOLUTE pension liabilities and foundation grants can be paid from ABSOLUTE RETURNS.<br />
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It's my fiduciary duty, unlike asset gatherer salesmen like you. I'm only paid well if, and only if, I make absolute money for clients. Unlike you I invest as a prudent man. You guys are breaking suitability and fiduciary rules for your unfortunate investors. Doing no analysis or due diligence before buying an alleged purple sheep at any price? What are the outrageous fees you charge for your so-called "work" actually for?<br />
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There seems to be a sheep, one side of which appears to be temporarily purple. This may be due to chemicals in the sheep-dip, an accident with dye or paint, an optical illusion, a practical joke or a smudge on the airplane window. I will closely study sheep fundamentals and talk to many shepherds, shearers and wool merchants with extensive domain expertise.<br />
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My data wrangling team will gather petabytes of global ovine data and conduct rigorous statistical analysis, mathematical modeling, stress tests and scenario simulations. Perhaps, after exhaustive research, I might be able to decide whether to short sell or even buy that apparently purple sheep, depending on its value and risk.<br />
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The Nobel Foundation, the professor's university endowment and long only dude's pension plan are my clients because they need the absolute returns I deliver irrespective of market direction or beta factors. You can't buy food, pay faculty or meet liabilities with relative returns in bear markets. Professor Passive's employer is able to offer student scholarships and pay his vast, tenured salary because it avoids his beloved, high risk passive funds. Too volatile."<br />
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Which manager should YOU invest with? Who should get the NZ$200 million mandate? Who is most likely to generate RELIABLE risk-adjusted returns? Whose fees represent the best VALUE for the work? What manager is really the "cheapest"? Which fund offers alignment between client and manager interests? "Cheap" index funds are the joke.<br />
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Would an investor truly following the <a href="http://en.wikipedia.org/wiki/Prudent_man_rule" target="_blank">prudent man</a> rule choose a passive fund given the fiduciary duty for due diligence in selecting appropriate investments for beneficiaries? Passive funds that do no security analysis or risk management are a clear breach of fiduciary duty. Too expensive for anyone.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-55258187050725051222022-04-07T20:08:00.005-07:002022-04-19T02:12:07.842-07:00Asset allocation?Asset allocation doesn't work. It does not drive portfolio returns. Whether mathematically or empirically, it is easy to show for all forward-looking goals, market scenarios and risk tolerances, investors big and small should NEVER asset allocate. Experts were wrong: take a look at the disastrous state of pensions and retirement savings. They are in that situation due to asset allocation. <br />
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Let's destroy asset allocation with a simple proof. If investors were required to put their entire portfolio in one stock of their choice, "experts" would conclude ONLY stock picking drives returns. Or if you flip a coin each month to be "100% stocks" or "100% cash" then market timing becomes the SOLE determining factor. Asset allocation is based on bad science. If you are already doing "asset allocation" then of course, "asset allocation" will decide the results, just as much as stock picking or market timing will.<br />
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Decide on conclusion you want; then search for a data set you know in advance will "confirm" the delusion. Brinson, Ibbotson etc studied investors that were already doing "asset allocation". If the superstars had confined themselves to market timers they would amazingly "discover" that market timing drove performance! Asset allocation would have no influence. Is it valuable to discover that asset allocators' returns and variances are driven by "asset allocation"? No.<br />
<br />Warren Buffett's returns are entirely driven by stock picking. He, like me, does not asset allocate. We money allocate. VERY different. I've read the academic papers, heard all the gurus speak, met with the geniuses marketing to me. Safe in mediocrity and groupthink but empirical garbage and dangerously mistaken. Sadly most investors obey such conventional "wisdom". As a data scientist I follow facts and evidence not flawed fallacies.<br />
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Naive asset percentages in various market betas is a breach of the fiduciary standard. Truly "prudent" people do NOT invest like that. Some urge low fee, high cost, high risk beta based funds but such speculative products have vicious volatility and devastating drawdowns. The prudent way to achieve investment goals for ALL long term scenarios is skilled strategy selection NOT academic asset allocation. <br />
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Was nothing learnt from 2008 crash? The ludicrous losses of pension portfolios in major drawdowns show "bet on betas" asset allocation fails. Portfolio returns are actually decided by level of manager talent, security selection and competent (or not) factor hedging. Asset allocation dominated conventional "wisdom" and wrecked too many portfolios. Meanwhile the skilled thrived in those wonderful market conditions. Trillions are mis-invested due to asset allocation.<br />
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60/40? Does x% in fixed income when bonds yielded 10% make sense even if they now yield 2% or less? Still x%? Of course not. Since client long term goals require the SAME absolute return no matter what, fixed income attractiveness varies as a function of interest rates. As for "high" yield, many junk bonds were yielding +15 to 20% when Michael Milken made his name. Today under 5%? "High" is absolute, not relative. Need a lot more coupons to absorb the defaults. And inflation.<br />
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Check out "risk free" government bonds during inflation. The "lower for longer" crowd urge loading up on duration at these rates! Risk reward? Equity markets are usually either too cheap or overpriced. Asset class silos have no place in this dynamic, volatile world. 100% in SKILL is what you need. Diversification is no free lunch and adds value only if it REALLY diversifies. Mostly it diworsifies.</div>
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Focus on talent. Investors don't have the time or risk appetite to gamble on indices. Time slows for no-one so don't grow old riding out drawdowns and gambling on the asset allocation crowd. Markets might rise - eventually - but that time CANNOT be recovered. 100% needs to be invested in skill so I invest with the world's best managers. Why risk a cent with anyone not good enough to run a hedge fund?<br />
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Asset allocation has cost retirements. It has also destroyed the spending budgets of university endowments and foundations. Liquid long only is bad but leveraged illiquid long only is crazy. Many pensions keep doing what they have always done and get what they always get: lower funded status. Why do an asset/liability study when asset allocation is useless? Liabilities need an absolute return. Best match to achieve that are skilled absolute return strategies.<br />
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Skill is necessary if you want consistent capital growth. Short positions are required; longs are optional. Landmark studies reached BIASED conclusions because asset allocation is what the CHOSEN investors already focused on. In contrast smart investors pay no attention to asset class labels and focus on security selection and tactical timing. Good fund managers analyze securities using skill. I have no interest in unskilled asset classes. Beta does not compensate for risk even in strong bull markets. Don't breach fiduciary duty to yourself or others you represent.<br />
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A stock and bond asset mix determines variation of returns only if you focus on beta. It's easy to debunk the asset allocation "axiom". If you encounter any "consultant" claiming that asset allocation accounts for over 90% of returns, don't walk away, run. Risk averse people invest in alpha. The true determinant of superior risk-adjusted returns is investment SKILL not percentages in UNSKILLED asset classes. It's the manager mix NOT the asset allocation. Check out the dire funded status of DB and DC pensions that gambled on betas due to conventional "wisdom".<br />
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It was a GREAT decade for the S&P. No beta for "passive" index funds but every day offered an opportunity set of fluctuating securities to capture alpha. It was an even better quarter century for the Nikkei. No beta since 1984 but vast alpha was generated from security selection and market timing by those with talent. Some "experts" say investors ought to have more in risky assets due to higher "expected" returns. Instead people would be wise to focus on 100% in skill. For those with liabilities to fund, intolerance of volatility or dislike of deep drawdowns, alpha is the prudent investment. Can't beat beta? Forget about beta.<br />
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In aggregate, stocks can underperform bonds for decades. 60/40 sounds prudent until rephrased as 90/10 risk. Why have a high risk appetite when unhedged equity indices NEVER compensate with sufficiently high reward even in bull markets. Last century's 8% return on 16% volatility was an insult but a last decade's negative total return with even more risk is absurd. Most bonds also don't reward enough for their risk. Do not go near index fund garbage. It is for speculators NOT fiduciaries.<br />
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Choose specific securities or hire other people with rare skill to do it for you. If your portfolio lost money in 2008 or you spend less than 100 hours a week dedicated to manager due diligence, portfolio construction and security selection you need to re-evaluate WHO is making investment decisions for you and HOW to upgrade. The Greeks got it right: alpha is before beta. If a manager is unable to make money or preserve capital in DOWN markets they aren't suitable for ANY portfolio.<br />
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Alpha beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/2009. That led to the mistake inherent in the crazy concept called <a href="http://en.wikipedia.org/wiki/Portable_alpha" target="_blank">portable alpha</a>. It was a beta-centric way of getting some investors into hedge funds but failed because it kept asset allocation front and center. It diluted the absolute return attribute and changed it into just another relative return index based product. The <a href="http://www.wealth-bulletin.com/portfolio/content/1055905120/%3Cbr%20/%3E" target="_blank">alpha beta separation</a> idea still has too much risk budget in beta. But why bother with beta at all? "Cheap" beta is expensive considering its risk. Cost and risk conscious investors favor alpha. It's a cheaper source of return.<br />
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The more vituperative commentary on hedge funds, the more one should invest in alpha vendors. Why tie up precious capital in riskier beta when lower risk alpha is available? Better to identify mispricings and arbitrages than invest in "the market" itself. It is safer to minimize market exposure and analyze specific securities to buy and short sell that just gambling on benchmarks. Most portfolios are very beta biased while some investors implement a beta plus alpha model. The natural progression is to alpha only which has a much better efficient frontier. I do not understand why investors must surrender their wealth to the hazards of beta when superior alternatives exist. <br />
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Selecting the RIGHT betas at the RIGHT time is a form of alpha anyway. Choosing the WHICH and WHEN of asset classes takes as much talent and expertise as at the security level. I have no idea where "the markets" are going in the long term but will not take the chance of finding out. Asset and security selection, timing and hedging skill, though rare, are the only properties a conservative investor can rely on if they need adequate and consistent absolute returns. Beta is passive but do we really live in a world that rewards passivity in any activity? I don't think so which is why they are called ACTIVITIES. Alpha comes from acumen driven ACTION.<br />
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Successful investing is about leveraging informational, structural and analytical advantages or hiring those that have them. Let's look at portfolios that did well over long periods but didn't asset allocate, instead focusing on security selection or timing. A low frequency trading firm like Warren Buffett's Berkshire Hathaway identifies specific multiyear opportunities in currencies, commodities, stock and bond markets, derivatives and event driven special situations. In contrast the <a href="http://www.nytimes.com/2009/07/24/business/24trading.html" target="_blank">high frequency trading</a> of Jim Simons' Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Producing alpha depends on your knowledge and technology edge applied to appropriate time horizons. <br />
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Beta bets drive many portfolios because that is what most investors do. It is like those who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The <a href="http://en.wikipedia.org/wiki/Anthropic_principle" target="_blank">anthropic principle</a> applied to finance. It is false logic similar to the "all swans are white because every swan I've seen is white" phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its woeful weaknesses. Efficient, unbeatable markets imply the non-existence of skill! Choose beta because alpha is just "random" luck in a zero sum game? The much cited <a href="http://www.fa-mag.com/component/content/article/1196.html?issue=59&magazineID=1&Itemid=27" target="_blank">Brinson Hood Beebower</a> paper has cost too many investors too much money. Beta people advocate index funds since they want you to invest in "the market". But the optimal way to achieve absolute returns at the total portfolio level is to be alpha-centric.<br />
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Beta vendors don't manage risk, don't market time and outsource ACTIVE security selection to benchmark construction firms. They even stay fully invested long only in bear markets! A beta-centric portfolio is where investors decide policy asset allocation and then hire managers to basically deliver the return from asset classes and hopefully a bit of alpha on top from tracking error constrained active mandates. Most long only funds have an R-squared with their benchmark over 70% - ie beta explains most of their returns. Alpha strategies and manager selection shouldn't be secondary but that is the result when beta bets dominate the allocation of investment capital.<br />
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Alpha vendors see a market of securities offering long/short opportunities in many time horizons within and between asset classes. An alpha-centric portfolio is where investors hire managers to analyze, trade and hedge for absolute returns. Of course you have to be good and work extremely hard to find alpha. Any manager that depends on beta is NOT running a hedge fund. A truly <a href="http://lexicon.ft.com/term.asp?t=efficient-portfolio" target="_blank">efficient portfolio</a> does not pollute itself with beta. Dismissing all hedge funds is like avoiding all stocks because Enron, General Motors and Nortel fell to zero. Don't invest in bonds because some default and there is no such thing as a <a href="http://money.cnn.com/2009/12/17/news/economy/treasurys.tumble.fortune/index.htm?cnn=yes" target="_blank">risk free rate</a>? Nortel stock lost -100% while a Nortel bond is up +700% but most missed it.<br />
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Pure alpha sources do not fit well into the beta allocation process that some find so compelling. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that AVERAGE performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if "hedge funds" were up or down each month. But what does that mean? Some made money and some lost money. Likewise I am often asked where I think "the market" is going. That is a beta question. Some stocks go up and others go down. Seek alpha.<br />
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Do I want "hedge funds" that outperform? No. I look for hedge funds that make money which is a very different target. I know that good hedge funds will have high risk-adjusted returns and bad ones will not. Alternative beta is just another beta and is therefore to be avoided. Most betas are becoming more correlated whether by geography or the equity, credit and real estate correlation to the economy. I am not concerned whether a hedge fund is "market neutral" or not. But it must be able to deliver absolute returns that are "economy neutral".<br />
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Alpha is the REAL diversifier because there are so MANY different ways of generating it. Focus on alpha if you want good returns regardless of the economy. Why pay attention to <a href="http://www.forbes.com/2009/12/23/asset-allocation-mutual-funds-etfs-personal-finance-bogleheads-view-dogu.html" target="_blank">asset classes</a> when investing in SKILL-BASED STRATEGIES makes more sense? Others are welcome to unhedged beta bets but for conservative investors like me beta with a bit of alpha is inferior to an ALPHA ONLY portfolio.<br /><div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-47654651468754807952021-08-07T12:08:00.000-07:002021-08-11T08:03:39.929-07:00Best hedge fund?<div style="margin-bottom: 0px; margin-left: 0px; margin-right: 0px; margin-top: 0px; margin: 0px;">
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Best hedge fund? When do past returns predict future performance? Defining "best" as highest risk adjusted alpha after deducting all style premia and beta factors, the greatest ever hedge fund manager is obvious.<br />
<br />Skill is predictive, luck is not. Alpha yes, beta no. It's better to select jockeys, rather than horses, as I wish to avoid the vexatious volatility and devastating drawdowns of smart/dumb beta. Invest with great managers before they are famous. Despite outstanding performance, hedge fund managers like George Soros, Warren Buffett and Jim Simons were unknown for decades.</div><div style="margin: 0px;"><br /></div>
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Your money is too important to be risked on "averages". I prefer strategies that deliver independently of market direction. Though rare, skill can be detected with detailed analysis. Bet on horses and lose years of gains in bear markets. No "average" for me or clients. Passive always fails, eventually. Time in drawdowns is never recovered.<br />
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Below is the chart of a famous fund. The fund is open and you can, if interested, invest in it. Experts say it's great but pathetic returns for the risk taken.<br />
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<a href="http://2.bp.blogspot.com/_tzn0BqMHySQ/SADN6nhFpAI/AAAAAAAAABk/1Cso-Qrlf6k/s1600-h/PerfectFund.gif" target="_blank"><img 275px="275px" 555px="555px" alt="top hedge fund" border="0" height:="height:" id="BLOGGER_PHOTO_ID_5188373177654682626" src="https://2.bp.blogspot.com/_tzn0BqMHySQ/SADN6nhFpAI/AAAAAAAAABk/1Cso-Qrlf6k/s400/PerfectFund.gif" style="cursor: pointer;" width:="width:" /></a><br />
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Seems good. +20% CAGR after fees for 10 consecutive positive years. The returns have been independently audited many times. Transparent, heavily regulated and available to all investors. No leverage, lockups, gates or valuation issues. The manager keeps it simple by investing long only in liquid equities on the largest market value stock exchange. It must be good, right?<br />
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After analysis I concluded the fund was too risky despite being recommended by rearview mirror loving "Nobel" geniuses. I decided to figure out who was the best manager ever. The criteria for a good fund are complex but necessary to find the best. Defining a top fund as that which achieved the highest risk-adjusted alpha over several decades, the wealth accumulated by the manager from his investment acumen, the consistency and repeatability of performance from protectable edges, then the best ever investor is obvious.<br />
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The “god of the markets”, 本間宗久 Munehisa Honma long/short hedge fund performed outstandingly for over 50 years. His main work, "Fountain of Gold", is the best finance book ever written. His trading ability enabled his family office to become the largest land owner in Japan. They later diversified into the <a href="http://www.honmagolf.co.jp/mono/c_0.php?lang=en" target="_blank">Honma golf</a> business which makes sense if you own vast tracts of flat land in a mountainous region.<br />
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A set of Honma clubs has "high" fees but like hedge funds versus index funds, you get what you pay for. Destroy your golf score with "cheap" clubs? Wreck your portfolio with 0.02 for passive or grow and preserve wealth by paying 2 and 20 for skill?<br />
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Munehisa Honma's net worth was over US$100 billion in today's money. Some years he "took home" more than the equivalent of US$10 billion so it's curious why pundits are excited on "news" John Paulson received "record" pay of just $3.7 billion. Fair "salary" for the over $12 billion he generated for clients that they would not OTHERWISE have.<br />
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Like Honma, Paulson hedged client portfolios. REAL hedge fund managers focus on achieving returns to monetize talent and build wealth. Shorting subprime was NOT the <a href="http://www.businessweek.com/the_thread/techbeat/archives/2009/11/hedge_fund_king.html" target="_blank">greatest trade ever</a>. Good but not greatest. "Ever" means since 2002? Recency bias yet again. Honma's short sale of rice futures in 1789 was far more profitable than Paulson's "big" credit short.<br />
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There's a fountain in the main garden of Honma's house as a reminder of the source of wealth. As befits many successful hedge fund managers, Honma was an avid art collector. He also advised the world's first sovereign wealth fund. Though rice was heavily traded and analyzed in those days, such liquidity did NOT produce an efficient market. He figured if he worked hard to develop competitive informational and analytical advantages he could extract alpha out of other traders, regardless of whether <a href="http://en.wikipedia.org/wiki/Fudasashi" target="_blank">futures brokers</a> themselves were bullish or bearish or prices were rising or falling. That's a TRUE hedge fund. Any firm needing a bull market to make money is NOT a hedge fund.<br />
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Note for the long only luddites: the GREATEST trades tend to be shorts. Hedge fund "pioneer" <a href="http://www.awjones.com/main.html" target="_blank">Alfred Winslow Jones</a> did not "invent" hedge funds. He invented the term but not the philosophy. Munehisa Honma was investing for absolute returns two centuries earlier. By 1755 Honma already knew that psychology and the IRRATIONAL actions of participants NOT economic logic drove markets. Behavioral finance isn't new, it's 253 years old. He didn't buy and hold rice and wait to be compensated for its higher risk. He did not "expect" a risk premium or "assume" that rice prices would rise over time. Index fans regard those as axiomatic for "stocks". Neither equities nor credit carry a risk premium. Trade them but NEVER hold them. <br />
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Munehisa Honma paved the way for the hedge fund managers of today. Translated adages from his main book - "Market action is more important than news". "Prices do not reflect actual value". "Buys and sells are decided on emotion not logic". He discovered the truth all that time ago and without the computers, analytics and communication systems we have. He also knew the dangers of transparency: "Never tell others your positions or strategies". His performance speaks for itself. They should retrospectively award him one of those "Nobel" prizes that economists still hold onto as they continue their futile search for a rational market.<br />
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Honma wrote of the returns to be made buying when most are selling and shorting when everyone else is buying. Consult the market about the market! Even today many spend valuable time on Fed watching when they could INSTEAD be seeing what the MARKET is saying. The Market told us we were entering a recession several months ago and the credit crisis was NOT "contained". The Market is not efficient but it forecasts better than any economist. As befits the samurai trader he was, the time between making a decision and implementing that decision must be minimized. Delayed execution and transparency are the enemies of performance.<br />
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Though primarily a statistical trader, Honma also spent time on fundamental analysis, talking to farmers and consumers about what moved rice prices, who was buying or selling and why. He had detailed historical weather data and analyzed it to predict a key factor driving rice yields. His strategies required low latency trading so, despite the pre-electronic era, he established a signaling system all the way from Sakata to the <a href="http://www.westga.edu/~bquest/2008/candlestick08.pdf" target="_blank">Dojima Exchange</a> 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.<br />
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Honma invented black box <a href="http://www.financialsense.com/asia/danielcode/2008/0120.html" target="_blank">algorithmic trading</a>. As his impact on the markets grew he evolved from market-taker to market-maker. He leveraged his informational advantages and adapted to the situation as needed. Those quants who download a decade of security prices and then overoptimize and curve-fit to the patterns of recent history might remind themselves that Honma analyzed 1,500 years of rice data BEFORE doing a trade. He focused on finding robust and persistent phenomena NOT spurious patterns containing zero PREDICTIVE information.<br />
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Feedback fuels future fluctuations. Honma would have scorned those economists that assert that markets have no memory. Securities are traded by humans and computers programmed by humans, both of whom DO have memory. If the input has memory then the output has memory. If no memory is assumed, prices might indeed follow a random walk. "Nobel" Prize "winner" <a href="http://www.nuclearphynance.com/User%20Files/53/PaulSamuelson.pdf" target="_blank">Paul Samuelson</a> supposedly "proved" that "Properly anticipated prices fluctuate randomly" which might have been relevant except for the INCONVENIENT TRUTH that prices are NEVER properly anticipated.<br />
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Stock, bond, currency, real estate and commodities prices are determined by participants with memory, so prices themselves also have memory. Honma accumulated more wealth exploiting security price memory than all the economists TOGETHER who have ever believed in memoryless markets. Not only is there NO efficiently priced security; it is impossible for an efficient market to exist. Amnesiac assets? Absurd. Rational agents? Really. The future state has no dependence on the present or past states? Preposterous.<br />
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Many trading techniques can be traced back to Honma. It is interesting how often Western investors get caught out trying to trade Japan. Some fixed-income arbitrage hedge funds got hurt by cash Japanese bonds recently. The yen carry trade has damaged many that didn't realise that a low interest rate does NOT imply a weak currency. As Honma wrote, the cheap can get MUCH cheaper.<br />
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Some might be skeptical of technical analysis and know nothing about Japanese-style technical analysis. Fair enough. There are plenty of fundamental ways to make money. But if a bigger investor with a few trillion yen to put to work believes in such things as candlesticks, Kagi, Renko, Heikin Ashi and Ichimoku then that may impact the markets and lose money for those who do not master such methods. If you don't know your edge then you don't have an edge but that edge must be enough to overcome other traders' edges. I haven't come across ANYONE able to consistently make money trading yen, JGBs or Japan equities without a thorough understanding of Japanese analytics.<br />
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I didn't trade any security in Japan until I knew ALL the above methods cold. Incredibly many rookies still try (and fail dismally) to trade Japan profitably. As Honma knew and John Maynard Keynes implied, the key is working out what others will do and how they value securities NOT one's own estimate. The market may NEVER value an asset "correctly" as some activist and value investors in Japan have recently found out to their cost.<br />
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Honma was the first successful quantitative trader. Isaac Newton's earlier trading forays weren't successful but then gravitational modeling is easier than financial modeling. The sun WILL rise tomorrow but the motion of the markets is less predictable. It is interesting how today more scientific method and new math are being applied to the markets. But OLD math and dubious economic "theory" have not coped well with modeling REALITY. Assets classes affect each other but the ways they interact change over time. Since no traded security moves randomly, the math of randomness is not useful in finance. Today many still use it because stochastic calculus is easy, unlike the quant methods that work.<br />
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ALL assets are connected. Honma monitored many things even if they had no apparent connection to rice prices. Everything is related and NOTHING is independent. Beware of ANY financial "model" that assumes independent, identically distributed prices. We have seen the dire results though it does allow alpha to be transported from those that use them to those who employ better methods to win the zero-sum game. The Central Limit Theorem has no applicability to the REAL statistical distribution of prices.<br />
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Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic is disdained by those who think we live in an orderly, bivalent world of true/false, right/wrong, yes/no and 0/1. I once developed a fuzzy model to calibrate the bullishness or bearishness of the Japanese market. It provided nice projections for the daily ranges for the JGB, Nikkei and yen. Given the inappropriate Ito stochastic integral for pricing derivatives, I also adapted the Sugeno fuzzy integral to derive a more accurate option replication and hedging model. Isn't the world itself FUZZY so fuzzy logic could be of use? The market is vague even at the best of times. The market is NEVER in a 1 or 0, bull or bear state; it is always somewhere between 0 and 1.<br />
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Japan therefore had the world's best ever hedge fund - Honma's long/short rice fund managed from the 1740s to the 1790s. The chart above is a Japan "passive" index fund performance from 1980-1989 but below is the ENTIRE performance chart since 1980. Past perfomance was not indicative for future performance in any country. The risk and volatility since 1990 have failed to compensate investors with high returns but that would not have surprised Honma. Performance comes from hard work and talent NOT buy and hope. A good heuristic for assessing investment strategies - if it is simple then it won't work. Easy "solutions" cause difficult problems, as we have seen.<br />
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<a href="http://4.bp.blogspot.com/_tzn0BqMHySQ/SAD0_HhFpBI/AAAAAAAAABs/4BSZeEMYIP4/s1600-h/ImperfectFund.gif" target="_blank"><img alt="top hedge fund" border="0" id="BLOGGER_PHOTO_ID_5188416135917577234" src="https://4.bp.blogspot.com/_tzn0BqMHySQ/SAD0_HhFpBI/AAAAAAAAABs/4BSZeEMYIP4/s400/ImperfectFund.gif" style="cursor: pointer;" /></a><br />
