Friday, March 26, 2010
Diversification when you need it the most
To someone as simple-minded as me, diversification during "normal" periods is nice and the higher correlations exhibited by global stock markets is a minor concern, but the most valuable form of diversification occurs during panics and crisis episodes - when virtually all asset classes go down. That's when you want something in your portfolio to save you.
Consider example of the crisis in 2008. During that and other periods of financial stress, the correlations of seemingly uncorrelated asset classes tend to converge to 1. Balanced fund portfolios, which were advertised as to be sufficiently diversified to withstand these kinds of shocks, were down 20-30%.
Max Darnell of First Quadrant addressed this diversification problem by explaining that you have to take a bet somewhere. Even though you may be diversifying your asset betas across asset classes, the fact that you are taking on beta generally means that you are making a bet on risk [emphasis mine]:
In short, diversification is not intended to be a tool for risk avoidance. Rather, it is meant to be used as though it were an acid that dissolves away impurities, i.e., uncompensated risk, leaving a pure risk that is more desirable principally because we are rewarded for holding it. The remaining risk will be risky. Otherwise, we wouldn’t be compensated for it.
Correlation isn’t causality
I wrote before that you shouldn’t confuse correlation with causality. Standard MPT style correlation analysis of asset returns are based on statistical correlations. Statistical correlations will tend to move around. Most critical to downside risk protection, don’t expect statistical correlations to hold up in accordance with historical experience during periods of extreme global volatility.
I prefer to look for diversification more analytically. For example, hard assets tend to perform well during periods of rising inflationary expectations, but default-free fixed income assets such as government bonds will perform poorly. Conversely, we can expect that during a credit crisis, which is associated with heightened default risk, prices of default-free government bonds with good credit will rise, while hard asset prices would be under pressure.
Alpha from beta?
Supposing you had a model that could identify macro-economic regimes, then a strategy of buying hard assets during periods of inflation; default-free assets during periods of deflation; and equities during periods of benign macro-economic risk would make good sense.
That would be creating alpha from diversification beta
Wednesday, March 17, 2010
But what exactly does it mean to be sophisticated? This is a question addressed by Jan de Dreu of RBS and Jacob Bikker of De Nederlandsche Bank in a study of Dutch pension plans. The duo bases its analysis on the fair assumption that “sophisticated” means “not succumbing to behavioural finance biases.” While many studies have examined behavioural biases in individual in private investors, they write, “much less is known about professional parties.”
They focus their attention on three cues of (the lack of) sophistication:
- “Gross Investment Rounding” (i.e. choosing asset allocation percentages that end in 5% or 10%)
- “Lack of Diversification” (basically, the lack of idiosyncratic risk such as that found in alternative investments)
- “Home Bias” (the tendency to invest close to home, where opportunities are more familiar)
They also examine overall risk as a sign of sophistication, but purposely avoid overall returns since they are beyond the direct control of investment professionals.
Institutional investors such as pension funds tend to use traditional “60/40″ or “70/30″ splits between equities and fixed income. While the average numbers across all investors tend to shift slightly each year (see related post), many institutions stick stubbornly to simple proportions like these – ones that end in a zero or a five.
But modern portfolio theory dictates that optimal allocations to various asset classes can and should be dynamic and are rarely nice even numbers like these. (Although, like a broken clock, we suppose that a “60/40″ allocation is correct on the odd occasion).
Consultants and hedge fund sales people know all too well the inertia they face when they argue that optimizers recommend that alternative asset allocations should comprise 40, 50 or even 100% of a client’s portfolio. Instead of adopting the “optimal” solution, investment committees will often default to something more plausible – say, 10%. In a sense, they are effectively adding a “career-risk” variable to the optimization. (After all, idiosyncratic risk has a much greater influence over career than systematic risk).
When they examined nearly 750 Dutch pension funds, they found that the vast majority had policy allocations to equities that ended in multiples of five. In fact, there even seemed to be a tendency for policy allocations to end in “0″, instead of “5″.
Rather than optimally dividing the remainder of the portfolio between bonds and other assets (alternatives, cash etc.), even the bond allocation percentages seemed pretty engineered…
You don’t need to be a finance Ph.D. to see that such allocations look pretty fishy – suggesting that they were created by humans, rather than portfolio optimizers.
But de Dreu and Bikker also point out something else in these charts: that there is very little agreement on the appropriate allocation to equities and bonds. “60/40″ is by no means the standard allocation.
When they dove into these results further, they found that large (“sophisticated”) funds tended not to use multiples of 5% as much as their smaller counterparts. (chart below created using data in the paper)
One might expect that larger investors might have a lower propensity to use “gross rounding”. But we were struck by the gradual increase in the gross rounding over time of the largest institutions. Are they becoming less sophisticated? And did the small and medium-sized institutions become more sophisticated between 2004 and 2006?
Who knows. But here’s a theory: After taking a bath in the equity market, small and medium-sized plans called in the consultants to conduct ALM studies…
Okay, so it’s a bit self-referential for us to argue that the use of alternative investments signals “sophistication” and then say that alternative investments tend to attract “sophisticated investors”. But in any event, de Dreu and Bikker confirm the intuition that large investors tend to hold more alternative investments than small ones. (chart below created with data from paper).