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Returns have not been good for the TOPIX since the high water mark set so long ago. The 1980s were NOT even the best decade; the 1950s compounded at a 25% CAGR and returned 10X investors' money. Even now, so many years into a bear market, the TOPIX remains the top returning stock index in the post war period. Would I therefore invest in it? Absolutely not. I want funds that WILL perform in the future not rely on a magnificent past. But for those who like "cheap" long only equity funds and historical data dredging, it is interesting they don't overweight Japan. As for me I am staying long yen, long JGBs and short the Nikkei for now.<br />
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I prefer the manager risk of TODAY's superstar traders and investors NOT the risk of long only funds. Honma-sensei thrived in volatile market conditions. Recession will make the absolute returns generated by top hedge fund managers important and they have the best ever, Munehisa Honma, also known as Sokyu Homma (本間宗久) and born Kosaku Kato, for inspiration.<br />
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Since Honma's era there have been many obituaries written for the hedge fund industry. We are on another iteration right now because a few beta dependent speculators masquerading as hedge funds recently blew up. That SOME hedge fund strategies are short volatility and can be modeled as effectively short sellers of put options and hoping a black swan won't show up to reveal their fund as a data snooping lemon is very OLD news. <br />
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Ten years ago Long-Term Capital Management short sold options and bet the house on convergence and got taken out by the "never happened before" Russia default. Fortunately there are many quality hedge funds run by managers who are fully aware of the dangers of being short gamma and convexity, potential "rare" event fat-tail risks, carefully hedge for those exposures or maintain a long volatility profile. Sure plenty of "hedge funds" are no good but there are many skilled hedge funds that do manage risk.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-19191539790711104452019-08-05T20:08:00.000-07:002019-08-30T03:47:17.676-07:00Buffett's Alpha?<div style="margin: 0px;">
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Warren Buffett prudently invests 99% of his wealth in absolute return strategies, like most risk averse savers. Leverage, arbitrage, derivatives, event-driven, opportunistic, special situations and macro strategies have driven his returns since inception in 1954. Short selling cocoa futures was Warren's first major arbitrage. Despite FACTS, some insult Warren by claiming he isn't even a hedge fund manager! If Berkshire Hathaway isn't the archetypal hedge fund, there are no hedge funds. BRKA manages $500 billion, AUM grown from capital appreciation not from wining and dining pension "consultants".<br />
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One counterexample, ONE, is sufficient to destroy the dangerous passive fad and ridicule index fund "Nobel" laureates. Don't trust naive lists of unanalyzed stocks sold as "low fee" but high cost, no skill, zero work, volatile index funds. Past returns DO predict the future if, and only if, the manager is skilled. Top hedge fund managers like Warren Buffett and George Soros invest in talent NOT beta. Why avoid the best? Passive pimps claim George and Warren are just lucky! Lucky for 60 years?<br />
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Warren prefers book value to measure his hedge fund's performance but only his partnership valued at NAV. Desiring permanent capital, Warren switched to a listed closed end fund legal structure so shareholder sentiment affects returns. "Lucky" hedge fund managers Warren Buffett and George Soros' returns since 1969 are charted below. Green line is speculator <a href="http://hedgefund.blogspot.com/2007/06/john-bogle-and-index-funds.html" target="_blank">John Bogle</a>'s high risk index fund that buys 500 stocks S&P ACTIVELY pick and frequently trade! Bogle claims skill doesn't exist and sells UNSKILLED toxic waste to risk-craving gamblers.<br />
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Warren is correct that the best investment book in english is "The Intelligent Investor". Runner up is "Alchemy of Finance" though hardly anyone tries to understand it, creating an edge for those that do. By far the top finance book in any language is Fountain of Gold, written by the <a href="http://hedgefund.blogspot.com/2008/04/best-hedge-fund.html" target="_blank">best hedge fund</a> manager ever. Rounding out the top are "Tunnel Thru the Air", "Margin of Safety" and of course "Il Deserto dei Tartari" read in original Italian. If, like me, you master every page of each book, you will produce higher risk adjusted returns than 99% of professional investors.<br />
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Many investors avoid quality funds. Market benchmarks are too risky. How do you find great managers? With skilled due diligence it is possible to identify FUTURE outperformers in advance. George Soros and Warren Buffett's skills were clear over 40 years ago so there was plenty of time to invest. Their successful absolute return strategies have brought major benefits for society and secure retirements for their grateful clients.<br />
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Mid-career professionals like Warren and George have delivered great returns while hedge fund managers aged under 80 build experience. Net of fees, George turned $1,000 into $14 million and Warren to $3 million in his actively managed closed end fund BRKA. He charges lower fees than passive managers and his hedge fund is open to all. The high risk S&P grew to just $0.039 million. Low fee funds are neither low cost nor low risk.<br />
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Warren Buffett runs the Berkshire Hathaway hedge fund and George Soros is the top performing living hedge fund manager. The optimal portfolio is investing 100% in talent and 0% in asset classes or funds that depend on their direction. Don't random walk your way to poverty. Don't fight the Fed and don't fight Warren. He is 100% invested in skill.<br />
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Warren made money for clients every year of 1960s but George produced absolute returns every year of 1970s, a far more difficult decade. In due diligence I haven't found anyone else that was able to do that. Warren has delivered a lot of alpha but George has made more. We can all be thankful to both of them for destroying the efficient markets hypothesis and the dangerous passive fad.<br />
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While Eugene Fama, William Sharpe, Robert Merton, Harry Markowitz, Myron Scholes were cooking up dumb "models" for portfolio "optimization" and how markets supposedly moved, REAL WORLD practitioners George and Warren were knocking the cover off the ball making a mockery of inbred academic stupidity. Follow the doers not idiot theorists on tenured salaries. <br />
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Samuelson set economics down the dangerous path it has taken since 1950s. True economists Adam Smith, Alfred Marshall and <a href="http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.27.3.213" target="_blank">John Maynard Keynes</a> must be spinning in their graves at the damage that he and followers wrought. Passive pimps cite Samuelson's "Challenge to Judgement" in their ludicrous claim that no manager can beat the market. All he had to do was look at Warren or George's (or John Templeton, Benjamin Graham, Ed Thorp, Munehisa Honma etc) track record. But he didn't. Why let FACTS destroy dumb theory?<br />
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Investing in SKILL is the only prudent allocation. Talent and hard work are necessary to find alpha which is why so few managers produce it. Index funds charge outrageous fees for ignoring risk, doing no due diligence and just tracking someone's list of stocks. Why wouldn't you want your money managed by the best? Hedge fund managers never retire as the calling is for life. The only variable is which clients they accept. George now only manages for friends and family. Warren's hedge fund is still open to YOU.<br />
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Portfolio performance is determined by manager mix NOT asset allocation. The more people believing in efficient markets the more inefficient markets become. Trillions in index funds creates more alpha capture opportunities. Benjamin Graham ran the Graham-Newman hedge fund from 1920s. Warren short sold cocoa futures in a special situations deal as far back as 1954. He also got into insurance to access the float and not need to borrow from prime brokers. In due diligence, I found so-called "first" hedge fund A.W. Jones mostly front ran analyst upgrades so was NOT skill-based and would be illegal today.<br />
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<a href="http://2.bp.blogspot.com/_tzn0BqMHySQ/TPJdPqI3TQI/AAAAAAAAAHE/oqzWct3uvpk/s1600/WBreturn.png" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5544596614837390594" src="https://2.bp.blogspot.com/_tzn0BqMHySQ/TPJdPqI3TQI/AAAAAAAAAHE/oqzWct3uvpk/s400/WBreturn.png" style="height: 275px; width: 555px;" /></a><br />
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Warren is mainly a derivatives and hybrids trader though he does hold a few core stocks as a hobby. "We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds". Remember that when passive investing zombies claim active management and security analysis are "pointless".<br />
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George and Warren generated high alpha from low frequency trading via various legal entities. Double Eagle - Quantum, Buffett Partnership - Berkshire Hathaway. Like many other hedge funds, they don't report returns to databases, only to clients. Neither has CAIA or CFA but both have exceptional quant skills. I have never found a good manager that doesn't, including if they run fundamental styles. Skilled managers do deliver reliable absolute returns and prove that market prices are NEVER correct.<br />
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George's track record is better but Warren is richer. Why? The snowball of POSITIVE compounding for longer. Both were born in August 1930 and Warren ran his hedge fund from 1957 but George didn't set up his until 1969. Warren was lucky to be in Omaha while Dzjchdzhe Shorash was in Budapest, more affected by WW2. Also Warren got into currency trading and philanthropy later. George's outperformance is due to more international diversification and because reflexivity is ignored. Value investing is copied more than reflexivity investing. The 2008 subprime credit crisis was a quintessential examples of reflexivity. <br />
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The sad passive fad is reflexivity in action. So many securities' pricing behavior are now driven by indices NOT economics. Index funds buy stocks because they are on a list not after thorough analysis and due diligence. The difference between benchmark stocks and bonds and those not in a widely tracked index are very noticeable. Such predictability creates even more ineffficiencies for the skilled to monetize. YES beta leads to alpha. <br />
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Warren ran a partnership from 1957-1969 and then implemented his strategies via Berkshire Hathaway. He first bought BRKA shares in 1962 at $7.60 and it's now $120,000 for a 22% CAGR. But the Buffett Partnership did better with all 13 years positive. Gross returns of 29.5% were net 23.8% to investors after his 25% incentive fee above 6% hurdle. What if, instead of "retiring" in 1970, Warren had continued the partnership and performance had persisted? Investing $1,000 in 1957 would now be $100 million. Fees that Warren might have been "paid" for turning $1,000 into $100 million would be $1 billion. That's good since clients would STILL have $99.9 million MORE than gambling on passive funds.<br />
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Warren, George and many others have destroyed efficient market hypotheses, random walk assumptions and the myth that asset allocation drives portfolio returns. BHB Brinson et al cost too many investors too much money and wrecked retirement plans, foundation spending and endowment budgets. In the real world fiduciary investors want ALL their capital in attractive opportunities and that requires skill. George and Warren's alpha capture from security selection worked better than static beta bets. No-one says it's easy but if you work hard it is possible as they have proved. Such teams CAN be identified at an early stage and charge whatever <a href="http://www.johnkay.com/2008/03/12/just-think-the-fees-you-could-charge-buffett/" target="_blank">hedge fund fees</a> clients are prepared to pay. <br />
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Academics say Warren is just an ex-post lucky outlier but some spotted his talents ex-ante. Were they lucky too? The S&P 500 also began in 1957 but has performed terribly by comparison - $1,000 would now be just $100,000, huge opportunity cost and pathetic "compensation" for its risk. Investing for absolute return using competitive edges and outside the box thinking has existed for centuries. Long only relative return is the fad. Passive indexing is even newer. The trouble with owning dartboards is that you get the treble 20 but you also tie up precious cash in 1s, 2s and 3s. With proper analysis, average hedge funds can be avoided just like average stocks. I prefer to identify the <a href="http://www.youtube.com/watch?v=6dD9NiZfQFQ&feature=related" target="_blank">Phil Taylor</a> of each strategy. How many darts must you throw to show skill? George and Warren have hit many treble 20s.<br />
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Warren wants to be judged on book value not stock price but you can't eat book value and I evaluate fund managers by what investors really receive. Partnerships are marked at NAV but the switch to BRKA subjected clients to the irrational and highly inefficient public markets. In 2008 BRKA book value dropped -9.6% but shareholders lost -31.8%. George made money in that allegedly "challenging" year. While the stock has returned slightly more than book value due to the valuation premium, the volatility has been high. Warren's actual Sharpe ratio is lower than his book value "Sharpe ratio", dropping from 1.4 to just 0.6. Of course that is still much better than the high risk S&P 500. VFINX, SPY and its brethren have been disasters.<br />
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<a href="http://2.bp.blogspot.com/_tzn0BqMHySQ/TPJeO7kWVrI/AAAAAAAAAHU/hf654c5yihE/s1600/WBincentives.png"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5544597701847832242" src="https://2.bp.blogspot.com/_tzn0BqMHySQ/TPJeO7kWVrI/AAAAAAAAAHU/hf654c5yihE/s400/WBincentives.png" style="cursor: pointer; height: 275px; width: 555px;" /></a><br />
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The Oracle of Omaha and the Brain of Budapest have "quit" before. George has hired "replacements" since 1981 and the extent of his involvement has fluctuated since though never without close knowledge of and implied oversight of the portfolio. For each Li Lu or Todd Combs there was a Jim Marquez or Stanley Druckenmiller. No man is an island and both sought out strong partners and talented employees from early on. Jim Rogers and Charlie Munger added significantly. Accredited investors - anyone with $80 - can access Warren and Charlie's abilities through BRKB, a listed closed-end fund. The active stockpickers at benchmark construction firms missed 45 years of massive growth but then add it to their "unmanaged" index!<br />
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Would Warren and George have bothered managing outside money if they hadn't been incentivized to do so and perform? It's skill that adds value. No alpha, no incentive fee. George's partnership fees were lower than Warrens's for gross returns above 25%. Since George and Warren's gross performance was in excess of 25%, George's fee structure was actually cheaper. Jim Simons and team have outperformed both for the past 20 years with much higher fees but the net returns of Medallion Fund were superior. The technological and personnel infrastructure requirements for high frequency trading cost more than for low frequency. If you don't like the fees, don't invest in hedge funds. Capacity for a good strategy is limited and demand exceeds supply of alpha. But it's expensive and dangerous waiting to find out WHETHER bargain beta might one day deliver.<br />
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Those "outrageous" fees? George charged 1% and 20% no hurdle whereas Warren charged 0% and 25% on 6% hurdle, then offered his money management skills for FREE in return for permanent, leveraged capital. But you would have done much better going with <a href="http://www.independent.co.uk/opinion/letters/letter-soros-and-quantum-fund-1370584.html" target="_blank">Soros Fund Management</a> in 1969 and paying those "high" fees than you would with BRKA. I am delighted for people to be well compensated for delivering what I need, ABSOLUTE ALPHA, from their RARE abilities. If someone turns $1,000 into $100 million from skill not luck or riding the market, they deserve $1 billion. Especially when manager interests are aligned with clients by them being the largest investor in their fund. When George or Warren has a bad month, they PERSONALLY lose more than any client. That INCENTIVIZES them to do their best to minimize the downside.<br />
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This chart assumes fees compounded without the manager needing to eat, live, pay employees, run the business etc. which of course they do. In recent years, with investor demands for larger teams, deep benches and operational infrastructure, fixed costs for hedge funds have risen to the 2 and 20 mode. Two people, a computer and a phone do not get institutional money today. Sad though to see an Omaha <a href="http://www.omaha.com/article/20101106/NEWS01/711069884/1141" target="_blank">pension fund</a> deep in a $600 million deficit when they could so easily have hired a local hedge fund run by <a href="http://www.nytimes.com/2010/11/17/opinion/17buffett.html?_r=1" target="_blank">Warren Buffett</a> to get them into surplus. The Hungary retirement system is not in good shape either but they could have invested with <a href="http://online.wsj.com/article/SB123793340762430957.html" target="_blank">George Soros</a> and would now be doing fine. Why avoid top absolute return managers when you have ABSOLUTE LIABILITIES to fund?<br />
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You can't eat relative returns but you CAN eat absolute returns and I'll take $100 million over $100,000 every time. I assume you would too. Sadly most "advice" focuses on asset allocation NOT manager selection. Save fees or upgrade skills? So what if the manager becomes a billionaire? They deserve it for the essential entrepreneurial service they offer. If clients get rich, it is fine by me if the manager gets richer. Plenty of "discount" funds are available but at what performance? Avoiding "high" fees for alpha is like saying to a Porsche dealer you will only pay $100 for a new car because that is what the raw materials cost. Or that Shakespeare was just a lucky fool who "randomly" chose words from the dictionary. I am writing this on Apple AAPL hardware using Microsoft MSFT software uploaded to a service owned by Google GOOG. Using those products may further enrich several people who are already billionaires. Does it matter? Or do SHARED incentives work? <br />
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No-one is forced to invest in hedge funds. Investors are free to make do with passive beta and <a href="http://blogs.telegraph.co.uk/finance/ianmcowie/100007842/warren-buffett-fund-illustrates-rip-off-management-charges/" target="_blank">relative return</a> if they can stomach the risk. I can't. Some even say alpha doesn't exist! If you flip a coin 10 times and get 8 heads it might be a fluke but NOT if you flip 1,000,000 coins and get 800,000 heads. Warren and George have flipped too many coins for their returns to be luck. They made their clients rich, deservedly got richer themselves and are giving their wealth away for the social benefit of the world. A rare financial win/win/win.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-80589332253594132932019-02-08T03:30:00.000-08:002019-03-21T00:44:29.792-07:00Portable alphaPortable alpha? Why "port" NEW sources of return onto OLD sources of return? In down markets most positive alpha gets swamped by negative beta. It also diverts attention from what investors really need: consistent absolute returns from a blended range of truly UNCONNECTED strategies. Different performance sources stand either as a return enhancer or risk reducer.<br />
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The portable alpha fad originates from the high risk 60/40 stock and bond asset allocation mania. Haven't we all evolved beyond that by now towards multi-strategy, multi-asset portfolios? Shouldn't investors move to a 5/5/5/5...5 split among strategy classes? An investor risking 60% in public/private equity and 40% in credit/fixed-income is NOT diversified and has NO chance of being able to meet pension liabilities or retirement spending targets. Passive products and traditional thinking are chronic diseases in too many portfolios.<br />
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If an investor owns thousands of stocks and bonds, they might think they have spread their risks sufficiently but they have not. Such a portfolio is concentrated in only two asset classes - equity and fixed-income - and just one strategy class - long only. Such lack of portfolio diversification is just too risky. Equity and credit correlations continue to rise in this current bull market and will get even higher in the coming bear market so historical notions of "diverse" asset allocation are not enough.<br />
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The initial efforts at asset class diversification into private equity and real estate did not do much to reduce strategy concentration. Long only equity is still long only equity regardless of whether it is public or private while real estate is dependent on a growing economy and benign credit markets and borrowing rates. Those "alternative" investments weren't really very alternative at all. Both derive from the traditional strategy of purchasing an asset, with no risk management or hedging, but often with leverage. Such assets, with their intermittent valuation and illiquidity disguise significant cointegration and dependence on the health of the public stock and bond markets.<br />
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Hedge funds are strategy classes NOT asset classes. For a properly diversified portfolio, investors need numerous sources of INDEPENDENT returns. They require strategy and asset class diversification to complement traditional securities. For example, with commodities and currencies, there is not really an "asset-like" return, therefore trading skills are required rather than established "investment" expertise.<br />
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Hedge funds generate returns from widely varied strategies and holding periods including, but not limited to, relative value, short selling, spread trading within and between securities and their derivatives, monetizing second order market phenomena through statistical and volatility arbitrage and new proprietary strategies. Similarly new asset classes, often requiring specialist domain expertise, include energy, distressed assets, CDOs, collateralised high yield loans, weather derivatives, movie financing, reinsurance, carbon emissions, fine art and even footballers and other potential return streams yet to be tradeable or investable. All this strategy and asset innovation REDUCES risks, exposures and portfolio dependence on the usual bets of hoping equity indices go up and hoping bond issuers pay coupons and principal.<br />
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The current trendy topic is the separation of alpha and beta. This assumes such a performance attribution split is necessary in evaluating and allocating to strategy classes, also known as hedge funds. Even the most "market neutral" hedge fund is dependent on some underlying, possibly changing, market factors. This hyperbolic focus on "Was it alpha or beta?" misses the point. What actually matters is getting a blended portfolio return of 10% or so at the lowest volatility, under ANY economic scenario EVERY year. It may be counterintuitive to some but the MORE different risks you take, the LESS the overall risk in the entire portfolio, provided the exposures are independent.<br />
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So why <a href="https://www.blogger.com/blogger.g?blogID=5403857" ref="http://www.ftmandate.com/news/fullstory.php/aid/1123/Portable_alpha_gains_widespread_acceptance.html" target="_blank">portable alpha</a>? Investors need to escape the mindset of benchmarking everything to stock and bonds. There is no need for a beta overlay; different return sources justify themselves. Obsession with outperformance of a traditional index, rather than absolute performance per se is what caused problems in the first place. If beta is doing well, who cares about alpha? In contrast, if market or strategy beta fares poorly, "outperformance" is unlikely to save the situation, because negative beta usually swamps any positive alpha. What really matters is having lots of completely different, performance generators with numerous strategies across many asset classes. There is no need to "port" these strategy returns onto traditional assets. Even strategies that haven't done well on a stand alone basis, like short biased hedge funds, can add value by smoothing volatility, lessening risk and factor dependencies.<br />
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Owning stocks and bonds might be necessary but is NEVER sufficient. And portable alpha isn't the answer, it is having sources of independent returns from as many DIFFERENT strategy and asset classes as possible. The safest option is to have many fund managers doing different things, in different ways, in different assets with holding periods ranging from seconds to decades. That is TRUE diversification.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-1128857487387785472018-08-08T08:00:00.000-07:002018-10-06T14:15:11.319-07:00Economics Nobel prizeNobel prize? Pricing options correctly is hard but finding dumb "prizes" is easy. The 1997 award to Myron Scholes and Robert Merton and that is with the bar set very low in a dismal field that had no TRUE Nobel. The Black-Scholes "formula" has led to many problems for investors but is still used to misprice options. The Literature Nobel prize was more suitable for Scholes and Merton. Rarely has such fantasy and fiction had such impact.<br />
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Fake "Nobels" are yet more 1960s economics lunacy that must be put out of its misery. Anyone using stochastic calculus to "price" derivatives is wrong. But I am glad they exist so they can transmit their random negative alpha into my deterministic positive alpha. Win the zero sum game arbing "Nobel" equations.<br />
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It devalues legitimate Nobels to let such an error stand. As REPLACEMENTS and for their roles in demolishing the delusional dogma of efficient markets, I nominate hedge fund managers George Soros, Warren Buffett and James Simons. Each separately proved over long time periods using very different strategies, the falsity of always "correctly" valued securities.<br />
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Just one counterexample ends the random walk "debate". Yes one consistently alpha generating suffices. Not that there was any debate among those investors with double or triple digit IQs. Only economics professors and index fund salesmen are stupid enough to claim markets are efficient. All products and pricing models dependent on "random" markets are unstable and unsuitable.<br />
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A heavy investor in hedge funds, the Nobel Endowment, wisely refuses to pay for a prize in oxymoronic economic "sciences" so Swedish taxpayers take the hit. Merton and Scholes are to financial engineering what the Titanic was to marine engineering. Neither would have gained tenure in the rigorous hard sciences but in soft economics they are superstars despite over 40 years of staggering wrongness. <br />
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The Swedish Central Bank, in conferring Nobel status on "economics", devalues the work of Alfred Nobel, REAL scientists, writers and peacemakers. With rare exceptions, prizes have been awarded for either being completely wrong or stating the obvious and then having your academic buddies say how clever you are. Physicists, chemists and medics must endure decades of scrutiny and skepticism by many independent scientists yet economists have a laxer and in-bred peer "review" structure. To encourage such erroneous assumptions shows how structurally flawed the "discipline" is. <br />
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I've probably read every paper written by the "Nobel" dudes and they got little right. The mathematics is correct but the simplifications are silly and conclusions are crazy. Rational investors, random walks with drift, continuous time, constant volatility, lognormal distributions, geometric Brownian motion, heat diffusion in finance(?), stocks that move like gas molecules(??) - give me a break.<br />
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None of those assumptions has the remotest applicability to financial markets. Their work does NOT approximate how securities behave. There is no theoretical basis or empirical relevance of their work to derivatives pricing. Amazing such rubbish is still used. More problems ahead for anyone using models derived from Black Scholes.<br />
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The 1970s may be different to today but, even then, if you had REALLY come up with a way to price options accurately, would you publish OR would you use it to make money? Just because Black-Scholes and Merton's work makes calculating option prices simple does not make it correct. Most of "Wall Street" uses models that can be traced back to it.<br />
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Being widely used does not ensure proof; all it guarantees is a LOT of people are wrong. Sure you can relax many of the assumptions and the "magic formula" still seems robust. Many would regard this as heresy but Black-Scholes and the "improvements" are useless for hedging and trading options. Incredibly some people are using Gaussian assumptions. Why?<br />
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I arbitraged those who used the "elegant" equation baed on absurd assumptions for years. My best quarter was summer 1998...LTCM. Try finding nickels in front of the steamroller and you will eventually be crushed. It is much better to be riding on the steamroller and crush such folks. The Long-Term Capital Management debacle was blamed on leverage, the Russian default and the trading team. While those had a role, LTCM was primarily a test of Scholes and Merton's rational market theories. Short selling of options was the primary culprit based on their model showing volatility to be overvalued and misguided faith that security prices must "revert" to their idea of "correctness".<br />
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If you short options you are short volatility; if volatility goes up you are quickly in trouble and the more the market moves against you the bigger your LOSING positions become. The more hedging you do, each time locking in a loss, pushes the market more against you especially if you are a big fund and massively short vol. There is less liquidity in options, especially long-dated ones and when marketmakers and other option liquidity providers sense oversized positions happily make it very difficult and expensive to cover that short vega exposure. Forcing LTCM into a vega short squeeze was not difficult for the market.<br />
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My options pricing model could not reconcile the cheapness at which LTCM was selling volatility swaps throughout 1997/1998. When turbulence hit they had no hope; the subsequent revelations of massive leverage were a reflection of the extreme shortness of vega that grew to dominate and devastate their portfolio. Leverage was always high but it turned into hyperleverage because they failed to understand the dangers. Long date vega gets illiquid when implied volatility rises sharply.<br />
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The family of Alfred Nobel are rightly opposed to an award for such "science". Nobel himself was EXPLICIT in his will for the FIVE fields he wished to endow. But if the Economics Memorial prize must endure it is time the people who receive it actually merit it. For the anti hedge fund brigade it it worth noting that the <a href="http://nobelprize.org/" target="_blank">Nobel Prize</a> foundation considers true hedge funds to be safe securities. That is how they invest the endowment to award the REAL Nobel prizes.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-1138967677880327292018-06-08T04:39:00.000-07:002018-07-28T19:42:55.724-07:00Sports bet hedge fundSports results don't correlate with economic factors unlike stocks, bonds, commodities and currencies. Sports bets also offer reliable arbitrages and consistent mispricings. Diversify PROPERLY with new sources of return. Most people bet on stocks or sports emotionally and their PREDICTABLE behavior allows money to be made out of them.<br />
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Invest in DIFFERENT alpha sources NOT beta asset classes. If your portfolio does not have an allocation to SPORTS ALPHA CAPTURE then the portfolio is likely not properly diversified. Efficient market hypothesizers say if I run a 100 meters enough times I'll random walk it in 8 seconds at some point! The first sub 2 hour marathon could be by you, yes YOU! Good luck betting on such stochastic stupidity. The so-called passive mania depends on EXACTLY THAT.<br />
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Skill is rare but DOES exist. I assume passive pimps think Pelé, Babe Ruth, Jack Nicklaus, Michael Jordan, Wayne Gretzky and Don Bradman were just "lucky" like hedge fund managers Jim Simons, George Soros, Warren Buffett, Benjamin Graham and the BEST ever investor <a href="http://hedgefund.blogspot.com/2008/04/best-hedge-fund.html" target="_blank">Munehisa Honma</a>? Some sportspeople are paid well because they deliver top value. Some funds can charge 2 and 20 because investors DESPERATELY need access to skill. Meanwhile clueless salespeople like Bogle, Fama et al claim skill does not exist! Incredible a few suckers still around that believe them.<br />
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Investing is like sport. Few are good enough to play in major leagues. The best become very wealthy, journeymen do not. Those NOT skilled play in minor leagues or work at mutual funds and join private equity firms. Losers 99.99%, winners 0.01%. Working hard to develop competitive edges others don't have combined with talent and dedication. Sports alpha doesn't exist just like investment alpha? No such thing as hard work? No skilled people just lucky ones? That's what the passive crowd want you to think while they collect absurd fees on YOUR money for ZERO work and NO analysis. Lose money? It's the market's fault, right?<br />
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Passive funds GUARANTEE most of YOUR money gets wasted on losers. Prudent fiduciary(?) John Bogle thinks if I golfed with Jack Nicklaus or played tennis against Roger Federer I had a 50% chance of winning. No-one has skill so it's a stochastic process! That is the absurd random walk theory behind "passive". Eugene Fama got a - not yet revoked - PhD, a fake "Nobel" and academic tenure for hypothesizing a 3ft tall person is as likely to slam dunk a basketball as a 7 footer. According to his "academic" ideas even if you weigh 80 lbs he thinks a great career may await you as a sumo wrestler or defensive linebacker. And some fools still wire their savings to him? Don't Forget Alpha.<br />
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How many sports teams would win if managers just randomly chose players? But naive investors are urged to do just that. Skill is necessary to win in any business. Passive pimps say there is no such thing as investment skill. There's no sporting ability as well? Selectors, coaches and scouts waste time because sports talent is just luck? Why does financial media report the stock market average but the sports media never insults viewers with "average" golf scores. 100+?<br />
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Investors are supposed to be satisfied with the "average" return but you don't see "average" sportspeople on TV. Could you watch a sport where every amateur competes? Media ratings would not be good just like the poor returns of holding "every" stock. Unlike the sports media, the financial media focuses on market "averages". Imagine Wimbledon including every owner of a tennis racket. Most matches would end 6-0, 6-0, 6-0 but would it change the tournament winner?<br />
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$7 billion is bet on the Super Bowl, almost all without thorough systematic analysis. Larger amounts will be bet on the soccer World Cup. The favorite is usually overpriced in most sports. Another anomaly, among many, is geographic bias. Many gamblers favor the team whose name they geographically most closely identify with, even when the owners, players, coaches and managers have no such locational origination. Those who invest or gamble based on emotion or patriotism are likely to lose money over time. Amazing how many throw money at teams from "their" city or country regardless of the odds. It is nice to arbitrage them though.<br />
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Curious the contrast of how unhedged betting on equity or credit markets is commonly regarded as "investing" but sports bets are "gambling". With skilled analysis, future winning teams and players can be identified, as can winning stocks. Short selling the losers is even better. Sports offer no beta, just like stocks(!), but there is plenty of absolute return available if you know what you are doing. You won't always be correct of course but all that is required is a small forecasting advantage. The odds reflect the crowd's perception of winning probability NOT the actual probability. Variant perception - the crowd must lose over time to those with more information and sophisticated analytics.<br />
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Sports produce a vast array of statistics, which with the right tools can be datamined for PREDICTIVE information. Take horse racing. I know quants who have taken serious money (USD 100 million+) out of only Tokyo or Hong Kong horse racing. Most bets are made based on the lucky number of the jockey or the feng shui of the stables or another irrelevant metric. Such illogicality allows the rare skilled, disciplined bettor to arbitrage the many unskilled and irrational.<br />
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In every sport, teams build up a database of results. Drilling down, each individual player or horse builds a career track record. Just like a stock, if you evaluate the data closely enough you will be able to make better bets than "random" would imply and arbitrage the prices of those who set the odds and spreads.<br />
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Nowadays with sports betting in reasonable size easy to implement and with significant global capacity, I would expect sports hedge funds to emerge. Before I entered finance I managed a private sports betting hedge fund. It will be fascinating to observe investor reaction to what, to me, has always been clear; making stock picks and sports bets is the SAME underlying investment process. Putting money on the Dallas Mavericks or Real Madrid is structurally isomorphic to betting on stock or bond prices.<br />
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Whether stocks or sports, it is a skilled quantitative and fundamental evaluation that enables accurate bets to be made after elimination of institutional rigidity and local or national biases. Develop an informational or analytical edge, make bets in many areas and arbitrage the emotional <a href="http://en.wikipedia.org/wiki/Arbitrage_betting" target="_blank">sports betting</a> crowd. There is plenty of sports alpha out there, globally.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-19441067739052435592018-02-20T15:48:00.000-08:002018-12-20T00:11:43.855-08:00Technology is moneyTime is not money. Technology is money. Information is money. Technology applied to information - data science - is money squared. The best way to predict the future is to invest in it. The only certainty is change. Good investors are inventing better ways to make money and disrupting the long only world that has failed people so dismally. NEW ideas have changed OLD strategies. <br />
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Creative destruction applies to investment innovation. There has been plenty of Darwinian natural selection in fund performance and survival of the fittest. Past returns are not predictive for future returns and market evolution means reliance on history is NOT applicable going forward. Investment technology benefits people just like other technologies so why ignore NEW things and hope to rely on the OLD ways?<br />
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Monetary policy should also take account of how globalization and capital flows have CHANGED the game. Economics is about maximizing the use of scarce resources and that includes how best to put money to work. The optimal utilization and protection investors' of capital are key to maintaining economic well-being. People respond to economic incentives. Performance fees INCENTIVIZE good fund managers to do a good job, work to MINIMIZE losses and control risks. <br />
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High compensation attracts the best people to set up and join the best investment firms. Responsible investing requires having the most skilled portfolio managers and traders taking care of your money. The 2 and 20 versus 0.20 fee debate is an example of how incentives lead to better products that more closely match INVESTOR needs. Index funds and "cheap" long only funds cost investors TOO much in bear markets. Pay minimum wage to fund managers and receive back minimum performance. <br />
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More information, lower trading costs, more liquidity, more computer power, new geographies, asset classes and financial products have enabled proper diversification. One reason buy and hold looked good in the PAST, although quite poor on a risk-adjusted basis, is that in earlier decades the costs of trading and information gathering were high. There wasn't much else to invest in other than long only but the range of opportunities TODAY is much broader. Long term performance is MUCH more important than long term holding periods. Some stock indices WENT up but WILL they now that financial markets are so different? <br />
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Formerly, many informational edges could not exceed the trading costs involved in executing the strategy but NOW they can. Commissions are lower, higher trading volumes mean less slippage and competition from national and global market deregulation have benefited ALL investors. Data gathering using machines with superior information processing capabilities have helped their human masters make and execute investment decisions. Financial innovation in the form of derivatives, structured products and hybrid securities allows risks to be sliced, diced and hedged as required. New strategies and assets have let investors FORTUNATE to be permitted to use them to get more diversified. <br />
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These benefits come with complexity which creates the need for "expensive" expertise in trading and managing these risks. Derivatives are useful trading and hedging vehicles OR weapons of financial destruction DEPENDING on the competence of those using them. Osaka rice futures and Chicago soybean futures have allowed farmers to transfer risk for generations AND built many traders' fortunes but have also wiped out many more unskilled speculators. Equity, interest rate and credit derivatives have been hugely beneficial to end users and competent investors but do damage if used wrongly. Fire has been very important to human economic development but fire in the wrong hands can be disastrous. We still need fire though. <br />
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Societe Generale's derivatives trader <a href="http://en.wikipedia.org/wiki/Jerome_Kerviel" target="_blank">Jérôme Kerviel</a> played with fire and lost $7 billion. I wonder if it would have been revealed if his rogue dealings had brought in $7 billion PROFIT? Curious how heavily regulated banks seem more prone to rogue traders than "unregulated" hedge funds. When it is your OWN money and own firm's reputation at risk you are more likely to catch unauthorized trading by the troops or question numbers that are out of line with margin limits. There have been a few hedge fund frauds although the premier meltdowns like LTCM, Amaranth, Bear Stearns were due to inexperience and lack of skill NOT rogue traders. You can't eliminate the possibility of losses but with proper due diligence and monitoring you CAN eliminate the risk of fraud AND incompetence in hedge funds. <br />
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I've written several posts about LBOs and CDOs but the products themselves are not to blame for losses anymore than credit derivatives. LBOs, pioneered by KKR, were a brilliant financial innovation but are too crowded now. The arbitrage has long gone. The issues that bothered me in recent years was their dependence on cooperative credit buyers, the strategy being too well-known and too much money in the "taking public firms private" trade. Similarly CDOs are potentially a great invention but it was executive arrogance, junk math, dubious pricing, mad modeling and ridiculous risk management that were the problems NOT the idea behind the products themselves. <br />
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The credit crisis is one factor that has led to the present economic situation. It looks like we are going to get some kind of stimulus package though whether it will be the catalyst for the necessary change in sentiment is anyone's guess. Rate cuts help banks with steeper positive carry, assuming credit worthy clients still exist and want to borrow, but the primary idea is that low rates spur spending and investors to move into riskier assets. <br />
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The possible flaw with this economic antidote is that when real estate and credit markets are performing even worse than stock markets then risk aversion can INCREASE. If your 401(k) statement shows a much lower number than the previous one and that house nearby just heavily reduced its asking price, a money market yield of 2% can START to look attractive compared with heading to the shopping mall or buying into the "stocks are cheap" sales pitch. Stocks can get MUCH cheaper but more importantly so can real estate. <br />
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Recession or not, stock markets ANTICIPATE problems and portfolio drawdowns change the economic outlook. Bear markets are "defined" as a drop of 20% but does it matter? A 20% fall is a huge loss already and needs a 25% rally just to get back to breakeven. So whatever economic scenario transpires, a fall of that magnitude for long only equity portfolios is not only unacceptable but also unnecessary. The appropriate use of hedging instruments and new investment strategies ought to have made such portfolio volatility obsolete by now. <br />
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Whether we are in a bear market or a recession is just semantic debate. Traditional equity, credit and real estate investors HAVE lost money and that WILL change behavior. The Fed has been criticised for "panicking" last week with a 75bp cut after heavy selloffs in Asia and Europe after the Societe Generale debacle but they probably had no choice given the circumstances. If Ben Bernanke had NOT cut, the US stock market would likely have lost 7-8% that day or 1,000 points on the Dow. Such a drop in a single day would have had a very negative impact on investor psychology. Central banks try to protect the economy and stock market fluctuations have a direct and immediate effect on economic well-being. <br />
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Doubly damaging is that not only have traditional strategies failed to preserve investors' capital but inflation is raising the cost of living. Reduced savings and less spending power are not a recipe for growth. Many analysts like to focus on a misleading metric called "core inflation" which EXCLUDES food and energy prices. So according to economists, as long as you don't eat, don't use any form of transportation and don't heat your home in the winter, insidious inflation is indeed "moderate"! For those of us outside the ivory tower in the harsh cold of the real world, let's hope stagflation is avoided. Six months ago some said credit contagion was "contained" and we know how that absurd assertion turned out. <br />
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Even if someone avoids new assets, structured products and hedge funds themselves I don't think anyone can dispute that such disruptive technologies have impacted market dynamics. You may dislike dark pools, derivatives, decimal point price increments, deregulated commissions and day traders as well but they have changed how securities fluctuate. A buy and hold investor is affected by new strategies and trading technologies whether they want to be or not. New ways of preserving wealth are like new ways of preserving health. But just as there are quacks and charlatans in medicine, there are plenty of good doctors in HEALTHCARE and talented fund managers in WEALTHCARE. <br />
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Financial and medical technology have other parallels. There was once a time when innovative surgeons were ridiculed for their "radical" ideas of washing hands and using anaesthesia before operating. Technological innovation in HEALTH management has benefited everyone. Why then in WEALTH management do many financial advisors remain in the stone age world of <strike>prehistoric</strike> "modern" portfolio theory? Hedge funds and derivatives are not fads and can assist in REDUCING market exposure BEFORE bad things happen. Portfolio immunization prevents economic diseases like recessions and inflation sickening investors. <br />
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"Hedge fund" is a loaded term these days so rebranding them simply as "diversifying skill-based strategies" would help. New investment technologies that seek, but do not guarantee, to produce absolute returns even if underlying asset classes fall apart. Some will deliver and many others won't but ALL investors need strategy diversification in their portfolios. As for "derivatives", they enable risk transfer from those that DON'T want an exposure to those that DO. Derivatives may be dangerous in the wrong hands but they are very useful and EVERY investor needs them. <br />
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Data-driven prediction and market anomaly detection are necessary for consistent returns. Systematic trading strategies like <a href="http://www.battleofthequants.com/agenda.html" target="_blank">quant funds</a> are in the news again because some weak models weren't properly tested for bearish conditions. Maybe it would be better to rebrand quantitative investing as carbon-based organisms outsourcing the more tedious aspects of security analysis, data gathering and trade execution to silicon-based organisms. Failing to make use of robust quantitative strategies and modeling techniques is a bit like refusing to use electricity or email. And why get one of those "unecessary" computers when sliderules have been so useful for so long? Society moves on. <br />
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Artificial intelligence complements human intelligence. Alan Turing didn't have financial markets in mind when he did his work but computerized traders can mimic and often "think" better than many human traders, thereby satisfying the <a href="http://loebner.net/Prizef/TuringArticle.html" target="_blank">Turing Test</a> as far as trading is concerned. It may be a while before computers can pass for a human in natural language processing or other endeavors but in finance the <a href="http://www.singularity.com/" target="_blank">Singularity</a> isn't near, it's already here.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-34821448369378505682018-02-01T16:08:00.000-08:002018-03-07T00:54:32.869-08:00Emerging marketsHighest stock market returns will come from: NOT WHERE YOU LIVE. National bias and portfolio patriotism costs investors so much. Always underweight or avoid investing in your "home" country. You have enough exposure just living there. World's top performers since 1900 were South Africa and Australia, frontiers then. Massive return opportunities were lost tying up capital in "northern" markets by geographically ignorant, domestically biased investors. Most pensions are at disastrous funding levels because they overweight "home".<br />
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Emerging markets? When India and China are the world's largest economies AGAIN, so what? They are 90% of the time. In most recent 2000 years, USA was biggest for 1, UK for 1 and China or India for 18. Other things being equal, the most populated nations MUST have the biggest economies. As recently as 1700 China and India accounted for 50% of global GDP. The so-called "Asian century" is simply reversion to usual state. Mesopotamia was also in Asia though it's currently called Iraq.<br />
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Markets offer alpha capture from short and long security selection NOT beta buy and hold. Emerging market beta? NO. Emerging market alpha? YES. Buy unpopular and short sell trendy. I've made the most alpha for clients short selling emerging markets but I've also had success investing in mis-valued securities in "obscure" places most "professionals" have never heard of. Buy when hotels in the capital city are empty; get short when they are full of "foreigners". Back up the shorting truck if they work for private equity firms and are in town pitching the local sovereign wealth fund.<br />
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While long only beta bets don't make sense, my PUPPIES portfolio, carefully selected securities in Philippines, Ukraine, Peru, Pakistan, Indonesia, Egypt and Sri Lanka returned +1,000% last decade. Ukraine bonds beat Ukraine stocks despite the PFTS being the top index so it was a NEGATIVE equity risk premium. Ghana continued to be negatively correlated. Cocoa and gold demand rises in tough times and vice versa.<br />
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BRIC? My <a href="http://hedgefund.blogspot.com/2006/03/future-stock-returns.html" target="_blank">CRIB</a> position, Colombia, Romania, Indonesia and Bangladesh, performed a lot better than that BRIC nonsense. Colombia has been an ignored superstar. Brazil, Russia, India and China offer long/short alpha opportunities but as to beta I have no interest.<br />
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BRIC for the future? Bolivia, Rwanda, Iran and Cambodia might be worth a bet and I've owned special situations in those countries. For a security to be a ten bagger, sentiment should be very negative when you buy. Preferably most people are unaware the country has investable opportunities. If you are scared of Iraq then Iceland is worth a look. Iceland imploded in 2008 but Ukraine and Russia were depressed in 1998 but two of the best performers in the subsequent decade. Take plenty of <a href="http://en.wikipedia.org/wiki/Salar_de_Uyuni" target="_blank">lithium</a> when investing in Bolivia. Like anywhere it exhibits manic depressive traits.<br />
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Emerging markets have emerged. The frontiers are now the emerging markets. Most investors take huge opportunity risk overweighting developed nations due to home bias nonsense. Why bet the country where you live will outperform? If anything you should underweight "home" to hedge your direct exposure to its economy. Why assume big markets will have the biggest returns? That is what "experts" recommend to their unfortunate clients. Optimists gamble on long only, realists hedge. Pessimists get even richer.<br />
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The efficient frontier needs the frontiers. Anyone treating emerging markets as an asset class knows NOTHING about emerging markets. Profitable short/long investment requires skilled country and security selection. Many investors missed high returns while enduring the uncompensated risks of "safer" domestic markets. No lost decade for portfolios that ignored "global" weightings.<br />
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<a href="http://3.bp.blogspot.com/_tzn0BqMHySQ/S2aZ_y0Pz0I/AAAAAAAAAFU/n4CIYgNxv1w/s1600-h/hobo.jpg"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5433199321720803138" src="https://3.bp.blogspot.com/_tzn0BqMHySQ/S2aZ_y0Pz0I/AAAAAAAAAFU/n4CIYgNxv1w/s400/hobo.jpg" style="height: 275px; width: 555px;" /></a><br />
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Most periods have been "Asian" since the Mesopotamia era when Iraq was the cradle of civilization. No doubt there were Babylon real estate brokers back then saying "House prices always rise over time". They don't. Subprime lending was around 5,000 years ago but few learnt the lessons. Those buying CDOs should have been looking at historical BIG DATA sets. Competent investors analyzed properly and got short. Most "correlation traders" used small sample sizes when they should have been looking at real estate time series starting in 3,000 BC.<br />
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Lost decade? For 2000s my pension grew nicely above actuarial expected return assumptions and at much less volatility than a risky long only portfolio. Not bad given the low market exposure and high manager diversification. I avoid traditional products due to the deep drawdowns and absence of skill so I use absolute return vendors for most strategies. Too many "experts" said avoid emerging markets and hedge funds! Absurd "advice" that has cost their unfortunate clients dearly. Investment science is more difficult than rocket science. I follow geographic FACT not economic THEORY and prefer cautious alpha sourcing to risky beta gambling.<br />
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Lost century? A year or decade is just noise. Long term conservative investors like me study centuries. Back in 1900 anyone would have been asinine to miss the ASS fund. Australia, South Africa and Sweden have had the HIGHEST real returns over the last 110 years. Note they were not heavily populated countries then or now. Given sales product groupthink and herd mentality I assume an ASS ETF is in the product pipeline though an EWA, EZA and EWD basket is fine assuming you make the assumption that past is future. I don't and have seen NO evidence that stocks are for the long run especially when everyone including famous university endowments need returns in the short run. <br />
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Global asset allocation based on capital-weighted beta is out of line with portfolio optimization. Any relative return benchmarked fund obeying global equity weights 20 years ago HAD to put 45% in Japanese equity beta and we know how that turned out. As elsewhere Japan is an alpha source and has been throughout the two decade bear market. Argentina in 1900 was a top ten economy yet was just downgraded from "emerging" to "frontier". Like every country Argentina is a place for smart alpha not dumb beta. Everywhere is "investable" if the margin of safety for reward exceeds the risk. I first invested in Armenia back in 2003. Since then China GDP growth 9%, Armenia GDP growth 11% but economic expansion is not alpha mining. <br />
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新年快乐! Learn Mandarin but only after achieving fluency in Zulu, Swedish, Australian, Ukrainian, Spanish, Russian, Portuguese, Romanian, Indonesian, Armenian, Hindi, Urdu, Bengali, Quechua and Sinhala? If so many already speak a language well would knowing it really be an edge? Perhaps but <a href="http://blog.wolfram.com/2010/01/07/global-hedge-fund-builds-enterprise-wide-data-management-system-in-mathematica/" target="_blank">mathematics</a> is the most useful language to master in the financial world. Yet so few speak it fluently or can apply it to REALISTIC models of the world - including most quants. It's time investors were less obsessed about asset classes and looked at strategies applied to alpha opportunity sets. Don't allocate X% to "emerging markets", fully invest in skill. It's not WHAT but WHO you invest with and let them decide where.<br />
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Not much changes in investor behavior. A famous quantitative guru was blown up by the first actively managed emerging markets ETF. Isaac Newton got taken for the equivalent of USD $4 million in 1720 with <a href="http://web.rollins.edu/~jsiry/South_Sea-Bubble.html" target="_blank">South Sea Bubble</a> shares. Isn't today's SPAC "a company for carrying out an undertaking of great advantage but nobody to know what it is"? Ignore labels, select good and bad listed and unlisted securities and hedge risk. I look for opportunities not asset allocation classifications but all countries are <a href="http://en.wikipedia.org/wiki/Emergence" target="_blank">emergent markets</a>.<br />
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Geographic constraints and arbitrary asset class names cost investors plenty. Why divide stocks into domestic and foreign? Why developed and developing? Or miss opportunities close to home? USA S&P 500 -1%, Canada S&P/TSX +5.6% or +9.1% in US$ but many USA investors completely missed Canadian stock market returns because they mistakenly split equities into USA and EAFE boxes. It is also time colonial, anglocentric terms like "Far East" were retired. On a sphere everywhere is far east of somewhere. I'm writing this in Beijing so New York is in the Far East for me, this week anyway.<br />
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Despite the archaic name, EFA is a good ETF for beta but it misses so much alpha available WITHIN its components. EEM and VWO obscure long/short opportunities INSIDE their security universes. The MSCI "World" has just 23 countries. Diversified? World? Even the ACWI "All-Country" World index only comprises 45. If you are a global investor then invest globally and evaluate opportunities from accurate perspectives.<br />
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GDP growth and investment opportunity sets are different. South Africa (nominal) and Australia (real) won the beta battle in the 20th century but are unlikely to ever be the largest economies even though much bigger in area than "European" maps show. You could have made similar arguments for the big <a href="http://www2.goldmansachs.com/ideas/brics/book/99-dreaming.pdf" target="_blank">BRIC</a> in 1901 as in 2001 and lost a LOT of money later. Of course things may be different this time! "Frontier market" beta is supposedly available with FRN but its largest holdings are in Chile, Egypt and Poland which are emerged in my opinion like many other former "emerging" countries.<br />
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Unprecedented times? The historical parallels of 2000s with 1900s are interesting. 1900-1903 bad, 1903-1906 credit binge, 1907-1908 severe credit crisis, 1908-1909 strong "recovery". Wasn't the <a href="http://en.wikipedia.org/wiki/Panic_of_1910%E2%80%931911" target="_blank">stock market crash</a> of 1910 brought on by failed attempts at financial reform? Weren't Russian and Chinese stocks and bonds considered core "long term" holdings in the 1900s? Anyone invested in passive "cheap" US equity index funds in 1905 would be waiting over thirty years for a sustained gain. That's good compared to the returns foreign investors in German beta would see: almost -100% twice. Of course those who invested in Germany in the late 1940s made good money though not as much if they had bought Japan.<br />
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The division between developed and developing is outdated. Having invested in Indian stocks from when I lived near Dalal Street and Chinese, Russian and Brazilian stocks since the mid-1990s why are they STILL classified as "emerging"? Nowhere can be emerging for ever. Given their major roles in the world economy, it is anachronistic to refer to these and many other countries as "emerging". All four had stock markets in 19th century. I saw a nice stock exchange in <a href="http://en.wikipedia.org/wiki/Old_Saint_Petersburg_Stock_Exchange_and_Rostral_Columns" target="_blank">Saint Petersburg</a> that was built back in 1810. Emerging for 200 years? I think not. Re-emerging maybe 15 years ago but mainstream now. Today's emerging markets are the frontiers. Today's frontiers are the pre-frontiers.<br />
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The beta mania hides the alpha available from security selection and arbitrage. Despite the "worst decade" claim, more than 100 USA stocks were up over 1,000% and many more went down to zero. The capital weighted S&P 500 -1% whereas S&P 500 equal weighted +4.54%. It was a fantastic decade for security selection in the USA. Same in Japan and Western Europe. Emerging markets or submerging markets don't matter when you seek alpha.<br />
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Risk free bonds haven't existed since the sovereign debt default by England in 1340. Nothing new about subprime loans to overleveraged nations. Thanks to financial INNOVATION we now have credit derivatives to hedge such risks. As I write this Greece is the "new" factor affecting markets yet Greece was in default for half the past 200 years. Everything is connected so everywhere needs to be tracked. Curious how "hedge funds" are considered so hazardous when "government bonds" have had a dire track record over the centuries. The true safe haven is investment SKILL not bonds. <br />
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Skill always has and always WILL have a great decade as there are more unskilled participants for the few skilled to extract the alpha from. In most countries public stocks, bonds, derivatives, futures, currencies, commodities, private equity and real estate offer alpha opportunities. Emerging markets "passive" long only is a bad idea if you wish to preserve your capital. Common sense investor Jack Bogle suggests "international" investing is unnecessary! Such advice is the antithesis of prudent diversification required in fiduciary portfolio construction. 10 billion would now be 45 billion to meet liabilities unlike the returns from his "low cost" asset allocation.<br />
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As a value investor the time to buy emerging market securities is when they are cheap and out of favor and vice versa for short selling. My best years for emerging markets alpha were 2008 and 1998 which were very negative years for beta. Investors want returns but that should not mean increasing risk by following the crowd. <a href="http://www.ipe.com/news/towers-watson-eyes-alternative-emerging-markets-beta_33769.php?s=emerging%20markets%20beta" target="_blank">Emerging markets</a> are not for buy and hold so it is sad to see repetition of such mistakes. Is it prudent to eschew bargain stocks but swarm in unhedged AFTER missing large percentages of the gains? The reason some thought there was an equity risk premium is because 1940-1980 was a bond bear market. Some say securities have no memory but it's the passive crowd that has amnesia.<br />
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Invest off the radar screen. The highest returns in a country are achieved when the flights to it and premier hotels in the largest cities have plenty of room. Start to sell when you can't get a reservation because the undiscovered has been discovered. My best investments have tended to be buying good managers in drawdowns and good securities in places "foreigners" aren't going. When I tell someone "I'm investing in X" and they look at me like I am crazy then I know I am on the right track. Liquidity is important but that doesn't mean the entire portfolio has to be liquid. I bought Vietnam <a href="http://www.economist.com/business-finance/displaystory.cfm?story_id=15580008" target="_blank">distressed debt</a> back in 1996 and sold out a few years later close to par yet even today the country is regarded as an "exotic" frontier. I haven't invested outside this planet yet but will this century in the final frontier. Moon and Mars ETFs?<br />
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Inertia investing is more common than momentum investing. Innovation and new sources of return are routinely ignored. Having missed a lot of recent beta from emerging markets, the performance chasers are piling in again to long only index funds when they could instead be reducing risk and accessing alpha in skill based managers. Risk averse investors will be better off in skilled emerging market strategies NOT unskilled long only. <br />
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Status quo investors continue to use normal distribution curves to "measure" risk and Black-Scholes to "price" options. Busy people keep to QWERTY when they could type faster on DVORAK keyboards. Most still look at the world as those famous Belgians, Mercator and Ortelius, intended them to so long ago. Anyone unaware that Africa AFK is 14 times the size of Greenland should not be investing anywhere. I have been to every African country and once travelled overland from Cape Town down to Casablanca and back. It is a BIG place whatever ancient maps and antiquated asset allocations claim. South Africa should be renamed North Africa. North Dakota is south of South Dakota on my maps.<br />
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There is a global alpha opportunity set out there. I don't know if this is another Asian century but it is definitely the Alpha century. Assets are abundant but skill is a rare natural resource with enormous growing demand. Alpha is more valuable than gold, oil, platinum, palladium, cerium or even <a href="http://scienceray.com/chemistry/what-is-californium/" target="_blank">californium</a> which sells for $27 billion a kilo. In contrast 2 and 20 for "emerging" investment skill is a bargain. I don't classify asset classes or countries into neat little boxes because they are all <a href="http://en.wikipedia.org/wiki/Stigmergy" target="_blank">stigmerging</a> markets in my experience. If you don't have a stigmergent analytical tool set, stop investing right now and find someone that does.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-51242071781238263092018-01-30T08:08:00.000-08:002018-02-21T23:47:23.113-08:00Passive index fadPassive fad will end badly. Manias ALWAYS do. Dumb beta index funds are just HIGH COST, HIGH RISK, low frequency trading strategies. Do you really think the stock pickers that ACTIVELY manage the S&P 1500 or Russell 2000 are the best? Why pay outrageous fees to ignore price and valuation, do no analysis, no due diligence, no risk management, no sell discipline, no hedging? What fiduciary duty for blindly trading stocks and knowing NOTHING about them? Is index investing prudent? Suitable as a fiduciary standard? No "prudent man" goes near "passive" toxic waste.<br />
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Buying a house? You hire a real estate broker. He immediately buys you 500 houses! Cost? He paid ANY price the owners want no matter how high. Quality? He bought blind. Suitable? Did he ask your residential goals and needs? Due diligence? Didn't visit any houses or neighborhoods. You tell him you are not happy. His reply: "Experts say passive pay any price, no due diligence is best". He then buys 2000 small houses for you.<br />
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Welcome to the wacky world of UNSKILLED index funds. Low fee, high cost. Higher risk. Would a genuinely prudent fiduciary actually invest beneficiaries' capital in such a dangerous "product" as a no analysis, no hedging, no talent index fund? Long only 500 is "diversified" or so unfocused as to be absurd? How about 2000? A single NON-PREDICTIVE factor called market capitalization drives their position sizing. Biggest house must be the best regardless of value?<br />
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Index funds GUARANTEE money to bad investments. Equity capital flows to and props up overvalued or dying businesses on a list (benchmark). And make even more loans to credit addicted corporate, municipal and sovereign debtors! Low fee is neither low cost nor low risk. Enough. No professional invests in index funds. None. While adored by ignorant "Nobel" economists, Jack Bogle, William Sharpe and others gamble away retail savers' retirement money. Speculative strategies like Bogle's absurd ideas have no place in diversified portfolios.<br />
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Jack Bogle, Wall Street darling, claims the high risk funds he markets are cheap. A compensation scheme masquerading as an investment strategy. No work so what justifies his exorbitant fees? Passive funds are expensive considering the severity of losses and years spent in drawdown destroying retirees' lives and wrecking pension liabilities. Genius salesman Bogle steals investors' precious time gambling on dumb lists. Cheap? I care about the total losses investors receive.<br />
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Unlike most, I take fiduciary duty seriously. That makes me sadly rare in the OCIO space. I don't risk a cent on Bogle's crazy retail garbage. He wagers on the biggest names and most addicted debtors while outsourcing ACTIVE security selection to index construction firms. They pride themselves on ignoring a stock's valuation or business prospects. Anyone investing in "passive" products is breaching fiduciary duty to themselves or beneficiaries.<br />
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Low cost? Nonsense. I wouldn't invest in an index fund if it PAID me 3% a year. Even NEGATIVE expense ratios would still make HIGH RISK speculative products unsuitable for prudent investors. He charges amateurs an outrageous 18bp for inflicting 50% losses! With such horrific drawdowns, Bogle's folly is uninvestable even if it was 318 basis points cheaper than what he claims is "cheap".<br />
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Markets are efficient, apparently, so security analysis is pointless? According to Bogle, hedge fund managers like Warren Buffett, George Soros and Jim Simons are just lucky monkeys. Bogle claims to be able to predict the long term future and urges you to gamble on his clairvoyance. Embrace the average as there is no skill? Expense ratios must be judged against net risk-adjusted returns and index funds have poor performance compared to skill strategies.<br />
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Name any industry where "average" succeeds over time. Capital preservation is the priority for any professional investor. Should we invest with dedicated, hard working managers that reduce volatility OR in a no work, unskilled speculative list of stocks S&P likes, with no attention to valuation or risk? Which would a prudent man REALLY chose? 2 and 20 for smart alpha is a bargain compared to 0.05 for dumb beta.<br />
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Deep drawdowns and high volatility are unacceptable. Better and safer ALTERNATIVES are the way to go. No-one can beat the market so Medallion's +35% CAGR after 5 and 44 fee returns were just luck? Bogle knows nothing about hedge funds but has strong opinions nonetheless. His dogmatic, uninformed preaching and bizarre faith in S&Ps ability to pick stocks. They don't know how to rate debt so why does Bogle think they are so good at equity?<br />
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Why endure the unstable returns and large losses of the unacceptably risky Bogle's folly when investment innovation has progressed far beyond the stone age world of unhedged buy and hold? Good hedge funds destroy index funds in terms of risk adjusted returns. Index funds obliterate peoples' savings in bear markets. Don't let Bogle's ludicrous "advice" blow up your portfolio or life.<br />
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The "average" is no place for YOUR money. Absurdly he says to ride out massive losses. That suits his penchant for expensive high risk gambling. Yet another 50% loss and destroying even more peoples' savings? The FDA would never permit a "cure" that kills so many but Bogle's "cheap" garbage is still allowed to infect portfolios. Bogle is just a bad Delta One trader. ENOUGH.<br />
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Bogle considers EVERY stock and bond to be worth investing YOUR money in as long as someone ACTIVELY decided to include it in some arbitrary benchmark. He says the largest stocks should get the biggest allocation regardless of valuation or business prospects. He thinks you should lend money to the most heavily indebted borrowers no matter how low the yield or high the default risk! Such thinking causes devastating damage to peoples' retirement plans.<br />
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Bogle loves risky index funds despite the availability of safer strategies. His firm charges egregious fees for passively doing nothing. No risk management or exposure reduction even during market crashes or economic meltdowns. Index dependent funds have no place in YOUR portfolio. The TOTAL COST is far too high. Avoid "low cost" beta and replace with "high value" alpha.<br />
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Index idiocy has infected many portfolios. Unlike Bogle, I require absolute returns above inflation no matter what the markets do. I won't let the volatile stock and bond markets destroy clients' wealth and liability funded status. They need performance in relevant - to them - time frames. On a value basis good hedge funds have the LOWEST fees and HIGHEST returns which is why cheapskates like me invest in them. I'm more conservative and cost sensitive than Bogle so invest in alpha instead.<br />
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Bogle says investors must always be 100% long only! Whatever the economic conditions, he thinks retirees, widows and orphans should speculate on markets. Trend following with no stop loss; Bogle is just a bad CTA. Is it sense to claim that security analysis is pointless or to criticize risk management and hedging? His speculative products' dire return on risk are unsuitable for conservative long term investors. Patience? Why wait when better ways to a secure financial future exist? Do you really want a manager's 500th "best" idea?<br />
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How can trillions in losses be "cheap"? After the S&P's many years below its high water mark and another -50% drawdown, I read Bogle's rant "The Little Book of Common Sense Investing". Who can afford to invest in such expensive, dangerous and WRONG ideas? People ought not to gamble their wealth away on the unskilled long only delta one products that Bogle pushes. No common sense in the book. Buy and hold everything in some arbitrary benchmark no matter what? It's a clear breach of fiduciary duty to buy securities with no analysis and ignorance of valuation.<br />
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There are safer and cheaper ways to invest than "passively" owning what some index construction firm ACTIVELY chose for capital-weighted "unmanaged" benchmarks. Why endure large losses and prolonged periods before a fund makes new profits? Index funds are higher risk and more expensive than real hedge funds. Passive "managers" rake in fat fees for poor performance, zero skill and disastrous drawdowns. <br />
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Index funds versus hedge funds is about PRICE versus VALUE and good hedge funds have proven their superior value proposition over many decades and after fees. It's time John Bogle looked at modern ways of managing money with an open mind rather than regurgitating misinformed views on absolute return strategies he knows nothing about. Skill-based funds whose consistently superior performance destroys his absurd philosophy. <br />
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Is it common sense to claim investment skill does not exist and investors should not try to identify better securities and talented fund managers? Not many people want to ride in a car driven by John Bogle. He would just place a brick on the accelerator, remove the steering wheel, gaze at the rear view mirror and await the nice destination he anticipates. No need to worry about ongoing risks and economic obstacles in the, according to Bogle, "certain" path to riches when huge capital gains loom in the so-called long term. <br />
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Anyone really using the "rules of humble arithmetic" doesn't put a cent in index funds. The empirical evidence overwhelmingly demonstrates the superior performance and safety of skill-based strategies over unskilled asset classes. And investors can diversify away systemic risk. That is why sophisticated institutions are moving to superior alternatives. It's the CHEAPEST liability solution.<br />
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Bogle says people should ride out drawdowns no matter how much client capital his preposterous products lose. Is it really "sensible" to suggest ignoring those 401(k) statements since they will supposedly be fine some day far into the future? John Maynard Keynes pointed out what happens in the long run so isn't it better to GROW and PRESERVE capital in the short run? Is it common sense to own every stock Standard and Poor's ACTIVELY manages in the "unmanaged" S&P 500 regardless of the underlying economic conditions and business prospects for each company?<br />
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The trouble with Jack Bogle is that he is too young and inexperienced. If he had been investing in the 1930s his love of long only would be gone. Keynes did well actively managing an absolute return fund in the depression. Is it prudent to passively hold value destroying corporations when you could be short selling or actively engaging them? Keynes said: "When somebody persuades me I am wrong, I change my mind. What do you do?" but Bogle says to buy and hold the constituents of an index no matter what. Dangerous "advice" that will cost investors dearly. The US market was lower in 1942 than it was in 1905. Could you wait that long? Huge opportunity cost. Some other indices went to zero as many will this century.<br />
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Successful investors like Warren Buffett "join" the pro-index brigade despite avoiding index funds themselves. This "Do as I say not as I do" is weird. Why does Warren have a quote on the book's cover supporting index funds when he manages a foreign exchange and commodities trading, arbitrage, event-driven, distressed securities, bid for Long-Term Capital Management, own a few stocks, multistrategy hedge fund called Berkshire Hathaway and has outperformed the S&P 500 since the 1950s? In actions, not words, Buffett's performance is an argument AGAINST indexing and FOR absolute return strategies.<br />
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Buffett's mentor <a href="http://en.wikipedia.org/wiki/Benjamin_Graham" target="_blank">Benjamin Graham</a> was also a hedge fund manager. Graham wrote that "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." Since index funds do NOT promise SAFETY OF PRINCIPAL, they are therefore speculative! "Don't take my word for it" as the Intelligent Investor himself would clearly have favored the hedging and limited drawdowns from quality hedge funds versus the lack of capital preservation of index funds. Long only performance is inadequate compensation for the RISK.<br />
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Bogle claims index funds are the "only way to guarantee stock market returns". Really? I think ABSOLUTE returns are what an investor needs, not guaranteeing their share of stock market crashes, damaging drawdowns, vicious volatility and sometimes decades of losses. There is no need to take outright market risk when there are so many inefficiencies and mispricings to exploit across global markets. Skill does exist and CAN be identified ahead of time and in my experience alpha is actually more reliable than beta. Strategy diversification, risk management and hedging against disaster are surely more sensible than the unhedged gambling that Bogle favors.<br />
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Risk tolerance? I have little tolerance for risk which is why I invest in good hedge funds. "Passive" products are simply too volatile and unreliable for conservative investors. Staying below their high water mark for so long is unacceptable especially when there are superior alternatives. John Bogle's followers were "lucky" to get back to breakeven TEMPORARILY after just 7 years compared to the 17 year drawdown from 1965-1982 or the devastation of 1929-1954. And check out 1905-1942 for a 37 year no growth nightmare. Should an investor have to endure even the possibility of waiting that long? 2005-2042?<br />
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I don't dispute that "passive" funds will likely outperform many, though not all, long only active managers over time. Skill is rare by definition. However that reflects the fact that UNHEDGED funds are too constrained and that talented fund managers are more likely to be at good hedge funds than long only funds. An AVERAGE hedge fund is not worth investing in but SKILLED hedge funds can be identified in advance IF you know what you are doing. Ben Graham and several Nebraska doctors backed Warren Buffett BEFORE his success as a hedge fund manager.<br />
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Hedge funds are not mentioned until "Funny Money" in a scathing, poorly researched, diatribe near the end of Bogle's book. "Too much hype"? Most hedge fund commentary is negative so what hype is Bogle referring to? Does he mean the REALITY of top hedge funds delivering absolute returns and preserving capital unlike the disastrous "cheap" products he pushes? Hedge funds don't just "invest in the very stocks and bonds that comprise the portfolio of the typical investor"; they use futures, options, derivatives, short selling, new kinds of assets and diverse holding periods to REDUCE risk. <br />
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According to Bogle, hedge funds offer "too many different strategies". That's a criticism? You need as many strategies as possible; it is a strength of the hedge fund industry not a weakness. Some hedge fund managers are successful and closed because their investors made far more. Index funds are the compensation strategy - you don't have to do much work but you still get paid that huge 18 bp for no work. And the extra layer of fees of a good fund of funds more than justifies itself in paying for evaluation, due diligence and monitoring of common sense investments like hedge funds.<br />
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The tyranny of fees fails to consider the product's value. Interesting how people get irate over hedge fund managers making a billion for doing a superb job while the firm Bogle founded levies exorbitant fees on $1.1 trillion and does NOTHING to hedge risk or avoid losses. For what you are getting in terms of risk-adjusted absolute returns the fees charged by proper hedge funds are CHEAPER than index funds.<br />
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The "low" fee charged for "managing" passive funds also obscures their enormous OPPORTUNITY COST for investors. While trillions have been languishing for almost a decade in index funds, vast money making opportunities have been missed. Such "common sense" is EXPENSIVE as investors await the assumed upward trend to reassert itself. Bogle also writes of the MIRACLE of compounding but fails to mention the MISERY of negative compounding that wrecked so many institutional and individual investors' portfolios. <br />
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Investing is NOT simple. Bogle cites Occam's Razor where the "easy" solution is supposedly optimal. William of Ockam has been misinterpreted and actually wrote "Entia non sunt multiplicanda praeter necessitatem". It is the simplest choice amongst VIABLE solutions that works. Index funds are too simple to be suitable for such ontological parsimony. The correct answer is multiple strategies within and across multiple asset classes and reducing risk as much as possible. <a href="http://en.wikipedia.org/wiki/William_of_Ockham" target="_blank">William of Ockam</a> would have seen quality hedge funds as the answer not the risky trap of just holding assets. Things are also more complex today; when Sir William entered Oxford University 700 years ago, long only real estate and commodities were the only investment choices available. Thank you for the simplicity of financial innovation.<br />
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Bogle argues for owning "all the nation's" publicly held companies. Which nation? All the companies? Just the biggest firms? Why just the public ones? Most companies are private. Good venture capital and focused (smaller!) private equity funds can offer excellent performance. By the time a company makes it to IPO a high percentage of its growth is usually over so why shouldn't investors access private companies. A stock that makes it to the rarified heights of the S&P 500 has already been a winner for many years and there have been many instances of index trackers forced into buying the top but they NEVER have the opportunity to buy the bottom. <br />
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Although considered "passive" the S&P 500 is quite actively managed as companies go bankrupt or get acquired. If you had bought the ORIGINAL 500 components in 1957 and held on with no adjustments whatsoever you would have OUTPERFORMED the "real" S&P 500 at slightly LOWER risk even though only 86 names survived over 50 years. That should be a very strong argument for TRUE buy and hold but John Bogle doesn't use it, instead pushing the frequently updated quasi-active index. <br />
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Innovation is always hated by salespeople with a vested interest in the status quo. Predictably Bogle is also not a fan of the equally weighted and fundamental indices that have appeared in recent years or ETFs. Bogle even thinks Exxon XOM and General Electric GE have the best stock price appreciation prospects; a sad consequence of cap-weighted indices is the biggest stocks get the largest percent of your money, regardless of business prospects or valuation. Surely common sense is for your cash to go to the BEST stocks not necessarily the BIGGEST stocks. <br />
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Why does the intellectual force behind passive capitalization-weighted indices urge a large active bet AGAINST global weightings? Bogle's "advice" to keep 80% of an equity portfolio in USA stocks is wrong, insufficiently diversified and logically inconsistent with his indexation argument. The world has moved on and such geographic constraints are not common sense. Investors need ALL of their equity portfolio allocated to the best opportunities wherever that may be. The USA is less than 45% of world market cap and the proportion drops each year. If an investor is a true Boglehead diehard then their portfolio should surely be in line with global market cap. 40% of equity in US stocks in the correct "passive" amount.<br />
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The Japanese Nikkei has, over the long haul, vastly outperformed the S&P 500 though of course not over the short or medium term. Even though still far below its high and having trodden water for so long, US investors would have done better holding Japan index funds for 50 years than US index funds. John Bogle does not mention this either and is generally quite negative on "foreign" equities.<br />
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Japan outperformed because decades ago it was an emerging market and offered similar VALUE to OTHER opportunity-rich countries today. Based on Bogle's relentless rules of humble arithmetic the dollar return on the Nikkei was MUCH higher than the dollar return on the S&P 500 so, according to his historical performance chasing logic, should not he be urging Japan as the common sense investment given his assumption that past is prologue? <br />
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Long term performance has little to do with long term investing. In fact some hedge fund managers with the best long term track records have the shortest holding periods. Steady capital growth does indeed the win the race but index funds are anything but steady. Good hedge funds are the reliable tortoise to the volatile and unpredictable index hare. Equity indices were designed to simply benchmark long only active managers; they are NOT a suitable product for conservative investors to actually put money in given the absence of risk management and high volatility. <br />
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You can read the <a href="http://johncbogle.com/wordpress/category/the-little-book-of-common-sense-investing/" target="_blank">John Bogle</a> blog. Common sense is going with investment skill and the hedging of risk not Boglehead nonsense. Investors need ABSOLUTE RETURNS, not EXPENSIVE "passive" products that are guaranteed to lose money in a bear market. Staying the course makes sense if you know the destination AND the route. There are safer vehicles for anyone's money than index funds. I track total returns for total cost and passive is just too expensive.<br />
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Bogle charges horrendous fees for zero work, speculating on stocks without any due diligence. Which is cheaper - paying a few basis points for 50% drawdowns, vicious volatility and years below high water marks or 2 and 20 for consistently positive NET returns above inflation, REGARDLESS of asset class direction?<br />
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<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-79911746299576304352018-01-08T20:08:00.000-08:002018-01-29T23:45:08.386-08:00Short sell passiveAll speculative fads end badly. Short sell passive beta, get long active alpha. Only for amateurs and suckers. No professional invests a cent in passive. NONE. NO analysis and NO risk management. Passive fails in ALL activities over the long term. Yale Endowment has 99% in ACTIVE strategies. Prominent hedge fund manager Warren Buffett has 99.99% of his wealth in alpha capture. Track what Warren or Yale do with their own money. No-one that knows what they are doing ever has or ever will go passive. Passive is ONLY for risk craving fools.<br />
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Big Short 2008? Jack Bogle's nemesis, <a href="http://www.elitetrader.com/vb/printthread.php?threadid=192953" target="_blank">Michael Burry</a> is not back working double shifts at the hospital because he actually bothered to analyze securities. Bogle is too busy marketing his "cheap" toxic funds so did ZERO DUE DILIGENCE! Index pimps do no analysis or risk management but charge fees anyway. Fees for what? Scion Capital charged only 2 and 20 to help clients achieve their retirement goals. Bogle stole years of peoples' time and wealth and inflicted massive losses from the 0.02 trash he sells. He has yet to apologize, admit his incompetence and the speculative bucket shop he founded is STILL allowed to operate despite 50% drawdowns.<br />
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Bogle gambles on dumb lists of securities NOT carefully selected stocks from prudent analysis. Bogle bet trillions on the absurd notion that S&P can pick stocks or bonds they were paid (by the borrower!) to rate "investment grade"! Incredibly Bogle has not apologized to clients and Burry for his staggering stupidity or for destroying so many hard working peoples' portfolios. No professional investor wagers a cent with speculators like John Bogle. Hard work, risk factor hedging and proper analysis are the ONLY way. Be delighted to pay the highest fees if the best hard working investors will accept you.<br />
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Greatest trade ever? If subprime CDOs had NOT blown up would The Big Long movies be made and books written? Buyers now called brilliant gurus for their perspicacity? Intermediaries excoriated for failing to disclose to loser shorts that winning longs bet against them? Would it have been news? Lesson for investors remains: caveat emptor, caveat venditor. Buyers, sellers be GRATEFUL to people betting against you. How else can alpha be made from them?<br />
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If credit had not imploded would <a href="http://www.valuewalk.com/wp-content/uploads/2015/05/2007_Subprime_Shorting-Home-Equity-Mezzanine-Tranches-1.pdf" target="_blank">Michael Lewis</a> have written "The Big Long" on credit bulls picking off clueless bears? Or Gregory Zuckerman on the "The Worst Trade Ever" how merger arbitrageur John Paulson went bankrupt style drifting into shorting subprime? Magnetar sucked into a black hole? What if Paulson HAD bought and then reversed to the short side. Would it have changed loan selection or credit rating? If I buy a security should it concern me if others are short? Should it affect analysis if others think differently?<br />
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Alpha capture is war and victors don't take prisoners. If you are uncomfortable with the FACTS of the zero-sum game then don't invest in anything. I love index funds as their risky unskilled gambling creates alpha opportunities for good active managers. I pity anyone speculating on long only "cheap" funds that do no analysis or risk management and squander 50% of client capital every few years. Why wouldn't you want your portfolio run by the best investors in the world? Or instead get suckered in by the unskilled passive pimps?<br />
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Could it be that skill and hard work can find misvaluations? Curious how passive zealots with their "random walk, security analysis is pointless, Buffett is a lucky coin flipper" mantra, say that Paulson, Magnetar dared to pick securities they correctly figured would fall in price! In an efficient market identifying such opportunities is impossible. Why should anyone be criticized finding overvalued, mis-rated CDOs. Thanks to such funds pensions, endowments and foundations have more to pay out their liabilities. Shame on unskilled long only funds that wrecked so many retirement plans and spending budgets.<br />
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Wary of "misleading" non-disclosure, I fled to the relative safety of stocks. I selected 500 overpriced reference securities to bet against. Luckily some quantitative geeks had already structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary failed to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the salestrader herself confided in an email that she was bearish at that time but her function was facilitating transactions regardless of personal or her firm's market positions. Anyone long SPY, an ETF asset-backed security, and not made aware of my short has recourse to complain that they didn't about my short? Ridiculous, but that is what some "smart investors" are trying with CDOs.<br />
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Deception? Designed to fail? For EVERY purchase there MUST be a seller. I wonder about that fateful meeting. Would buyers have walked away if the marketing materials had stated on the front page in bold red ink "A merger arbitrage fund you likely haven't heard of with no known expertise or track record in credit helped choose the underlying loans and might bet against them". Or proprietary traders at this moment happen to be bearish on subprime but they have been right AND wrong in the past". How might this have changed investor appetite? Lists of shorted stocks are published but does this make every long get out? Never buy IPOs as insiders are selling? <br />
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There are ALWAYS bears on anything. If there are no bears get short immediately! If then unknown Paolo Pellegrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an outlier opinion ignored by the street. Even I wrote several bearish posts in early 2007 and investors that followed that advice have made very high returns but most ignored those too.<br />
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Today I naively took the risk of renting a car. After closing the deal I was shocked to see vehicles coming in the OPPOSITE direction. NO-ONE TOLD ME. The salesperson said nothing and the documentation had NO disclosure about this risky two-way flow. More due diligence revealed that despite heavy regulation and licensing, these dubious inventions KILL over 1,000 people EACH DAY from such collisions! Again zero mention in the legal paperwork. Did the arranger commit fraud by failing to inform of the dangers? CDOs can't be traded by most individuals but calamitous CARs are still widely available to the public. Why? Where are the regulators? Get these murderous C-A-R things off the street, NOW.<br />
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If I had an accident could I claim they had selected a car they "knew" would crash or would it be outcome bias? Subpoena to Congress those merchants of mayhem and dealers in destruction like car rental firms? I even saw a "rogue" employee knowingly bet against me driving north while I headed south. Such conflicts of interest and idiotic innovation needs to stop before even more people die in toxic tort products known as cars. Ban derivatives trading so ban driving since it is much riskier? The world thrived for a long time before "monstrousities" like C-D-Os and C-A-Rs were created. Get CDOs wrong and just lose money but outlawing CARs would save millions of lives over time. <br />
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Alpha battles have casualties. Finding alpha is a zero-sum ADVERSARIAL game of losers AND winners. Zero-skill, crowded beta is "cheap" but insightful analysis and variant perception costs 2 and 20 or more. Contrasting views make a market. It is dumb and suboptimal to presume a counterparty is looking out for you when they take the OTHER side. That is why they are called COUNTERPARTIES. The juxtaposition of ideas helps prick bubbles earlier than a one-way market. If I buy I WANT as many smart people as possible hoping I am wrong. If I short sell I am most comfortable and make the highest returns when sophisticated professionals are buying and A-list analysts regard it as a core long. PLEASE, PLEASE EVERYONE BET AGAINST ME.<br />
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You can ONLY produce alpha when others lose. Therefore it is essential for others to oppose you. Longs need shorts and vice versa. The most alpha appears when most are wrong. A rating of "strong buy" on a stock or "AAA" for a bond is just someone else's opinion. It is up to investors to do their own analysis or hire advisors working FOR them. Do your own due diligence or find someone to do it, for YOU, that has the rare expertise and whose interests and INCENTIVES are aligned with yours. Cheerleaders cheer the team that pays them not necessarily YOUR team. It is not of the slightest interest to me that others have the opposite opinion except that the more there are the more likely I will be correct.<br />
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If I buy the more shorts the better since there is higher probability of a short squeeze. If everyone is buying, it is often time to short sell. Rather than being horrified that others think differently, it is excellent and favorable news. When I buy a security I assume and expect people are betting against me. If a market maker has a bid-offer spread and I take the offer, they are often left short temporarily if they don't have inventory. They are then technically betting against a client but does it matter? Any market participant surely knows there will be opposing positions. Investors are free to choose pure execution-only brokers or investment banks well-known to have large proprietary trading operations that may or may not be betting in a different direction. The only Chinese Wall runs just north of here in Beijing. <br />
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Would regulation and transparency have prevented the credit crisis? There have been many financial panics and real estate crashes in the past. Did CDOs and shorts "cause" those also? Why have there been worse ones where there were no derivatives or shorting? No security EVER trades for what it is worth; differences of opinion fuel all markets. If you short sell something you need as many people as possible to be bullish. Shorting rarely causes a security to go down. When you buy, the preferred situation is that many others are short. Exploiting the madness of crowds is the key factor for alpha. The more investors doing the opposite is POSITIVE if you have an edge. If you've done you're research it ought to increase trade conviction. If you don't have an edge why are you investing? Some think security analysis is a waste of time and <a href="http://aol.forbes.com/2001/08/06/070_print.html" target="_blank">John Bogle</a> was as accurate as usual in ridiculing hedge fund managers who bother with skilled hard work.<br />
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All deals produce winners and losers. For every buyer there must be a seller and often a short seller. Is it always necessary to disclose that others including originators might bet against you? And if they do should it change your view or rating given your analytical edge? If you are bullish surely more bears should make you more bullish if you are confident of your ability. Blame the crisis on 2 and 20 and deal structurers or the 2 and 28 ARM lenders? Or on the inevitable boom and bust, greed and fear of the crowd. Manage risk and invest in skill to survive PREDICTABLE cyclical behaviour. Variant perception is what creates value for clients. Some speculate on conspiracy and collusion but it is usually just the Emotional Markets Hypothesis at work. All securities at all times are wrongly priced.<br />
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Short selling does not make securities to implode. It can however slow bubbles from turning into superbubbles and potentially worse problems. It may be counterintuitive but short selling subprime may have prevented larger losses and bigger issues. Some argue that credit repackaging exacerbated and perpetuated it but do not explain earlier crashes and meltdowns. With only longs, the Japanese credit bubble of the 1980s happened without CDOs, structured products or hedge funds betting against it. Subprime lending was invented in Japan and the crash's effects still exist with the stock AND real estate markets 75% below high water marks. Short sellers and transfer of risk are positives not negatives for economic growth. Real estate booms and busts have occured for centuries. Sovereign defaults and bailouts are common yet rookies treat the Greek situation like it is unprecedented. Greece has been bankrupt more often than not since 1810.<br />
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One of the strangest results of the 2007-2008 post mortem was the slow motion reverberation from credit to equity. Even if you missed the credit short there was plenty of time to get short of equities. No-one could have predicted the crisis? Really? Many correlation "traders" short sold correlation at 0.3 and watched helpless as it gapped straight up to 1.0. Gaussian copulas absurdly assume constant default probabilities just like gaussian Black-Scholes crazily relies on constant volatility to allegedly "price" derivatives. The added complication with credit is the non-linear binary payoff. Either the debt is serviced or bankrupt. With low interest rates, yields often do not compensate for default risk. All an investor can do is their own analysis or hire an expert whose interests are the same as theirs. If you need a friend get a dog.<br />
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Full transparency: I am short many other asset-backed securities and credit structured products, however I might reverse and go long between 20 microseconds and 20 years from now. Whatever or whenever an investor buys or sells, it is PREFERABLE that others are betting the opposite way. To generate consistent alpha it is necessary to have counterparties with different opinions. It is obligatory for others to disagree with you. Their existence is mandatory for those <a href="http://finance.yahoo.com/tech-ticker/congressional-hypocrites-were-betting-against-stocks-as-country-collapsed-477789.html;_ylt=Aq6NIBd3j0eXnRzs3YkfQ1a7YWsA;_ylu=X3oDMTE2M2hvOWQ3BHBvcwMxMQRzZWMDdG9wU3RvcmllcwRzbGsDY29uZ3Jlc3Npb25h?tickers=gs,xlf,spy,%5Edji,%5Egspc,%5Eixic,qqqq&sec=topStories&pos=9&asset=&ccode=" target="_blank">seeking alpha</a>.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-1671383112503825032017-11-11T20:08:00.000-08:002017-12-26T16:19:55.600-08:00Are you diversified?NO you are NOT diversified because the way relationships and dependencies are calculated between allegedly "different" asset classes and securities is WRONG. Correlation metrics have nothing to do with achieving diversification. Most "experts" don't know how easy it is to prove that for any time series of any length, there exist infinite other PERFECTLY CORRELATED (+1.0) data sets but still INCREASE diversification. That simple fact invalidates Markowitz-Sharpe portfolio "optimization". Trillions are wrongly invested due to dumb guesses, pathetic analytics, absurd assumptions, dubious advice and junk statistics.<br />
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Corollary also applies: infinite other data sets exist that are zero or perfectly negatively correlated (-1.0) but REDUCE diversification. Simple proof but ignored by the asset allocation crowd selling their risky ideas. No wonder most pension plans are in a disastrous liability funding state despite having paid massive fees for so-called advice and bad math. The efficient frontier is dangerously INEFFICIENT.<br />
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"Standard" deviations and the "correlation" contradiction render mean variance portfolio optimization nonsense. It destroys the premise upon which so many portfolios are supposedly risk/return "optimized". Pension consultants and investment "experts" are paid vast fees to conjure up elaborate correlation matrices which are USELESS even in the highly unlikely chance such "capital market assumptions" turn out to be correct!<br />
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Correlation estimates are worthless. What is the point of an elaborate correlation matrix - guesses on future correlations between asset classes - when the metric itself is FAILS to capture pairwise relationships and dependencies between those assets? If the guesses are wrong or right is irrelevant. I'm seen far too many "uncorrelated" strategies totally dependent on an "up" market. And good managers excluded because they had a "high" correlation.<br />
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Securities rising and falling together? Diversification has nothing to do with correlation. Correlation is a misleading metric of no help in portfolio construction. "Modern" portfolio theory is based on dangerously flawed statistics. Conventional wisdom is wrong: highly correlated funds CAN diversify portfolios but some "uncorrelated" strategies are dependent on market factors.<br />
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Correlation doesn't measure dependence. Below is a hypothetical fund with consistent reliable absolute returns every year and CAGR +17.65% but PERFECTLY correlated to the viciously volatile and unreliable S&P 500. Risk and return are unconnected AND uncorrelated. The fund provided great diversification despite calamitous correlation. More "sophisticated" tools like cointegration and copulas are also useless.<br />
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<a href="http://4.bp.blogspot.com/_tzn0BqMHySQ/TJbEgCX7uEI/AAAAAAAAAGE/euT9TDvk85o/s1600/geoalpha_20456_image001.gif"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5518814448061233218" src="https://4.bp.blogspot.com/_tzn0BqMHySQ/TJbEgCX7uEI/AAAAAAAAAGE/euT9TDvk85o/s400/geoalpha_20456_image001.gif" style="cursor: hand; cursor: pointer; height: 275px; width: 555px;" /></a><br />
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So much for Markowitz and Sharpe. The converse is also true. A zero correlated asset can be completely dependent on the underlying. Check out something as simple as Y=X*X. Y has no correlation to X but depends fully on X. Plenty of "uncorrelated" products pretending to be "hedge funds" need up markets to make money. Why bother with closet index funds marketing themselves as "absolute return" products?<br />
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The diversification "free lunch" has been arbitraged away, at least in mainstream risky asset classes. The best way to diversify a long is with a short NOT another long. Diversify the right way not diworsify the old way but correlation is STILL used as a critical input for portfolio construction and risk management. Why?<br />
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During meltdowns correlations rise but now it occurs in "normal" market conditions as well, adding to risk rather than reducing it. Securities may move together more due to herding, ETFs and algorithmic trading. The passive mania forces benchmark components up or down regardless of value whether stocks, bonds or commodities. Hasn't everyone learnt the danger of "cheap" index tracking and its expensive cost?<br />
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Beta is often cited as a measure of volatility. But it's really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta security that is high risk and a high beta fund LESS risky than the market. Idiosyncratic risk isn't a risk; it's the idiosyncratic alpha you want. Alpha and absolute returns aren't the same. The textbook calculations of beta and alpha are based on correlation which, as the example above shows, isn't useful. The identification of true beta - dependence on underlying risk factors - and true alpha - value added through skill rather than luck - is much more complicated. <br />
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The omnipotent correlation matrix drives much portfolio "optimization". A bunch of inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On "up days" most stocks go up but they don't all rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don't mind if an investment has <a href="http://www.cnbc.com/id/39214118/page/2/" target="_blank">correlation</a> of +1.00, 0.00, -1.00 or anything in between. It's irrelevant. I do care it has minimal sensitivity to anything else in the portfolio. Sadly for investors MVO and CAPM have been shown to be simple, elegant and completely useless. MPT is pronounced EMPTY and is better called Mediocre Portfolio Theory.<br />
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"Modern" portfolio theory requires lots of wild guesses known as <a href="http://www.publicpensionsonline.com/public/images/2008%20long-term.pdf" target="_blank">capital market assumptions</a>, including expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor "results" speak for themselves. Those variables aren't robust, stable or likely to be accurate in constructing a long term portfolio.<br />
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I've kept track of such facile forecasts and the tea leaf reading so-called "experts" who made them. Pretty bad outcomes but those fortune teller predictions keep being used. We are ALL affected by assets being (mis) allocated in this failed framework. Unlike the crystal ball gazers, I find mispriced securities and safer strategies whose returns outweigh the risks. Is that so radical? At least it works.<br />
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Severe drawdowns are unacceptable. It is not surprising conventional wisdom has performed so badly with fake "Nobel" prizes awarded for such "efficient", mean variance "optimized" nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence.<br />
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So why is this stuff still used? Everybody knows everything so the markets are random, right? CMA causes almost as many problems as absurd actuarial assumptions. If you keep doing what you always do, you receive what you always get: growing liabilities AND declining assets. Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.<br />
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Dispersion? Every month reports emerge on how AVERAGE "hedge funds" performed. Those numbers are meaningless with such disparity of skills and zero-sum nature of alpha. Many public domain strategies are too well-known now so it is not surprising AGGREGATE alpha tends to zero. Skill is rare. The average hides a range of numbers from managers performing very well to many that did not. 2008 saw huge dispersion. The typical hedge fund lost -20% but over 2000 MADE money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of R-squareds, covariances and variances just don't make the grade. <br />
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The best sources of low dependence are diversifying by time horizon and spatially. High frequency trading continues to perform well. Amazing how the majority of portfolios still don't allocate to this reliable source of alpha. Last decade was great and returns have also been good this so-called "challenging" year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Despite many years of superior returns most investors avoid high frequency strategies! Perhaps "buy and hold for milliseconds" is the natural evolution from the archaic "buy and hold for years". Everything operates on short time horizons nowadays which is a mismatch with so-called "long term" investing. Instead I favor long term performance.<br />
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Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term "emerging markets" is often semantic arbitrage for countries that are actually developed. The big BRIC has lost badly to my BRIC but the SLIME has been the star this year. Sri Lanka, <a href="http://www.iranbourse.com/Default.aspx?tabid=70" target="_blank">Iran</a>, Mongolia and Estonia were missed by almost all international strategists. Could the geographic diversification strategy nowadays be to invest in places that don't offer ETFs? Don't asset allocate X% to emerging market beta. Invest 100% in alpha WHEREVER it can be found.<br />
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Unlike that unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistical parameters, I know that a properly diversified portfolio of the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver over time in all possible scenarios. Changing markets and <a href="http://fxtrade.oanda.com/analysis/currency-correlation" target="_blank">crowded trades</a> are no excuse for not being able to deliver absolute returns. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important.<br />
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Two investment products might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on underlying markets and focus on skill-based strategies. I prefer calculating co-relation and association metrics not coRRelations. High asset co-dependencies show the markets are even more inefficient. REAL strategy diversification is what investors need.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-4625915305892339682017-10-01T09:05:00.000-07:002017-10-28T00:16:17.848-07:00Quant hedge fundQuant is dead. Long live quant. Outperformance by GOOD systematic managers has been a consistent feature of skill-based alpha capture for over 250 years. However the area is highly kurtotic. 1% of quant strategies are good. 99% of quant strategies, including "passive" index tracking, are bad. There is no "average" quant fund.<br />
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Hedge fund geeks bearing greeks? Some models don't work so all models don't work? Quant is complicated so stay with "simple" beta? Humans do the programming at quant funds so it is their sagacity or stupidity driving results. It depends on the questions people ask their computers. If you input wrong questions with wrong assumptions then the "answers" will be wrong.<br />
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Computers can monitor the world 24/7/365. Their loyalty is total and they don't lose interest after buying the yacht, the Ferrari and the IPO for "permanent" capital. Computers analyze and react to information on a 100,000 securities in microseconds unlike a dumb, slow, sub 300 IQ human trader. Silicon-based managers can analyze new data, have the order in and executed before a carbon-based life form has even noticed. Are humans even good enough to make investment decisions nowadays? Let me know if you find one.<br />
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Computers also don't think they are "star traders" when they fluke a lucky profit. They don't take lunch, vacations or calls from search firms. They don't quit and try to set up their own fund with proprietary information and clients from their current employer. They don't have clandestine meetings with competitors. They don't complain about colleagues, clients or bonuses. They don't get sick or crash cars. There is a lot in favor of purely systematic strategies if they are good. It is amazing so many investors still avoid them.<br />
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Pablo Picasso once said “Computers are useless. They can only give you answers.” I consider quant strategies, including managed futures CTAs, equity market neutral, statistical and volatility arbitrage and high frequency trading strategies to be essential to include in ALL portfolios. The fact that they take rare skill and superior PROPRIETARY mathematical models to implement should not scare away any investor. Quant funds are "finished"? Nonsense. <br />
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I've heard many times that quant investing will replace humans but conversely I am hearing, yet again, that "this is the end of quant"! Both are wrong. There is nothing new about BAD quantitative models having problems. Implosions by "geniuses" include portfolio "insurance" of 1987, the mortgage-backed securities "models" of 1994 or Long-Term Capital Management's options mispricing "Nobels" in 1998. Just as there are good and bad human stockpickers there are good and bad human quants. Show me a fundamental strategy that hasn't run into a deep drawdown at some point. <br />
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The biggest risk taken by investors is KEY PERSON risk. A critical due diligence issue is human assets go home each day. Investing requires process rigor and eliminating emotion. I've invested successfully in thousands of securities and hundreds of funds for a long period of time. But I am not smart or quick enough to make investment decisions. My colleagues, silicon-based life forms Hitachi-san and Toshiba-san, were responsible for all the alpha we produced over the years. All I did was the programming. They did the work.<br />
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Due diligence on a quant strategy is EASIER than evaluating a fundamental strategy. I don't need to see formulae or resumes to determine if someone knows what they are doing. Computers are just an analytical and execution tool that every good fund manager uses to varying degrees. The darkest, least reliable and most misunderstood black box is the EMOTIONAL and therefore inconsistent human brain. <br />
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Hyperbole and generalization often lead to misunderstanding. Presumably that is why some financial "professionals" think quants are in a quagmire, derivatives are dangerous and leverage is lunacy. There are far more bad qualitative hedge funds than bad quantitative hedge funds so beware of the QUALIS as much as the QUANTS.<br />
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Some multistrategy hedge funds that couldn't unwind illiquid credit instruments were forced to unwind what was liquid to meet margin calls. The risk of mixing liquid and illiquid securities is one reason why there will ALWAYS be demand for single-strategy hedge funds despite the "expert" predictions for the dominance of multistrategy funds.<br />
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The situation was also exacerbated by rookie short sellers from the 130/30 newbie crowd panicking when their short positions began to tick up on the short covering. I wonder how many of them knew beforehand that short positions get LARGER as you lose money. I wouldn't be surprised if some of the less experienced 130/30 managers were temporarily more like 120/40 or even 110/50. Mandate infraction! NEVER let a formerly long only asset gatherer learn shorting on YOUR or your pension funds' nickel.<br />
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Funds of hedge funds that avoid all quant strategies are wrong. Intermediaries should earn their fees by identifying skilled and the unskilled managers NOT eschewing systematic strategies period. Process driven investment decisions are the foundation of EVERY successful fund. Given the large amounts of data that silicon-based computers can analyse if their carbon-based masters deign to provide it, it makes sense to outsource such work to them. If the strategy blows up, is the hammer or the handyman to blame? Computers are just a dumb tool that simply follows what a HUMAN decides to input and analyze.<br />
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Even odder are those investors who make an allocation to "quant" and then refrain from other quant funds. As if all quant strategies were the same! Investing successfully is hard. It makes sense to use every available tool. A systematic, replicable investment process using qualitative AND quantitative analysis is surely the foundation of any successful hedge fund, though how they weight the two varies. The simple fact is there are GOOD pricing and trading models around and there are BAD ones. It usually takes bear markets and volatility to show which is which. But whether the models produce positive or negative alpha is ENTIRELY up to human specification. Garbage in, garbage out or genius in, genius out.<br />
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Investors should be wary of everything. Considering the non-quant problems and dire risk management policies on display recently, the faith in the value of human discretion seems ironic. Sure there are plenty of poorly designed and badly tested quant trading systems out there as there are delusional pricing models but that does not preclude the existence of robust quant fund products. A computer making the trading decisions rather than a human does NOT mean an increase in systemic risk or a decrease in the persistence of a good strategy. It just puts the emphasis on ensuring the computer is making decisions in a different way.<br />
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With quant funds it comes down to the fear of the unknown and hatred of opacity. Discretionary investors can be reasonably open about how they pick stocks since the edge is the skill in implementing the strategy. Good systematic strategy developers cannot be so open since 1) the edge is the strategy 2) no-one outside quant will understand 3) other quants will copy or steal it leading to the inefficiency disappearing and trade crowding problems. The distinction comes down to whether the human decides or the computer, programmed by humans, decides. But is that really a distinction? If a systematic trading model needs adjusting or tweaking to "new" phenomena then it wasn't properly tested in the first place.<br />
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Any successful investment strategy needs a robust decision-making framework and elimination of emotions. The best way is a division of labor between humans that are good at gathering data and machines that are good at processing that data in the way a human asks them to do. The more short term the trading the more useful automatic execution and market-making technology is going to be. It makes sense that PROVIDED the algorithm has been put together competently to ask the computer to trade if time is of the essence. High frequency trading is very dependent on low latency and incorporating a human override in such strategies will miss opportunities. With high frequency the speed of execution and reduction of slippage often is THE profit driver. People wonder how Renaissance Technologies' Medallion Fund performs so well but it is clear where its competitive TECHNOLOGY advantages are.<br />
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Just because public domain quant strategies using the same methodologies will identify the same ideas and opportunities does not invalidate other proprietary methods. The models that ran into trouble - 1) find two paired stocks historically cointegrated and take the other side when they are X sigma apart or 2) throw every fundamental and technical variable you can find into the hopper and data dredge for patterns that worked in the past - are now very crowded. Apart from some now very large hedge funds - a few good, most bad, there were investment bank proprietary desks heavily in the statistical arbitrage and factor model strategies using higher leverage. <br />
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Models are only as good as the assumptions humans give them and the programmer's representation of reality. Unfortunately interpreting reality is rather complicated. To put it mildly, the facts have not been kind to the theories. If you code up some VBA, C++ or C# and tell the computer that we live in a nice "normal", "standard" world of rational entities that spend their days maximizing their utility and immediately changing prices accurately to incorporate new information then you WILL run into trouble. The computer only knows things that YOU choose to let the program know about. If you lose money beyond statistical expectation then that is a human error NOT computer error.<br />
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Few investment managers admit to using that big institutional no-no called technical analysis despite the fact that so many do. But calling it quantitative analysis is still ok...just. Yet another example of semantic arbitrage, like calling something market neutral when it isn't remotely market neutral. Humans using computing power allows detection of predictive structure and we've progressed far beyond moving averages, breakouts, candlesticks, RSI, MACD and Elliott waves. Technical analysts look at patterns of prices and volume while fundamental analysts look at patterns of earnings and book value. Growth investors are trend followers while value investors are countertrend. Are fundamental analysis and technical analysis that far apart or is it just a change of inputs to the model?<br />
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Computers are just a tool. Humans design "discretionary" investment strategies and they design "systematic" investment strategies. If they are good or bad is all up to humans. Whether they data mine the past or test hypotheses of the future is up to us. Computers are good at information processing but can only analyse the data they are given in the way their human masters designate. Quantitative risk management is only possible based on the factors input to the system; if the machine is blind to a new factor there will be error propagation of non-linear orders of magnitude. Computers are simple creatures; if you only tell them about bell-curves and the "rarity" of six sigma moves then they are obviously not going to perform well when 25 sigma moves inevitably come along.<br />
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There are no axioms or proofs in real world markets. Asset classes don't go to business school or finance class. A standard IQ test can be coached but the markets are an IQ test where the questions AND answers change while you are taking it! If you assume randomness and try to impose rationality on a deterministic, chaotic process like the markets then your models are wrong. Everything is connected so models that assume independence are headed for trouble. A good model is one that provides a persistent trading or pricing edge, can cope with a non-linear, dependent, varying risk factor world and whose underlying theory and equations have NEVER been published.<br />
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As simple fools, computers are not good at complex event analysis because most programming hasn't focused on that area. Unless its human owner has informed it that most CDO pricing models are wrong, that if A defaults then the chance of B and C also defaulting is MUCH higher than "assumed" and that there are a bunch of other people out there running very similar equity mean reversion programs, then the model won't pick up that maybe it should change things. It just follows YOUR orders.<br />
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Correlation crisis? If quants neglect to tell their computers that if a weaker player is forced to unwind then the opposite of what "should" happen might occur then that is also human error. If the computer doesn't know that liquidity is variable and can even vanish then whose fault is that omission? CDO mispricing was primarily based on the gruesome Gaussian copula model. Quick investment tip: never, EVER risk capital on any model that assumes a "Gaussian" world. Gaussian things make the mathematics easy which is why they don't work. Bank CEOs might bear that in mind; there are quite a few careers still being bet on the multivariate normal curve. "Passive" index funds rely on the ludicrous random walk Brownian motion supposedly exhibited by stocks. There no limit to human stupidity,<br />
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Even if you buy into this "normal", "independent" market prices nonsense, 95% VaR estimates mean that about 1 day every month on "average" you will lose more than that. While $480 million losses may look bad, on $10 billion notional it is only 4.8%. If the Morgan Stanley quants made the human decision to run $2 billion notional cash at 5X leverage, losses of that magnitude, while serious, are not beyond the realms of expectation. The valuation noise on large portfolios is going to be tens or hundreds of millions even in quiet times let alone market stress. <br />
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Strangely no heads have rolled at Goldman Sachs' Global Negative Alpha "hedge fund" despite squandering over $3 billion of client money on its disastrous trading "models". $8.4 billion losses, mostly from buying market share in CDOs and structured credit with little concept of risk or trading acumen, are another matter. The losses were entirely due to human decisions and inexperience as are many of the yet to be announced severe credit drawdowns from other firms.<br />
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Computers are at the mercy of what data their programmers choose to give them. Even genetic algorithms and neural nets rely on the system constraints, parameters and data sets provided by their controllers. Computers have solved simple finite systems like a chess game because it is a closed and rational problem. There is always an optimal move in any situation. But financial markets are much more complex, require decision-making under uncertainty and the rules change WHILE you are playing. <br />
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Sports and investing are similar. Hard work, talent and coping with variables that a computer, with current technology, is not able to handle. We are a long way from artificially matching the kinesthetic intelligence of a basketball or soccer player. I saw a robot try to play tennis recently; it wasn't very good. The intelligence necessary to master ball games is higher than that required for board games. Chess is easy but baseball and football require much higher intellect and computational prowess far beyond that dumb, clunky computer you are now looking at. Chess requires less brainpower than ice hockey or rugby, which both require faster data processing and analytics than ANY computer can currently achieve.<br />
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In financial markets computers are just an aid to human decision-making and will ONLY be that for a long time. Some humans create good pricing models and black box trading systems but other humans create bad ones. Due diligence on quali funds and quant funds, yes but avoid all of them? No.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-1148627229389740712017-03-09T00:00:00.000-08:002017-03-23T22:47:20.818-07:00Billionaire hedge fundOnly current and future billionaires are good enough to manage my money. I hire the best NOT the average. I require managers to be incentivized and align their personal portfolios with clients. George Soros and Warren Buffett got billions in their "paychecks" during 1990s for making clients tens of billions. Society benefits so much from talent making their skills available to others. Despite nonsense from media experts, true hedge fund billionaires got there mostly due to compounding their OWN capital in their OWN fund. Not from "high" fees.<br />
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Many top investors refuse to accept "outside" money but thankfully some do still endure the hassles. Jesse Livermore "took home" $100 million in 1929 which is far more than a billion in today's money. Highest compensation to any hedge fund manager was Munehisa Honma who often "trousered" $10 billion a year. Top hedge fund managers deservedly "pocket" billions for helping pensions pay retirees and foundations support good causes.<br />
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Speculators like Jack Bogle prefer dumb lists of stocks! Cheap index funds NOT skill. I don't know why as they are risky and expensive considering the heavy losses, limited "work" involved and lack of talent. Lose a big percentage of investors' hard-earned money? It's the market's fault not theirs, right? Who would invest in such toxic waste as an index fund? Two 50% drawdowns last decade and vicious volatility. The DB pension and 401k disaster is entirely due to the doomed passive fad and horrific asset allocation/fund selection.<br />
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Capital weighted funds are just naive factor models. Invest in stocks that have ALREADY gone up the most. Get someone to make a list of these stocks for a benchmark, track them, and then endure years below a high water mark. Would a prudent man invest in such a dangerous product as an index fund? No-one with fiduciary responsibility to themselves, their family or beneficiaries. Low fee is not low cost.<br />
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The S&P 500 is just a low quality ACTIVELY managed trading strategy. A hedge fund's franchise is in trouble if it loses money in even a single year but Bogle's Folly, the S&P 500 index tracker, gets away with high risk speculation that is unsuitable for any investor's long term financial goals. Avoid index funds because they cost too much.<br />
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Hedge fund managers that produce diversifying risk-adjusted returns in ALL market conditions are a bargain. Getting paid a few billion is fair for the value contributed to the wellbeing of retirees savings and pension sponsors in desperate need of RELIABLE absolute returns to pay absolute liabilities. But why do "hedge fund rich lists" treat investment gains on personal capital as income?<br />
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Incentives work. Hedge fund "salaries" get publicity but overstate what managers earn. Most "pay" is capital gains NOT income. You can't just take a firm's AUM and returns, plug in rack rate fees and get a "wage". Hedge funds employ many highly qualified people who deserve their share plus expensive technology to implement the strategies. Big "salaries" occur when high absolute returns are generated for clients.<br />
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Alignment of interests is rare in finance and benefits investors. People who aren't skilled enough to work at hedge funds join long only firms. The worst of the worst of the investment "management" industry run index funds. Do you want YOUR money managed by a cheap incompetent fool as John Bogle, David Swensen and Eugene Fama advocate? Passive is only for the pathetic. Choose the most expensive managers not the "cheapest" who lose so much.<br />
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James Simons, founder of Renaissance Technologies, was "paid" $1.5 billion last year. As with ALL real hedge fund managers he eats his own cooking. He is the largest investor in Medallion Fund which is the world's best quantitative hedge fund. The fund performed well so he had investment gains. It wasn't salary. Some "income" came from client fees but that reflects the demand for and skill entailed in generating CONSISTENT absolute returns. Senior management having SUBSTANTIAL personal assets in the fund is alignment with clients. <br />
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Financial engineering is no different to mechanical engineering in that you get what you pay for. Performance costs need to be assessed against the quality and engineering of a product. The <a href="http://en.wikipedia.org/wiki/Trabant" target="_blank">Trabant</a> and <a href="http://en.wikipedia.org/wiki/Bugatti_Veyron_16.4" target="_blank">Bugatti Veyron</a> are German cars. You could buy a Trabant for $100 but you can't buy a Veyron for $1 million. So which car is CHEAPER? Which has the better performance? The Bugatti Veyron is the BARGAIN if you consider the VALUE of the product. Which would you invest in? The Trabant index fund or the Veyron hedge fund? 2 and 20 for alpha is a great deal compared to 0.10 for beta.<br />
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Good hedge funds are cheap and index funds are a rip-off considering what investors receive. Medallion Fund returned 29.5% NET of 5% and 44% fees. The "highly respected" S&P 500 index fund made a derisory 4.77% this year, had a 50% drawdown again a while back, has STILL not made up for the litany of losses and yet charges an egregious 18bp - for what? Long term investors would have done better keeping their money in a bank than gambling their savings away on speculative "passive" funds. <br />
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An index fund "manager" on minimum wage is overpaid whereas Jim Simons, relative to his value, is undercompensated. Worrying about hedge fund manager "pay" is like refusing to use Google because Sergey Brin and Larry Page "trousered" over $5 billion each last year. If you don't like that "salary" then don't Google? If you don't want 80% of the profits a talented hedge fund manager makes for you then don't invest alongside them. There are plenty of "cheap" relative return and index funds out there to lose your savings in.<br />
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Are good hedge fund managers really paid so highly considering how well their clients do? That money is NOT salary. The hedge fund industry seems to be the only business that considers people successfully investing their OWN money as paid compensation. Those pay figures are not a wage. They are simply a measure of the increase in equity in their own hedge funds.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-15939541693807940592017-03-08T08:08:00.000-08:002017-03-18T12:47:17.634-07:002 and 202 and 20? A friend just ate at a famous restaurant. Experts say she was ripped off. Nearby was a much more famous eatery packed with satisfied diners. Food there cost a few dollars compared to hundreds where she ate. I asked about her decision to avoid "low cost" product but she said while aware of "cheap" fees, differences in SKILL, EXPERIENCE and VALUE were vast between 3 star Michelin chefs and McDonalds burgerflippers.<br />
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Personally I'm much more comfortable investing alongside talented people who either are or will be billionaires. I'm just along for the ride in their OWN portfolios where almost all their wealth is managed. To pay such a tiny entrance fee of a bargain basement 2 and 20 is a remarkable deal. In due diligence I require affidavits and my forensic CPA team to attest that founders and senior investment staff have minimum 80% of total wealth in the specific fund I am also investing in. George, Warren and most other REAL hedge fund managers easily meet that criterion.<br />
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Index funds and fast food price "cheap" due to the ingredients, work and talent that goes into them. I can't stomach the contents of either. Quality funds and top restaurants are capacity constrained. If you don't like superior quality avoid hedge funds and try the LOW FEE, HIGH COST crowd. Investors are free to take their chances in no skill funds. I'd certainly prefer if people DON'T invest in good hedge funds as AUM capacity is always a problem with talented managers. If others avoid, I can put even more capital with the best.<br />
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Bogle is right! Go with cheap unskilled. DO NOT invest in hedge funds. I need EXCLUSIVE capacity with skilled investors. Gamble your wealth away on long only and enjoy the vicious volatility and MINUS 50% losses along the way. Hard work, deep analysis and risk management are for losers, right? My clients are risk averse and need billions in capacity with quality managers. Cost is determined by demand and supply. There's vast demand for a tiny number of great hedge funds. Fees are trivial compared to their value. 2 and 20 for alpha is a bargain.<br />
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Good hedge fund = three Michelin stars, passive index fund = cheap fast food. 2 and 20 has become the skill-based fee standard due to INVESTORS. Low fees are associated with low quality funds. Pay peanuts, get monkeys. The next bear market will show (again) how EXPENSIVE index funds really are. Unlike Fama, French and Malkiel, at least McDonalds workers earn their pay. Tenured fools do not survive long in the real world they claim to be able to model.<br />
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Incentives work. Economic incentives are the foundation of any functioning industry. Index funds have poor risk-adjusted returns and devastating drawdowns in bear markets because they are NOT incentivized or good enough to manage risk. Do you really want the B-team managing YOUR money? Be very wary of funds that don't charge performance fees. The manager is stating he is not good enough to charge them. <br />
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I once asked a group of large institutions which of the following fee structures they would prefer for an otherwise identical fund. A) 2 and 20 B) 0 and 25 or C) 0 and 50 above a 10% hurdle. All, yes ALL, said they would choose A). They feared B and C might induce a manager to take too much risk. I've also seen two similar strategy hedge funds make it to a final selection "beauty parade" with the first charging 1 and 20 and the other 3 and 30. Guess who got the mandate? Quality rarely competes on price. Take a look at the "performance" of funds with no incentive fees! Hedge funds are an example of a <a href="http://en.wikipedia.org/wiki/Veblen_good" target="_blank">Veblen good</a>. The higher fees the more popular.<br />
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50% drawdowns and NEGATIVE real returns for over a decade are common with high risk index funds like the S&P 500. Get what you pay for. I've heard "fees are too high and will fall" for years but it never happens. Why should they drop? You can always find low cost INFERIOR products. In my experience hedge funds with low fees aren't top tier and just repackaging beta. Check out the abysmal risk-adjusted returns from "cheap" index and relative return funds. <br />
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Avoid funds that don't charge incentive fees. The manager isn't incentivized to manage risk or make money for YOU. John Bogle sits around destroying peoples' retirements with his absurd "advice". Investors need alpha because "cheap" beta is too risky. If you don't like "high" fees DON'T invest in hedge funds. It leaves more room for my clients that prefer absolute returns more than relative returns because they have trillions in ABSOLUTE liabilities to meet.<br />
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The capacity for a quality hedge fund is limited like getting a reservation at a good restaurant. MCD has lots of room and doesn't take reservations! The S&P500 risk-adjusted returns have been disastrous since 1957 but passive trackers charge outrageously high fees for the "work" involved. Why is such unsuitable, expensive, dangerous dreck still being sold to retail investors?<br />
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Price is what you pay, value is what you get. 2 and 20 fees for REAL absolute returns is a great deal. Demand outstrips supply but some investors still balk at paying for skill. It makes sense that those with the rare ability to generate alpha charge a fair rate for access to that technology. Alpha is like oil in requiring specialist expertise and equipment to locate and extract. Oil fuels airplanes and alpha fuels portfolios not beta if you are risk averse like me.<br />
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It would be great to have a stock market that went up 10% each and every year but we don't. It would be even better to buy a risk free bond yielding 5% above the inflation rate and be certain to receive back interest and principal but we don't have that either. It would be nice to live in a world where car and home insurance weren't necessary but they are. People pay insurance premiums to cover against bad events. Investors pay hedge fund fees to those FEW managers able to make money for them in tough economic conditions. <br />
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A listed hedge fund called Berkshire Hathaway recently issued a shareholder letter saying the 2 and 20 crowd is not worth it. That is obvious since talent is rare. The "crowd" cannot have skill, by definition. BRKA made "hundreds of millions" trading those apparent weapons of mass destruction called DERIVATIVES. Do as I do not as I say? The fee "debate" throws the baby out with the bathwater. As the hedge fund's manager Warren Buffett correctly wrote, "derivatives, just like stocks and bonds, are sometimes wildly mispriced". Surely those able to identify such anomalies can charge whatever fees clients are freely willing to pay. The crowd exists so that the best managers can arbitrage it. <br />
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If Warren Buffett can subsist on cherry coke and hamburgers that is his right and privilege but most people need more sophisticated fare in their diets AND their portfolios. No-one is forced to invest in hedge funds anymore than forced to eat at a good restaurant. People do because the after fee product is superior. It takes great skill to become a top chef and great skill to become a top money manager. Just like good food, alpha and outstanding risk-adjusted returns are worth paying for. <br />
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Hedge funds might appear to be portfolio deadweight during strong bull markets. It could even temporarily seem like an investor does not need them. The fees are "higher" and the performance will generally be "lower" comparatively when stocks are doing well. Hedging has a cost. Sophisticated strategies are also more expensive to implement. But such contentions fail to take account of the role of good hedge funds in achieving portfolio diversification, reducing volatility and monetizing true investment skill.<br />
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The fees for alpha stem from widespread investor demand but limited supply. Good hedge funds are rare but there are trillions of dollars of global money looking for a RELIABLE return higher than government bonds but with LESS risk than long only equity. Competent hedge funds more than justify their fees. Fund of hedge funds and other intermediary allocators charge a second layer of fees to those investors without the resources, time and expertise to do it themselves. Multistrategy is NOT multimanager.<br />
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There has been renewed attack on hedge fund fees recently. Some think they are too high so they avoid "expensive" hedge funds and take their chances with the enormous risk of long only equity. That is good for sophisticated investors since it leaves more room for those that understand the diversification value of SKILLED strategies. In a recent paper <a href="http://www.nytimes.com/2007/03/04/business/yourmoney/04stra.html?ex=1330664400&en=7ae785d60a8ea0b9&ei=5088&partner=rssnyt&emc=rss" target="_blank">Mark Kritzman</a> concludes that after fee performance of "all" hedge funds reduces their value to investors. So? We already knew the AVERAGE hedge fund isn't any good and does not merit its fees just like the AVERAGE restaurant.<br />
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Reliable alpha producers, after fees, CAN be identified ahead of time and that performance IS of great value to investors. However, it usually takes a bear market for investors to realise this. Mark Kritzman would have reached a very different conclusion had he used solely 2000-2002 or 1970s data. No-one disputes that if a fund makes 22% gross, the client would be better off if the fees were zero instead of 2 and 20. Next time you go shopping insist on paying only what it cost to manufacture what you bought. Good luck with that. And index funds don't seem so "cheap" when they squander 50% of YOUR money.<br />
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It surely does not take an empirical study to determine that 16% to the investor is not as good as 22%. What matters is that the 16% performance offers a new, diversifying source of return. 80% of mutual funds are likely to underperform their index and, likewise, 80% of hedge funds are unlikely to be alpha generators. There is no doubt paying 2 and 20 for repackaged beta is unnecessary but 2 and 20 for alpha is a bargain. <br />
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The fee structure of hedge funds will not change because there is no incentive to change and professional investors, unlike the mainstream media, look at the after fee RISK ADJUSTED returns. Whatever the critics and hedge fund replicators think, 2 and 20 is here to stay. Warren Buffett was able to charge 0 and 25 in his hedge fund because he was the sole employee and markets were less complex and competitive in the 50s and 60s. The "2" nowadays goes towards the higher strategy development costs in today's markets and paying the deep benches of employees now required by investors. I'd be the first to concede that the "20" should only be charged on the alpha, not the beta. <br />
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The AVERAGE gold miner probably won't find gold and the AVERAGE fund manager won't find alpha. Those who figure out a way to generate alpha deserve the higher fees since it is worth more than gold. Alpha is theoretically in vast supply but the research costs are high. This is where these "limited supply of alpha" people get it so wrong. Gold is also considered "rare" because no-one, yet, has invented a way to economically isolate gold dissolved in sea water, but the world's oceans contain billions of tons. There is lots of alpha out there.<br />
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Alpha is rare and expensive because very few will ever reliably find a rich supply or develop a sustainable way to mine that seam. But plenty of alpha is out there and investors will ALWAYS be prepared to pay a premium for the highest quality money managers. Just because alpha, oil and gold are DIFFICULT to produce does not mean they are not abundant. It's the extraction costs that merit that 2 and 20. "Cheap" beta won't do it and is too risky anyway.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-51161194020607429352017-01-01T06:44:00.000-08:002017-01-20T06:58:16.021-08:00130/30130/30? Hedge fund lite? Adding shorts is a step in the right direction away from high risk long only. But why slightly modify the performance straitjacket instead of removing it and selecting skilled managers to produce absolute returns in the best, unconstrained way they see fit? Invest in proper hedge funds. 130/30 will soon be yet another forgotten idea like portable alpha.<br />
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Adjust gross and net exposures as alpha capture conditions fluctuate. That means being 30/130 or 0/0 or 0/100 or any other split as market opportunities warrant. Investors should escape the outdated and uncompensated mania for beta. 130/30 is just another beta product and so is of NO interest to conservative investors like me. Any fund manager that won't go net short is unsuitable.<br />
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130/30 won't protect investors from a bear market. Given the 100% net long exposure, the "innovation" of adding 130/30 funds to portfolios is as useful as rearranging the Titanic's deckchairs. 130/30 is mostly about being able to put on significantly negative ideas on smaller cap equities which are precisely the stocks which have less borrowable supply, a higher lending fee and are more prone to short squeezes. The RETURN ON RISK for most 130/30 strategies is worse than 100/0 funds despite what the marketers claim. Those skilled enough to profitably short set up hedge funds NOT 130/30.<br />
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130/30 is not a hedge fund strategy and does little to help diversify a portfolio. Relative return is not absolute return. It might seem "cheaper" than a hedge fund but what are investors actually receiving? Anyone still wary of hedge funds should remember that "new" 130/30 products are considerably riskier than PROPER hedge funds. 130/30 strategies have higher volatility and WILL lose money in down markets. Short extension is about beta NOT alpha. It is time every investment mandate required fund managers to MAKE MONEY, not simply to fulfil some antiquated notion of "asset allocation". Absolute return is the way to go for a prudent fiduciary.<br />
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Why invest in 130/30 when there are better skilled strategies around with genuine alpha? Of course even in strong bull markets some stocks drop and the freedom to implement negative views on specific securities is mandatory for quality fund managers. So if an investor likes the idea of 130/30 here is what I would do:<br />
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1) Pick some good equity long/short hedge funds and put them in the equities allocation NOT the alternatives bucket. Hedge funds are not an asset class. Most equity hedge funds are long-biased anyway and provide enough exposure data to construct an overall 130/30 portfolio split. Same effect but MORE skill.<br />
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2) Allocate $1.3 billion to some good LONG ONLY traditional active managers. And put $300 million with some SHORT ONLY hedge funds. Construct your own double alpha 130/30 portfolio by accessing performance-driven managers skilled in selecting either good or bad stocks.<br />
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The main argument for 130/30 is that it supposedly maximizes alpha for a given level of tracking error. But does it? There is a lot of smoke and mirrors in that contention and conveniently confuses net exposures with gross exposures. The net market exposure is 100% but the gross exposure is 160%. With 130/30 it seems the CORRECT benchmark is often more like 1.6*beta NOT 1.0*beta. It is the common trick of making beta resemble alpha through leverage. <br />
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In a real hedge fund the net exposure of longs MINUS shorts offsetting each other can be the better metric but the way many of these 1X0/X0 are being presented longs PLUS shorts looks more applicable. Alpha is the excess RISK-ADJUSTED performance NOT any return above the unleveraged index. I doubt these products will exhibit less volatility than a normal long only fund. 130/30 are taking MORE risk than an index fund so their appropriate benchmark is not the 100/0 index.<br />
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Then there is the information ratio or alpha divided by tracking error. 130/30 only maximizes the information ratio if more alpha REALLY was generated as a result of that increased market exposure without a similar trade off in volatility. If the S&P 500 goes up 20% the chances are alpha was only generated ABOVE 32% (1.6*20) NOT 20% as they claim. In the dire panoply of misleading performance measures, tracking error targets are a sad example. Investors are basically saying to a manager "Please beat the benchmark by a tiny bit but not by a lot". Dumb.<br />
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Next time the S&P 500 drops 50% (and it will!) do you want a low "error" or a high one? The only thing obsessing with tracking error achieves is GUARANTEE that relative return managers follow the index idiots over the cliff. I think ALL fund managers should be hired for one reason alone: to make money into MORE money. If they have their own assets in the fund and are performance-driven NOT asset growth driven the interests with their clients are better aligned as is the inclination to hedge risk. Active risk is minor compared to the absolute risk of the equity market. <br />
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Constraints impede risk-adjusted performance. Good hedge funds work because of flexibility in dynamically altering their market exposures. Simply relaxing the no-shorting constraint a little doesn't help and neither does this active short extension or enhanced indexing nonsense. A manager should be allowed to be positioned 190/10, 100/100 or 10/190 and sometimes 0/0 all in cash) if they deem necessary. Active fees pay for market judgement and risk management more than anything else. It is worth noting that in a bear market 130/30 or 1X0/X0 asset gathering products WILL have negative returns. It is STRATEGY allocation that matters not minor changes to ASSET allocation.<br />
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130/30 products don't do much to diversify a portfolio. The STRATEGY is the SAME as 100/0; long biased stock picking but just with wider bounds on overweighting and underweighting specific securities. The argument is that it allows more meaningful underweighting of the smaller cap index components. But short selling also opens up issues that a shorting neophyte takes at least a decade to develop the necessary experience in. Short positions get LARGER as you LOSE money. The worst case scenario on a long is losing 100% but better risk control is needed on shorts given unlimited upside. <br />
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And there are the ongoing issues of a short sell candidate possibly not being available, being recalled, dividend payments and short squeezes. The adjustment from simply zero weighting a stock to a negative weighting is NOT trivial; it requires many years experience of ACTUALLY shorting. Some firms that have shown limited ability to produce alpha on the long side claim they can now generate "enhanced alpha" by having the freedom to operate on the more difficult - for them - short side. <br />
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130/30 is really a dispersion or equity correlation trade. It has been difficult for weaker traditional "quant" long only managers to produce alpha because the bull market led to low dispersion. They claim that by allowing 20-40% shorting it allows them to have a better chance of making some money. But why not allocate instead to hedge funds that have traded dispersion and correlation for many years? Why not use put options to implement the short side and avoid the complications of shorting? Why not equitize a 30/30 market neutral fund by overlaying an index swap or future yourself? Dispersion also varies; in a bear market correlation between stocks tends to be much lower. There are also ongoing issues of position sizing and weighting each stock in these more complex portfolios.<br />
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Why procrastinate with this intermediate step towards real absolute return mandates? Why put money in a non-diversifying, limited track record product where alpha is calculated on the net exposure while the risk (and fees!) are more dependent on the gross exposure? The ONLY tracking error that ACTUALLY matters is not to an arbitrary stock index but to the assumed actuarial return. In terms of matching assets to liabilities good hedge funds have the LOWEST portfolio tracking error.<br />
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Do the due diligence, pick some good hedge funds and let the manager decide how to vary their net and gross exposures. A truly prudent investor would not look at <a href="http://www.pionline.com/apps/pbcs.dll/article?AID=/20070514/PRINTSUB/70511052/1039/frontpage" target="_blank">130/30</a> when lower risk funds are available from dedicated specialists. Active extension funds have little to do with absolute return and the ONLY reason to hire any money manager, whatever the style, is for ABSOLUTE RETURN. 130/30 is another spin on relative return product lineup so why bother when YOU need absolute return?<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-37611057507515529282016-11-02T16:08:00.000-07:002016-12-01T21:40:43.108-08:00Yale portfolioDavid Swensen, a fund of funds manager for Yale, urges Mom and Pop into high cost "low fee" index funds because he argues they aren't as smart as he thinks he is. Meanwhile he gambles alumni donations on illiquid highly leveraged products. Most didn't see his obvious lack of strategy diversification and his mistaking of leveraged beta for skilled alpha. Long term institutions have budgets, student scholarships and faculty salaries to pay in the short term.<br />
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Endowment model was seen as a "solution" but it was deeply flawed and overexposed to market downturns. David Swensen, a well-known gambler who, for now, is still allowed to speculate with Yale alumni donations, took massive risks that have not been justified by the low returns his dubious wagers have generated. Hoping to be compensated for the non-existent "illiquidity premium" is dangerous and stupid.<br />
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The SHORT TERM matters because short term liabilities come due REGARDLESS of long term performance. Market fluctuations ought not to have a deleterious effect on capital growth or spending policy. Having too much tied up in illiquid assets makes it hard to be nimble to capture changing opportunities or BENEFIT from volatile market conditions. Flexibility, adaptability and liquidity are prerequisites for consistent performance. When liquid markets sneeze, illiquid assets catch pneumonia.<br />
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Short term volatility cannot be ignored regardless of ultimate time horizon. Among Swensen's many errors were not realizing that long term institutions need short term capital protection, volatility immunization, real diversification and minimized drawdowns. They also need liquidity to adjust to changing opportunities. The "alternative" assets failed to offer alternative performance. The RETURN ON RISK of Swensen's folly, even in the good times, was very low.<br />
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High frequency trading strategies would be far more suitable for Yale than the private equity dreck he adores. By his own admission Swensen is not smart enough to understand systematic strategies so he avoids them and further damages the endowment. Incredibly Yale has never invested in negatively correlated areas like high frequency trading, managed futures or tail risk strategies! Sadly his acolytes are now spreading the high risk disease to other endowments.<br />
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Volatility immunization and portfolio agility matter. The endowment model had little chance of achieving what universities, foundations, pensions, sovereign wealth funds actually need. Reliable absolute returns with capital preservation at minimum risk and maximum liquidity EVERY year. For that you need to hedge with proper strategy diversification. Assets alone do not have the necessary repertoire of return streams to de-risk a portfolio. You also need access to the expertise required for tactical trading, short selling and market timing.<br />
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I don't believe in static <a href="http://www.investmentnews.com/article/20090510/REG/305109976" target="_blank">asset allocation</a> and despite reading countless "seminal" papers have seen little evidence of its utility in achieving RELIABLE performance. Why focus so much on beta that fails to work in an alpha world? Such a blunt tool is ineffective for dealing with the sharp complexities of today's markets. It's an anachronism and fails to emphasize RISK. The world has moved on in financial engineering and portfolio innovation. As a conservative investor I favor skill diversification. It works if you know what you are doing and conduct proper portfolio construction and manager due diligence. <br />
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The endowment model's percentage in marketable alternatives, hedge funds, was too low while the allocation to long only non-marketable alternatives, mostly private equity and real estate, was too high. While asset allocation is about attempting to capture ASSUMED risk premia for a given risk tolerance, the endowment model increased the ASSUMPTION RISK by replacing liquid with illiquid. While you can generally hedge liquid securities, difficult with illiquid assets. Non-marketable alternatives must still be marked to market. Even if there isn't a market! Where was the scenario analysis and stress testing to construct a truly robust portfolio during a recession? <br />
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A dynamic investment opportunity set is not optimally captured with occasional rebalances to a policy asset allocation. Overweight alpha, not beta and certainly not illiquid alternative betas. Skill is the driver of outstanding risk-adjusted returns but asset classes don't have skill. Good fund managers do. The opportunity cost from overallocating to illiquidity was expensive. There is no long term; only a series of short terms which require competent navigation and risk management. Ride out deep drawdowns? No. Diversify to avoid them? Yes.<br />
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Long term investors still need short term returns. Long term performance neither requires nor implies a long term holding period. Some of the best track records have been by managers with short term strategies. Interesting how the same people who said you can't make money day trading now say too much money is being made in high frequency trading! Also the long term investor cannot ignore short term volatility or losses. University endowments survive for centuries but in the short term, professors and other staff have to be paid, spending budgets met and capital projects funded at the same time as alumni contributions fall due to the economy. Hedge for bad times!<br />
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CoRelations are more important than coRRelations. Many illiquid assets like private equity or real estate give the appearance of low volatility because they are valued infrequently. This creates the supposed low correlation to public markets. The disaster that was "Modern" Portfolio Theory favors such assets in a naive mean-variance optimization. But quantitative correlation measures do not give much insight into the coRelationships and coDependencies between risky assets and a risky economy.<br />
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While liquid security correlations infamously tend to 1 in down markets, the situation is exacerbated with illiquid assets that cannot be easily sold. Illiquid assets were often able to disguise their high coRelation because of delayed or overoptimistic valuations. However their dependence on a good economy was obvious ahead of time. The notion that liquid markets are efficient but illiquid ones aren't was always ludicrous. Some of the most widely traded and analyzed public securities are the MOST mispriced. <br />
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Real estate has been around a lot longer than stocks or bonds. It is not an alternative investment and relies on economic growth and availability of leverage. Real assets? Long only commodities is an even riskier concept than long only equity. Oil and gas partnerships fluctuate with the price of...oil and gas. Long/short commodities trading is safer. Many managed futures CTAs have demonstrated the ability to make money in up AND down markets. Gold and cocoa may be at highs as I write this but they are short term trading vehicles NOT long term investments. Inflation hedging? That's what TIPS and inflation derivatives are for.<br />
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Better <a href="http://www.forbes.com/2009/02/20/harvard-endowment-failed-business_harvard.html?loomia_ow=t0:s0:a41:g26:r26:c0.010484:b28148778:z0&partner=loomia" target="_blank">portfolio optimization</a> requires preparing for short term market tornados and long term economic ice ages. The endowment model carried almost no insurance against a bad financial climate. That is why substantial allocations to skill-based strategies that can make money in bad times are essential. Not enough short sales means not enough hedging. Derivatives are not to be avoided; they are MANDATORY for the risk averse. And the endowment model needed more attention to proper risk management, not basic VaR and CVaR stuff since much worse case scenarios than the assumed "worst" case have a habit of actually occurring. Most Monte-Carlo simulations and stochastic asset/liability models output too much optimism. That is not prudent for a fiduciary.<br />
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Despite all that <a href="http://www.reuters.com/article/domesticNews/idUSTRE5896EV20090910" target="_blank">alternative beta</a>, there was still a large bet on a good economy of rising equity, easy credit and real estate. Replacing liquid assets with illiquid assets relied on the notion that there is such a thing as a liquidity premium. Many investors, even now, expect to be "paid" for taking higher risk. Despite what the economics journals claim, there is NO link between risk and return. Just because "stocks" are riskier than "bonds" does not guarantee outperformance over ANY time period. <br />
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Substituting unleveraged long only public equity with leveraged long only private equity was asking for trouble but was widely popularized by the CIO at the Yale Endowment, <a href="http://en.wikipedia.org/wiki/David_F._Swensen" target="_blank">David Swensen</a>. Amazing how some people fell into such an obvious trap. Why overcommit to 10 year lockups and ongoing capital calls when there is so much alpha available in the VERY inefficient public markets? Private equity was a misnomer anyway; the correct term was private debt with a sliver of equity.<br />
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Construct a portfolio that can adapt to market conditions and achieve a RELIABLE absolute return at the LOWEST necessary risk. Hedge funds are NOT an asset class and do not fit into an asset allocation methodology. The only thing to overweight is SKILL not assumed risk premia. Client wealth can and should be protected and increased regardless of economic volatility. A bear market is no excuse for a diversified portfolio to lose money. <a href="http://stanford.edu/~wfsharpe/mia/rr/mia_rr2.htm" target="_blank">Portfolio choice?</a> Simple, choose alpha. Alternative alpha.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-4540346731861198102016-08-11T15:08:00.000-07:002016-10-17T23:02:09.588-07:00Hedge fund salaryHedge funds provide vast benefits to society. Foundations 100% invested in alternatives have more capital to give to charitable causes. Pensions mostly invested in proper hedge funds have better funded liabilities so avoid benefit reductions, raised retirement ages and higher sponsor contributions. University endowments fully allocated to absolute return gain more for student scholarships and faculty salaries. Wealthy families and ultra high net worth individuals give more to philanthropy.<br />
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Good hedge fund managers are underpaid considering the value they provide. Thanks to the superb returns delivered by skilled managers, investors large and small are able to achieve goals without exposing savings to the absurdly volatile stock market. Why risk money on unskilled stock and bond benchmarks? The value, functionality and consistency of performance makes hedge funds CHEAPER than passive investments on a long term value comparison. Chalkboard = index fund; Apple iPad = hedge fund.<br />
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Fiduciaries are required to ensure money is managed prudently. Index funds are obviously NOT prudent since they neglect to research securities nor attempt to hedge or even manage risk. Some investors take their chances with "low fee", high cost unskilled funds that do no security analysis or due diligence. Smart investors invest in skill strategies because AFTER FEE risk-adjusted returns are so much higher.<br />
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<a href="http://3.bp.blogspot.com/_tzn0BqMHySQ/S71FYBH_uQI/AAAAAAAAAFg/mWXvYvmEBxs/s1600/historyIndexmscistandard_5108_image001.gif"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5457594602364057858" src="https://3.bp.blogspot.com/_tzn0BqMHySQ/S71FYBH_uQI/AAAAAAAAAFg/mWXvYvmEBxs/s400/historyIndexmscistandard_5108_image001.gif" style="cursor: hand; cursor: pointer; height: 275px; width: 555px;" /></a><br />
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I'm a value investor and very conservative. I started by purchasing emerging and frontier market debt, equity and real estate far cheaper that its intrinsic worth. Also I spent many years buying deeply mispriced options, derivatives and hybrid securities in those "unpredictable" and "efficient" markets fantasized about by "Nobel" prize tenured(!) economists. Recently I've been helping clients construct portfolios of strategies run by managers whose fees are a bargain compared to their VALUE. The higher <a href="http://www.nytimes.com/2010/04/01/business/01hedge.html" target="_blank">hedge fund pay</a>, the more investors make. <br />
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Incentives work. We can be thankful REAL hedge funds exist to provide alpha when traditional investments don't. 2 and 20 incentivizes top managers to accept outside capital and build an institutional infrastructure when they could simply choose to just manage family and friend money. If you want to be sure of a secure retirement avoid long only stocks and bonds and focus on diversified absolute return strategies. Hedge fund salaries align the interests of clients with managers and reflect the enormous demand for and limited supply of true financial acumen.<br />
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Investors can choose old products or more powerful performance. Individual investors ALLOWED to invest in good hedge funds retire earlier and wealthier. Make clients billions and receive $1 billion for doing so is a win/win deal. Hedge funds provide deeper liquidity and act as a buyer of last resort thereby REDUCING market volatility. Making money in a recession is when alpha is needed most and what clients hired managers to do. <br />
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Those notorious "wages" mostly go to <a href="http://www.absolutereturn-alpha.com/Article/2464254/Blogs/SACs-Cohen-donates-50-million-to-childrens-medical-center.html" target="_blank">hedge fund charity</a>. Hedge fund pay is a kurtotic variable where fat tails render means meaningless. Rich lists miscalculate "income" and customers ultimately sign all "paychecks". Those delivering absolute returns deserve a share for making and saving clients far more. Funds below high water marks aren't paid well in drawdowns as the 20% incentive fee only applies to new profits. Necessity is the mother of invention and we need INNOVATIVE alpha sources and lower risk portfolios.<br />
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Successful hedge fund managers are entrepreneurs with an essential service in high demand. No matter how long a firm has been in existence I regard hedge fund investing as similar to venture capital. Angels that stake other private business get just 25%, and often less, of gross returns whereas investors in hedge funds receive 75% of gains. Managers retain the balance for sweat equity, 100 hour work weeks and low pay when underwater. Hedge funds make their talents and technologies available for a very competitive price. The value proposition is over three times better and with considerably less risk.<br />
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Positive numbers in 2008 and 2009 is impressive and over 1,000 managers did just that. "Aggregate" hedge fund returns are routinely cited but not AVERAGE hedge fund pay. In finance the average can confuse and disguise risk. Some CDO structurers mixed 700 FICO with 400 FICO scores for "average" default rates and a few managers figured out the dangerous result years beforehand. Some good hedge funds that lost money in 2008 worked nearly gratis last year with the 2% going to employee and infrastructure costs. Much "pay" was capital gains on own cash: shared upside AND downside aligned with investors.<br />
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Hedge fund managers able to deliver persistent returns could avoid many hassles by only trading personal, family and friend money. To use up capacity and endure the due diligence and monitoring to accept outside OPM cash it should be financially worthwhile. Many good hedge fund managers like <a href="http://scioncapital.com/" target="_blank">Michael Burry</a> close due to success and before reaching billionaire status. Reverse survivorship bias? Why do so many assume that a hedge fund that ceases to exist must have blown up? Are two of the best shows on TV, 24 and Lost, "failures" because they are also shutting down?<br />
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An unbiased qualitative and quantitative analysis of the FACTS shows that absolute alpha is a bargain. I prefer managers to make billions since investors will receive many more billions under that payoff scenario. Hedge funds don't exclusively trade for the superrich; they manage money or soon will be for most retirement plans and eventually a majority of individual investors of every net worth. Few on the rich list spend much time on static asset allocation. They focus on security selection, tactical timing and, most important, value creation for clients.<br />
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In other industries "change in net worth" is not "salary". <a href="http://www.businessinsider.com/meet-the-top-10-earning-hedge-fund-managers-of-2009-2010-4" target="_blank">David Tepper</a>, manager of Appaloosa, apparently received the highest "paycheck" of $4 billion, followed by George Soros at $3.3 billion, James Simons on $2.5 billion and John Paulson with $2.3 billion. They and their teams produced a lot of alpha and rightly received compensation for skill and shared capital alignment with investors. Given the anomalies and inefficiencies created by forced selling in late 2008, I wrote it was obvious 2009 would be an excellent year for alpha just like deleveraging in late 1998 and negative sentiment on hedge funds led to a great 1999. The hot money panicked but sophisticated investors saw the opportunity.<br />
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I am typing this post on my newly acquired Apple <a href="http://www.apple.com/ipad/features/" target="_blank">iPad</a>. That might help Steve Jobs be "paid" more billions but, like absolute return, the product is tangibly useful and fills a need. Similar to proper hedge fund managers, the Apple AAPL people deliver performance that most want so they get paid well. The Masters golf championship is being held today where someone will receive a lot of money for the best putting skill. Putt for dough and perform for dough since investment skill is much more valuable. Unskilled golfers don't play at the Masters and unskilled fund managers don't work at GOOD hedge funds. But hedge fund databases list thousands of hedge funds that aren't good, dragging down "aggregate" returns. Can you imagine the typical score at the Masters if every "golfer" played? 100+?<br />
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Performance net to clients is what matters. Wisdom surpasses wealth and fees for expert knowledge are more than justified. 20 years is a long time applicable to most investors. Below is the total return of the MSCI World versus hedge fund benchmark, the HFR Fund Weighted Composite. Clearly consistent outperformance net of all fees and the difference will be just as wide in 2010-2030. Considering the 80/20 Pareto rule of thumb I use that 80% of hedge funds do not generate alpha, investors with robust portfolio structuring and manager due diligence processes have done better and will continue to do so. Expertise exists at many levels and has great value.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-34898870878806170302016-08-08T17:39:00.000-07:002016-10-13T06:18:10.816-07:00Private equity due diligencePrivate equity due diligence to ask before signing up for the claimed "diversification", pumped up IRRs, high stock market beta, dubious mark to market valuations and massive leverage inherent in the vast majority of private equity funds.<br />
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1) A quant says she studied public market equivalents to evaluate private equity and found no evidence of your claimed portfolio diversification benefits. You:<br />
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i) If LPs invested in a public equity large-cap value index fund and borrowed 3X more cash and put that in also, they outperformed most private equity funds in most vintages. Please don't tell anyone leveraged buy-outs usually underperform leveraged public equity<br />
ii) Quants should creep back into their hedge fund hovels. We are a pure alpha generator. Beta repackager? Pure brilliance drives our performance<br />
iii) Our funds' returns are totally independent of the public markets and IRRs can never be transformed into time-weighted metrics anyway<br />
iv) We comply with "peer" return reporting and our LPs are delighted with the numbers we claim to achieve and muppets always commit to our new funds<br />
v) We avoid anyone with mathematical ability beyond third grade arithmetic. It would wreck our business model<br />
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2) Why is your firm IPOing an MLP when you claim a company being private is so good? MLPs are really for energy partnerships by the way not financial firms<br />
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i) We urgently need a public stock currency so we can short sell our founders' equity before it's too late<br />
ii) So we can take ourselves private again later. Only way to get the proprietary dealflow we claim to have access to<br />
iii) It's the master plan. Take all other companies private while we go public and the passive index crowd will only be able to buy us. We love John Bogle; he buys the toxic waste we list as long as it's in an index!<br />
iv) Permanent capital - ten year lockups at high fees for the repackaged beta we provide doesn't pay for the standard of living to which I have become accustomed<br />
v) Future carry monetization, getting out while we still can...anything else that sounds plausible to the unwashed consultant masses and sell-side analysts<br />
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3) Why did the private equity GP cross the road?<br />
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i) To avoid the roadkill of lending banks, default protection sellers and heavily indebted corporate dividend dreck he issued recently<br />
ii) Because there was an unemployed former head-of-state on the other side looking for another "marketing" sinecure<br />
iii) Trucks and SUVs cannot hit private equity GPs, just like economic downturns cannot hit us<br />
iv) Road? I always use the helicopter. I might buy roads but I don't use them. They are for common people not us genuises<br />
v) Because he saw a bunch of disgruntled LPs ahead, that had just found out that private equity is just an expensive form of unskilled public equity<br />
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4) The most important hire for a private equity firm is:<br />
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i) A former corporate titan with a golden rolodex who I met recently in Davos<br />
ii) A has-been politician who told you they have lots of global "friends"<br />
iii) Good-looking male and female fund raising placement agents. Sell the sizzle because we have no steak. Consultants urge brands not performance<br />
iv) Some associates pretend to do some actual work while I am out partying and pontificating and some bozo is visiting for onsite due diligence<br />
v) Anyone who can look at the balance sheets of our recent deals and doesn't vomit<br />
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5) What is the outlook for big private equity?<br />
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i) Big private equity deals are arbed out and the industry destructing credit cataclysm heading our way is getting bigger in the sky<br />
ii) Private equity? What's that? We are a hedge fund firm now<br />
iii) There will soon be no banks left who will finance the debt on our deals so we are reliant on dumber hedge funds that don't understand credit either<br />
iv) We are going to crush those hedge fund clowns although we ourselves use more leverage and take higher risk<br />
v) The day trading trash running hedge funds are bound to get it wrong if they try to step on our hallowed turf of long term private equity.<br />
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6) How many private equity people does it take to change a light bulb?<br />
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i) A syndicate of 10 private equity firms, 100 investment bankers and a 100 lawyers<br />
ii) Not applicable. My deals never fail and my light bulbs never fail<br />
iii) I think one of the underbutlers takes care of my light bulbs<br />
iv) Don't know. But the LPs pay for our light bulbs somewhere in the numbers<br />
v) CEOs of our portfolio companies change our light bulbs whenever we say so<br />
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7) What are you working on right now?<br />
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i) I can't talk about future LBO dealflow but, off the record, the tickers AMZN, XOM, MSFT, AAPL and GOOG could be available soon<br />
ii) sprucing up my resume to try to get a hedge fund job<br />
iii) raising a new fund and getting our own and portfolio IPOs out while we still can<br />
iv) Not much. We prefer to do deals just before carry fee calculations<br />
v) Selling an overvalued pre-IPO stake to a big Asian investor so muppets will think we have a proprietary pipeline into "Asian" deals. If only!<br />
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8) What is your outlook for the alternative investment industry?<br />
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i) LBOs are widely understood now. Corporations can take on debt and recapitalize themselves. Quick flips are gone and we have little to offer<br />
ii) Hedge funds speculate in synthetic securities, dubious derivatives and arcane assets incomprehensible to anyone without a Fields medal. Forget about hedgies<br />
iii) We've had a good run with institutional investors and our MLP IPOs permit some extra fun with retail as we exit the big private equity end game<br />
iv) "Absolute consent", "Yank the bank", "Snooze you lose". As long as we retain total control of every aspect of the financing behind deals we will be fine<br />
v) Who cares? My estates, planes and yachts will be secure after the IPO<br />
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9) Where have all the trade buyers gone?<br />
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i) Private equity people are supreme geniuses but trade buyers are just "corporate" bureaucrats that couldn't get a Wall Street job<br />
ii) Trade buyers have a thorough understanding of the valuations, prospects and risks for their industry and deep domain experience but private equity firms don't<br />
iii) Private equity funds have taken any potential strategic buyers private already<br />
iv) Private equity firms invite banks into the syndicate and pay higher "advisory" and fairness "opinion" fees than trade buyers<br />
v) Trade buyers acquire a firm when it makes a logical fit at a sensible price whereas private equity firms are a tad less choosy and a lot dumber<br />
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10) What do you think of your portfolio company CEOs, CFOs and chairmans of the board?<br />
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i) Are our partners in restructuring and realizing gains in a future public listing<br />
ii) Are required, by law, to work to maximize shareholder value<br />
iii) Were required, by us, to cooperate to minimize shareholder value to get the stock down to our target acquisition price<br />
iv) Must agree to pay us vast dividends, transaction and monitoring fees they can't afford regardless of EBITDA and financial strength<br />
v) Might receive a few crumbs of compensation that drop off our table. If they were that smart they'd be working here not there<br />
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Bonus question:<br />
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Fund A fully invests from day one and an independent administrator begins calculating accurate performance numbers. Investors have liquidity and access to all their compounded capital at worst a few month's notice. Even if the markets implode and the world economy collapses, Fund A still generates good absolute risk-adjusted returns. Fund A runs liquid strategies.<br />
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Fund B draws down your capital over several years. You must keep low yielding cash at hand because you don't know when the calls will come. It charges fees from day one but returns are calculated from when it invests. Investors won't know for a decade how the fund performed and even then it is not so clear. Fund B is dependent on good equity AND credit markets.<br />
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Should a prudent fiduciary seeking REAL diversification invest in Fund A or Fund B?<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-78616047671185231482016-08-03T17:28:00.000-07:002016-10-10T21:13:57.347-07:00Smart investorRich enough to reduce risk? Why are most people not permitted to invest with quality portfolio managers? Ancient 1930s laws make high risk long only available to anyone yet prevent Mom and Pop from accessing top talent. Why should their retirement plans rely on fund managers that don't have the brains, talent and experience to run a real hedge fund? Why "protect" retirees from the most suitable investment products? Who is REALLY being protected?<br />
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1. Freedom. How wealthy should one be to allowed to invest with top managers? The "accredited investor" amount must be REDUCED to give access to quality money management and proper portfolio diversification. Regulators are even attempting to RAISE the net worth required to invest in hedge funds! They should look at how the financial world has evolved since 1982 not simply inflation adjusting for "sophistication". Time is not money; information and innovation are money and all investors are WEALTHIER today in that regard. It's time EVERY investor was allowed to access better sources of absolute return. <br />
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2. Empowerment. Financial and technological innovation has empowered individuals of all wealth levels to make better investment decisions on a more level playing field. Investors have access to information that is vastly more comprehensive than 25 years ago. The ability to check out potential funds and managers is far superior. Back then there was no financial TV and no investment websites. No media coverage or scrutiny of hedge funds. Almost no third party evaluation and research on any fund managers. Adjusting for information and innovation there is now little need to "protect" the non-accredited investor.<br />
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3. Global financial innovation. In 1982 it was basically US stocks and US bonds for most US investors - large or small - but products and markets have evolved and almost the entire world is now investable. A much wider variety of assets and strategies are also now available but many require expertise to navigate. During the past 25 years, electronic trading and deregulation have made execution much cheaper making shorter term, higher frequency strategies feasible. Arbitrages that were not possible, due to illiquidity, high transaction costs or non-existent securities (at that time), are now tradeable. The relationships between different asset classes in different countries over different holding periods creates new money making opportunities. Why can't anyone who wants to benefit from financial technological advances in investment strategies be allowed to do so? <br />
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4. Risk management. Nowadays financial engineers have the product tools to eliminate or repackage many market exposures. In 1982 the ability to hedge out risk factors was very limited. Equity and interest rate derivatives markets were embryonic while weather, property and credit derivatives were over a decade away. The opportunity to reduce some risks and keep those you are skilled enough to take is the key financial development in the last 25 years. Why should retail investors only have available unhedged stocks and bonds? Why must the retail investment product industry ALONE stay stuck in the time warp of long only? Yes, managers with the skills to manage risk charge higher fees but should not people have the freedom to choose those funds if they want? Another word for hedge could be insurance, so why not allow retail investors to invest with managers who make an effort to insure their portfolios? Yes you CAN diversify away systemic market risk.<br />
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5. Risk tolerance. The risk continuum is cash -> bonds -> hedge funds -> long only equity. Good hedge funds are LESS risky than long only funds. However how you measure it, their VaR, or value at risk, is lower and the volatility of returns is less. The downside and drawdown risk is much lower and of course the Sharpe and Sortino ratios are far better. The performance in bear markets, in particular, is vastly superior. For the past 50 years hedge funds have outperformed long only products on a risk-adjusted basis. At least let risk-averse investors get a higher return than bonds without enduring the devastating losses and volatility of public stock indices, if they so choose. Just as some investors will prefer to remain in the hazardous stone age world of long only unhedged funds, should not others have the freedom to invest in risk managed investment products?<br />
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6. Track record. Back in 1982 stocks AND bonds had been poor investments for many years. Yet hedge fund managers like George Soros, Warren Buffett and others knocked the cover off the ball throughout the 1970s. The original accredited investor law came in 1933, yet the stock market then was lower than 30 years previously, while hedge fund managers like Jesse Livermore, Bernie Baruch and others performed outstandingly during that era. More recently better hedge funds made money in 2000, 2001 and 2002. Isn't it about time the proven ability of good hedge funds to make money in a bear market was made generally available? Isn't it logical that the mass affluent have a way to partially immunize their portfolios against 50-80% drops in the stock AND real estate markets BEFORE they do?<br />
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7. Retirement. Hedge funds in DB plans but not DC? It is inconsistent that hedge funds are deemed suitable for retail beneficiaries of defined-benefit plans but NOT defined-contribution menus. Many DB pension funds either have or are in the process of including hedge funds in their portfolios, because they recognize the return enhancing and risk reducing benefits. But today the move is to defined contribution and self-directed pensions. DC pensions infamously perform MUCH worse than DB pensions since they are not managed by a dedicated investment team, have higher fees, less diversification and no economies of scale. With DC pensions, individuals are out in the cold and their employers' bottom line is not affected. Why can't individuals, saving for their retirement, get added portfolio diversification away from long only and towards more consistently performing products. Every 401(k) menu should have, at the minimum, some good hedge fund of fund offerings. Make a portfolio of 50% bonds and 50% hedge fund of funds the default DC option. If an individual decides to gamble their retirement away on long only equity they can then choose to take that much HIGHER risk.<br />
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8. Hedge funds are NOT a threat to mutual funds. No hedge fund manager has the time, ability or inclination to build the massive sales, marketing, hand-holding and record-keeping infrastructure necessary to "go retail". Proper hedge funds focus on performance generation not asset gathering. But why should a financially smart, self-directed investor be precluded from putting some of their money, no matter how small, with their chosen hedge fund? Assuming the manager agrees, which is a big assumption given the desire for big tickets these days, what rationale does the SEC have for preventing consenting adults from doing this? Some retail investors would prefer to put their money with hunter gatherers rather than asset gatherers. Hunters are incentivized to perform successfully, otherwise they starve.<br />
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9. Complexity. Hedge funds are sophisticated and the instruments many of them trade require specialist expertise. Cannot all investors be permitted to access and pay for this skill? Retail investors should be allowed to properly diversify their portfolios with new, lower risk sources of return. The SEC assumes a negative net worth "natural person" who wins the lottery suddenly becomes an investment expert. Finance is complicated but so is surgery or flying a plane. Why do people have the freedom to find a good doctor or good pilot but not a good money manager? Also retail investors in many other countries are allowed to choose between long only funds and hedge funds, that compete side by side in a free market. The SEC could learn a lot from overseas regulators. Australians and Japanese can easily buy retail hedge funds. French retail investors pick them up with their groceries at le supermarché.<br />
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10. Administration. Hedge fund scandals have primarily been confined to the USA. The SEC could require ALL onshore US-domiciled funds to have INDEPENDENT administration and valuation. Almost all frauds can either be traced to fudging the valuation of securities or managers having total control of fund cashflows. In the offshore world, wire transfers from investors go to a NEUTRAL fund administrator and I don't see why this could not happen with ALL onshore funds. It is a safer check and balance for institutional, high net worth AND retail investors.<br />
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Fund manager selection does indeed require sophistication, but that applies to ALL strategies including long only. Unless an individual, of any wealth level, has the time and expertise to pick hedge and traditional funds themselves, they need INFORMED advice from those with the skills to conduct thorough analytical due diligence on managers and construct a TRULY diversified portfolio. The accredited investor rule has never justified the division of individual investors into "sophisticated" and "non-sophisticated", based on such a blunt measure as net worth. <br />
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Individuals are now responsible for their own pension investment decisions. Isn't it about time those who choose to were allowed to diversify return sources and reduce equity market dependence? Let's hope they don't have to wait until 2032. "Blogs are a great way to infer passion and depth of feeling" said Christopher Cox, SEC chairman, recently. He can read an overwhelming vote AGAINST restricting hedge fund investments to "smart" investors at the <a href="http://www.sec.gov/comments/s7-25-06/s72506.shtml" target="_blank">SEC</a> website. The SEC is receiving <a href="http://www.sec.gov/cgi-bin/ruling-comments?ruling=s72506&rule_path=/comments/s7-25-06&file_num=S7-25-06&action=Show_Form&title=Prohibition%20of%20Fraud%20by%20Advisers%20to%20Certain%20Pooled%20Investment%20Vehicles;%20Accredited%20Investors%20in%20Certain%20Private%20Investment%20Vehicles" target="_blank">hedge fund regulation</a> comments.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-1159284738438781052016-07-28T06:03:00.000-07:002016-12-01T20:22:53.772-08:00Big or best fundHedge fund due diligence? Many people confuse BIG with BEST. Investors are urged to put more in big companies than small companies! Why? They are even expected to lend the most money to biggest sovereign debt addicts? With hedge funds, there is almost no overlap on a list of the best firms versus the biggest. Media and consultants focus on big firms. Instead I focus on managers that will make me the most money in the future. Isn't that the point?<br />
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The AUM sweet spot for risk adjusted returns for most hedge fund managers is in the tens to hundreds of millions NOT billions. Over 90% of the world's BEST hedge funds manage TOTAL firm assets of less than USD 1 billion. In fact I typically advise institutional clients to redeem if a fund gets above that. Apart from the importance of proper due diligence that's the biggest and best lesson to learn from Amaranth and other blow ups/performance disappointments.<br />
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Hedge funds are dead. Long live hedge funds. Maybe I consult in the wrong circles but the pensions, sovereign wealth funds and other fiduciary institutions I deal with want a reliable +10% over the long term not ± 30% maybe. There was none of the widely predicted contagion as proper hedge funds either were unaffected or benefited. As in 1998 with LTCM, the demise of an incompetent firm created massive alpha capture opportunities for the rare skilled.<br />
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Due diligence issues: - Amaranth<br />
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We could all make a massive leveraged bet on one idea but is this what investors want given the possibility of massive capital destruction? The best meteorologists with the fastest supercomputers haven't a clue on next winter's severity so why did Brian Hunter think he had an edge? His energy trading strategy may have been dressed up with spreads, options and "sophisticated" theories but it just amounted to a long natural gas beta bet with scant knowledge of how energy futures actually trade.<br />
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1. What it said on the packet versus real contents. Amaranth was clearly not what it marketed itself as. Multistrategy is inconsistent with having 55% of the fund in what was, effectively, one trade. Hedge fund regulation would NOT have prevented this. Soon Nick Maounis and Brian Hunter will be on the road trying to raise money for their new "hedge funds". Securities markets have perfect memory but most investors themselves forget very quickly. No competent manager could EVER lose such a high percentage of client capital. And losing leopards rarely change their speculation spots. Myron Scholes, John Meriweather, Victor Niederhoffer...<br />
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2. Risk adjusted returns. Even when Amaranth appeared to be doing well on topline "performance", adjusting for the risk and leverage to generate those returns, real performance was lousy. Amaranth's returns, since inception, were due to luck NOT skill. I remember when Long-Term Capital Management knocked out +40% in 1995/96 and "experts" considered them geniuses. They should have been making at least +200% each year for the risks they were taking. LTCM's risk-adjusted returns even in the so-called "good" times were abysmal. Incompetent hedge fund blowups are just the manifestation of what occurs every day. The capture of alpha out of the unskilled by the skilled.<br />
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3. Inexperience. In the conference call Nick Maounis cited "unusual" market behavior, not expecting the market to go against us and no viable way to exit our positions in the market. This is the level of "expertise" clients were paying 5.20% and 20% for? There was nothing unusual about it and a trader's job is to expect the unexpected, diversify and manage risk. Any security that goes up a lot can go down a lot as any COMPETENT trader knows. If your exposures are too big for the market to absorb then the positions are WRONG. Before you get in any trade you have to know where the exit is. A world class front-office and technology infrastructure does not help if you give a box of matches to a moron.<br />
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4. Red flags. The signs were there IF you did your homework. Many independent fund of funds and advisors either took a look and said no or redeemed a while back. <a href="http://cms.skidmore.edu/yourvoice/sussman.cfm" target="_blank">Donald Sussman</a> founder of Paloma and former boss and seed investor for Nick Maounis, withdrew three years ago. Why did this not concern others? Businessweek magazine pointed out that <a href="http://www.businessweek.com/magazine/content/05_23/b3936115_mz070.htm" target="_blank">Amaranth</a> was basically charging a management fee of 5.2%! There are very few hedge funds that can justify fees that high and Amaranth was NEVER one of them. The end of the article includes a fatuous comment from consultants <a href="http://www.signonsandiego.com/news/metro/20061024-9999-7m24rocaton.html" target="_blank">Rocaton</a> who loved Amaranth incidentally. Perhaps they should have looked at the thousands of better hedge funds they routinely disdain. There's vast hedge fund capacity out there if you bother to look AND have the skills to find it which clearly Rocaton does not.<br />
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5. Style drift and uncontrolled asset growth. While I believe in funds evolving, innovating and diversifying into new strategies, Amaranth basically had a convertible arbitrage guy failing to supervise an energy guy and clearly neither understood the commodities markets or had the necessary trading acumen. Good hedge funds managing multiple billions across several strategies took 10-15 years to get there. Amaranth tried to short circuit the learning process required to grow into and manage such size. They never had the experience or risk management discipline to profitably trade in the energy markets. CB arb is basically a long gamma strategy while being long a natural gas spread is effectively short gamma; that's why I suspect Nick Maounis had no idea a big move would affect them so badly. In CB arb a large fluctuation in the equity, in EITHER direction, usually benefits you, assuming you've hedged the credit risk.<br />
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6. Drexel Burnham Lambert disease! "I am so good I want to trade from my hometown!". Out of sight, out of mind? Is Greenwich such a bad a place to live and work? The houses and winters are a lot nicer than in Calgary. Talent should be nurtured but "stars" usually end up compromising a firm's stability. Intermediaries always tell investors about onsite due diligence visits in their presentations but how many went to Calgary to kick the tires? Not many but that is what the second layer of fees is supposed to pay for. <br />
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An investor doing due diligence should interview ALL traders with significant P/L responsibility WHEREVER they are. If they encounter ANYONE who in their subjective opinion appears brash, they should under no circumstances invest no matter how otherwise attractive the fund looks. I know many good traders and I have hired and fired several brash traders, but I have never met a good, brash trader. NEVER.<br />
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7. OTC derivatives. When you can, ALWAYS trade on an exchange where you have many counterparties and some anonymity. If you try to keep things "quiet" by transacting big OTC trades, you lose liquidity and increase your risk. Investment banks crave hedge fund business but prime broking and commissions are NOT the main profit driver. The BIG money comes from the flow of information. Amaranth concentrated its large natural gas position with counterparties who were, in effect, competitors. The information provided was of great use to their proprietary energy trading desks. Hedge fund traders need to know that deals they do with counterparties CAN AND WILL BE USED AGAINST THEM. The NYMEX speculative limits are not just to maintain orderly markets but to SAVE traders from themselves.<br />
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8. Chief Risk Officer. In the conference call Nick Maounis reiterated the strength of his risk management team. I don't see how this can be reconciled to events; with a proper risk management process for a real hedge fund this could never have happened. How experienced is the CRO? How much independence does she have? Does she have mandatory position override if "star traders" exceed limits? Are there any limits? Is she compensated well no matter how the hedge fund performs? Is her compensation of the same magnitude (same number of digits!) as the senior portfolio managers? Brian Hunter was not a rogue trader; "management" knew his positions. Natural gas is infamously volatile and his inexperience jeopardised the entire franchise. VaR is pretty useless but even VaR would have flagged this risk as would a realistic Monte Carlo simulation.<br />
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9. Industry skill varies. Fund of funds and advisors, as with hedge funds, range from extremely good to extremely bad. The extra layer of fees is worth it IF AND ONLY IF that fee is earned. Ongoing monitoring and due diligence is MUCH more important than initial. Interesting how many independent fund of funds operators avoided the Amaranth debacle while several broker/dealer asset management arms were invested. Could the difference be when hedge fund selection and monitoring is your CORE business and you eat your own cooking?<br />
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10. Questions to ask intermediaries and advisors: Do you just sit back and channel money to the usual names instead of earning your fee by sourcing and discovering real investment talent? Is some spreadsheet junky doing the due diligence or is the fund being assessed by someone with years of experience in ACTUALLY trading that strategy? Does your management structure ensure the selection of mediocre, "can't be fired for hiring IBM", type funds? Are you verifying that a "multistrategy" fund actually is multistrategy? Can you differentiate alpha from beta? Are your recommended funds lucky or skilled and how do you know?<br />
<br /><div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-1143357673622311492016-07-27T23:10:00.000-07:002016-09-30T17:11:11.343-07:00Funds of fundsYou can't be too careful with hedge funds. We have large amounts to invest so all our managers are required to make daily visits to our conveniently located <a href="http://en.wikipedia.org/wiki/South_Pole" target="_blank">head office</a> for performance updates. We do rigorous background checks unlike mere F3s and F2s. Initial due diligence includes managers providing a pint of blood and pound of flesh for DNA analysis. We also require their great-aunt's, next door neighbor's second-cousin's original birth certificate.<br />
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The required 1,000 question RFP questionnaire sorts the wheat from chaff in the swashbuckling cowboy world, that media thinks exists in hedge fund land. All trades by F3, F2 and F1 managers must be pre-authorized by our byzantine bureaucracy with approval forms to be submitted in original notarized triplicate to the numerous F4 oversight committees.<br />
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We occupy vast amounts of F3, F2 and F1 managers' time drilling down in a paranoid display of obsessive verification. Private detectives monitor the entire life and habits of managers in excruciating detail. A red flag from preschool days will be grounds for exclusion from the F4. All managers' personal emails, phone and voice conversations are monitored. Live feed cameras are located in every trader's home so we can catch all those frauds the media is convinced are rife in hedge fund land. Ankle bracelets and a 24/7/365 security escort are mandatory for managers hoping to make it into our portfolio.<br />
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Funds of hedge funds? There are more than 10,000 hedge funds and over 2,000 funds of hedge funds. Choosing which FOHF has become as complex as selecting underlying managers. Now there are funds of funds of hedge funds, abbreviated to F3s or Fcubes. Due to insatiable investor demand it's time for F4 - the world's first fund of fund of fund of hedge funds. Solving the problem for investors on how to select F3s.<br />
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F4 hypercube will navigate the minefield, avoid headline risk and detect all those rotten apples in the F3 industry. The F4 won't repeat the mistakes that occur at F2 and F3 levels like confusing large AUMs with best future performance, channeling money to hasbeen favorites running dinosaur strategies or insisting that their funds were true alpha generators not the usual disguised beta bandits.<br />
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We are also working on a guaranteed F4 so that we can bury even more fees in the product. We have also locked up F5 and F6 trademarks and patents for when the business evolves to the obvious next level. Quintuple and sextuple fee layers are the next big thing. If you want to diversify away all sources of risk and return the F4 is for you. Avoid the complications and headaches of direct investment in <a href="http://www.investmentnews.com/article/20051003/SUB/510030716" target="_blank">hedge funds, funds of hedge funds and F3s</a>.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-71341703237938585872016-06-12T05:08:00.000-07:002016-12-01T21:43:52.036-08:00Hedge fund crisisHope 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.<br />
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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.<br />
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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.<br />
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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?<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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There is NOTHING unprecedented about recent volatility. Many long biased "hedge funds" closed as a result of the <a href="http://www.awjones.com/images/Hard_Times_Come_to_the_Hedge_Funds-Loomis-Fortune-1-70.pdf" target="_blank">hard times for hedge funds</a> 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.<br />
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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.<br />
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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?<br />
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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 <a href="http://www.forbes.com/business/2008/10/17/hedge-funds-redemption-biz-wall-cx_lm_1017hedgefund.html%3Cbr%20/%3E" target="_blank">hedge fund apocalypse</a> 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.<br />
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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.<br />
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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 <a href="http://www.economist.com/finance/displayStory.cfm?source=hptextfeature&story_id=12465372" target="_blank">absolute return</a> 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. <br />
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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.<br />
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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.<br />
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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 <a href="http://www.bloomberg.com/apps/news?pid=20601103&sid=aYUpBdvzdbBw&refer=us" target="_blank">hedge fund allocation</a> 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.<br />
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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.<br />
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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.<br />
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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. <br />
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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.<br />
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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 <a href="http://blogs.wsj.com/economics/2007/08/08/2007-vs-1998-better-in-most-ways-worse-in-some/" target="_blank">short stocks</a> and <a href="http://beta.minyanville.com/articles/GS-VIX-volatility/index/a/13723" target="_blank">long volatility</a> 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.<br />
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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.<br />
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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 <a href="http://www.businessweek.com/investing/insights/blog/archives/2008/11/every_stock_mut.html" target="_blank">asset class</a> for a long time.<br />
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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.<br />
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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.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.comtag:blogger.com,1999:blog-5403857.post-82034580983827412132016-04-01T06:22:00.000-07:002016-06-20T15:22:14.993-07:00Arbitrage hedge fundMore dumb money is invested in the markets than ever before. So there are MORE opportunities for hard working, smart people to capture alpha from all that dumb money. Experts claim there is no such thing as arbitrage as it supposedly would be copied and eliminated! They are so wrong. If you have the expertise and resources there are many profitable arbitrages on Wall Street. Markets are becoming even LESS efficient.<br />
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A common metaphor is that if a $100 bill is dropped in the street it would immediately be picked up therefore no arbitrage can persist. But what if YOU are the person that finds it? Someone will. What if you specialize in walking the streets 24/7/365 looking for drops? What if you spent some of your "high" fees on skilled employees and sophisticated technology to monitor more streets in many cities and countries?</div>
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What if you had low latency execution and modeled behavior so you could identify the streets with the highest probability of high value drops? What if your costs are low enough that you can make a profit from picking up $10, $5 or $1 bills - even quarters? What if your computers are so quick they can catch the cash BEFORE it hits the ground? What if you monitored areas no-one else had thought to look?<br />
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Nickels in front of steamroller strategies are silly ideas where "star" traders and Nobel laureates risk client capital for 5 cents and get crushed for billions. Arbitrages in the public domain do disappear. Transparency is the enemy of arbitrage. Opacity is essential. The arbs you want are $100 bills all over the ground and no steamrollers in sight. The best trades are waiting for easy money and just walking over and picking it up. Thanks to the passive mania there are many available but you have to be smart and quick to find them.<br />
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Skill and hard work are the edge. Secrecy, opacity and incentive fees keep the edge. NEVER invest with someone who isn't secretive. Avoid fund managers that appear in the media or don't charge performance fees. Just because 99.99% of financial "professionals" can't find good arbitrages, doesn't mean exploitable inefficiencies don't exist. THEY DO. Markets are very inefficient and many investors are predictably irrational so mispricings and anomalies reliably appear.<br />
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If an arbitrage becomes crowded it becomes hazardous. The risk/reward expectation changes from positive to negative. That is why demands for greater transparency are so dangerous. Sadly many weaker hedge funds in their craze for dumber money reveal far too much. Never invest in a hedge fund that reveals its positions to favored investors.<br />
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There are several hedge fund arbitrage strategies of which statistical arb, merger arb, fixed-income arb, capital structure arb, volatility arb and CB arb are perhaps the most well-known. Naive investors even think these are "non-directional" which is unfortunate as there is always some directional dependence inherent in a strategy. But within these categories there is a vast difference in the skill and methodologies by which these arbs are implemented. Probably only plain vanilla merger and CB arb are arbed out but even within those there is plenty of room to find non-vanilla opportunities. You just have to be VERY skilled at what you do. Better than 99% of other "professionals" in the strategy.<br />
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Some arbitrage amounts to short selling the liquid and going long the illiquid. That usually works fine in a bull market but can get dangerous when bearish times emerge. Some strategies have become so well-known that doing the opposite can make sense. REVERSE merger arb is betting on an announced deal NOT going through; spreads are so tight on most deals these days that the profits on one deal breaking can more than pay for other losses. REVERSE distressed debt is where you buy credit default options on "highly rated" securities likely to become credit impaired. Performed perfectly in the recent subprime mortgage and CDO debacle.<br />
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The carry trade whereby yen or swiss francs are borrowed and sold short and the proceeds invested in something with a higher yield is considered by some to be an arb. A common interest rate "arb" is borrowing short term to invest long term. There is a fair amount of commodities "arb" around playing contango and backwardation term structure. Activist equity and distressed debt hedge funds arb the difference between undervalued assets and their estimated true worth. Too many people have the carry trade on so REVERSE carry is NOW likely the best trade.<br />
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Lesser known but no less lucrative is model arbitrage. This is where a fund takes advantage of mispricings usually of fairly exotic derivatives and structured products. With counterparties keen to be seen at the "cutting edge" of financial engineering, their different models, software and underlying statistical assumptions can lead to pricing anomalies. It can be as basic as different interpolation methodologies of interest rate, credit and volatility term structures. Even a few basis points adds up when leverage, convexity and optionality get thrown in. Some providers don't seem able to measure correlation or credit risk correctly. Sometimes however the "error" is more subtle often involving stupid stochastic model based mumbo jumbo. A true quant is someone that arbitrages the other quants!<br />
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Other equity "market neutral" strategies are "analyst arbitrage" and "IPO arbitrage". A manager uses a carrot and stick approach to ensure they are the "first call" on sell-side analyst rating changes and to get into lucrative IPO allocations. Usually the carrot is paying high commissions and the stick is threatening to take their business elsewhere. There are several "hedge funds" around whose performance is NOT due to stock picking or trading ability but entirely due to their "skill" in analyst arb and brokers seeking favor by providing "market color" on other clients' positions and imminent transactions for front running. Is that skill? I don't think so and I don't allocate to those funds.<br />
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<a href="http://www.bloomberg.com/apps/news?pid=20601109&sid=amK25dKbMrhQ&refer=home" target="_blank">Algorithmic trading</a> is so popular these days that arbing some of the more popular trade execution systems can work. Trend following has become so well known that arbing trend followers is possible; trends are readily identifiable therefore it is quite easy to know what positions certain funds have on. Once a particular trend ends, their behavior in exiting the trade can become predictable and exploitable. Again this is where black box trading systems must remain opaque otherwise performance will be temporary. Very temporary.<br />
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Arbitrage could be considered to form the basis of everything a true hedge fund does. Namely the identification, monetization and risk management of market inefficiencies, anomalies and mispricings. That's as good a hedge fund definition as any. Given the trade secrets involved in the best arbitrage trades one wonders how hedge fund "replication" can offer much value. Most arbs are not easy to find or exploit which creates high barriers to entry. Interesting how arbitrage wasn't among the list of misunderstood terms in a recent survey of hedge fund definitions. Much arbitrage is really spread trading. Some spreads are reliable but many more others are as risky as the outright position. <br />
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The inspiration for this post came from my wandering over to pick up some arbitrage profits that had been lying in the corner courtesy of the ISE. Having designed highly profitable <a href="http://www.iseoptions.com/" target="_blank">volatility arbitrage</a> strategies and the current options trading boom it seemed obvious that ISE would likely get bought out at a high premium. It was an "arb" because the acquisition value of ISE was clearly more than the value accorded it by "efficient" public markets. Ironically the calls on ISE itself were massively undervalued due to the marketmakers STILL using that idiotic Black-Scholes option mispricing formula.<br />
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If only it was always as easy as that. Most arbs are more difficult to identify. Good arbitrages are never signposted but they are out there and ALWAYS will be.<div class="blogger-post-footer"><b> by Allen Veryan. Copyright </b></div>Hedge Fundhttp://www.blogger.com/profile/06235340160893314729noreply@blogger.com