As you might also guess, funds that did not use gross rounding for policy allocations were twice as likely to use alternative investments. (We wondered if this is because of greater sophistication or simply because the introduction of a third asset class – alternative investments – simply forces investment committees to tweak their existing gross roundings.)
Home Sweet Home
Finally, de Dreu and Bikker examine whether small or unsophisticated funds tend to invest a higher proportion of their portfolios in Europe.
As you might guess due to their relative lack of investment manpower, smaller funds do indeed invest more in Europe. But the duo also finds that nearly half of funds that use gross rounding (allocations ending in multiples of 5%), invest in the EMU. This compares to only about a third of funds that do not use gross rounding – suggesting that “sophisticated” pension funds tend to invest more outside of Europe that their less sophisticated brethren.
The paper includes several other notable observations about the behaviour of different types of and sizes of pension funds. Assuming the Dutch aren’t all that different from the rest of us, these results should help explain a lot of the frustration faced by consultants and hedge fund sales people as they try to make the case for alternative investments.
Which brings us to a bit of good news about the state of the hedge fund industry: Investors were already putting money back into both hedge funds and funds of hedge funds in the final quarter of 2009, according to to the latest quarterly survey by Brighton House Associates, released earlier this month. The even better news for hedge fund industry participants: They were putting money into strategies that they felt would be good long-term bets rather than just a way to recover their 2008 losses.
The report, which surveys more than 1300 alternative investment managers every quarter, has become a useful snapshot of what investors are thinking and where their intentions lie in terms of alternative investment allocations. And the latest report was certainly no let-down.
According to the results global macro and commodities were among the top strategy picks of investors in the final three months of last year – a sign that investors are looking for hedge fund managers focused on trends related to the global economic recovery – and not just any recovery. (see chart highlighting investor strategy interests below.)
Funds taking advantage of opportunities in the secondaries space were also of interest to investors, according to the survey results, as were funds of hedge of funds, which after suffering from additional outflows through the first half of last year finally began to level off and recover. Of those investors interested in funds of hedge funds, the family office set proved the most keen -a reflection of the sobering post-crisis reality that trying to build a portfolio of managers and strategies on your own is not only difficult and costly but also potentially hazardous.
Real estate funds also benefited from a fourth-quarter market rebound, especially in the US and Europe where investors were interested in sourcing fund opportunities in commercial real estate, according to the survey. Interest in CTA / managed futures funds of funds also gained traction, thanks in large part to rising prices for gold and other commodities. Investors even expressed interest in private equity funds, particularly those focused on buyout opportunities.
And in all the talk about increased investor interest, rising inflows and diversification into various alternatives strategies, the bad news?
There isn’t any, according to the report.
“Early indications for 2010 are that the loosening of credit is finally beginning to have a significant impact on the alternative investment community as capital is beginning to flow back into the industry following the redemptions sparked by the crisis in 2008.”
Let’s all hope so.
The HFRI Composite routinely shellacked the FoF Index in the 1990s. But since the turn of the century, the FoF index has generally exhibited performance that resembled the broader indexes – with lower volatility…
While it may not look like it due to the absolute performance disparity between the two indexes, the FoF Index actually has a high correlation to the Composite Index…
So in a sense, the HFRI FoF is a deleveraged version of the Composite Index. Or, put another way: a portfolio containing roughly 66% Composite Index and 33% cash.
This tight relationship held up until last year when the HFRI FoF underperformed the HFRI Composite Index by a whopping 8.5%, even higher than 2003’s 7.9% under-performance (note that 2003, like 2009, was another barn-burner for the Composite Index.)
So what happened? Theories abound. Author and industry commentator Cathleen Rittereiser recently told Dow Jones:
“Arguably, funds of funds, could and should have reinvested their cash in hedge funds a lot earlier, especially if anecdotes are true that every fund in creation was open.”
Rittereiser is reflecting a common view of last year’s FoF under-performance – that funds of funds were sitting on mattresses full of cash they hoarded in case of massive withdrawals. This cash cushion apparently came back to haunt them.
A new study from Fitch Ratings backs up this hypothesis. The following chart from the firm’s recent Q1, 2010 Quarterly Hedge Fund Report shows that funds of funds actually performed in line with single hedge funds on a risk-adjusted basis. (If you draw a Capital Market Line between the HFRI Composite (green triangle) and, say, a 2% risk free rate, the FoF index isn’t really that far below it). (Click to enlarge chart)
Some say it wasn’t the mattresses full of cash that were the problems for FoFs, it was their return-chasing (or “safety-chasing”) behaviour. After watching global macro stay afloat in a stormy 2008, funds may have sought refuge in the strategy. Kristoffer Houlihan, Director of Risk Management at PAAMCO told the FT as much recently. According to the FT:
“…some managers sought refuge in global macro, a generally conservative, steady strategy. In 2008, global macro funds were off only fractionally, beating the industry average by more than 20 percentage points. This year, as of November, global macro has registered gains just north of 8 per cent, trailing the industry by 13.5 percentage points. The strategy delivered absolute returns, but in the context of the 2009 bull market its performance looked sluggish.”
Whatever the reason for last year’s anomaly, it will be very interesting to see if fund of funds indexes come back in line in 2010. Things are off to a good start. The difference between the HFRI Composite and the HFRI FoF Index in January: 1 bp.
But there may be a little more to the story than meets the eye.
Studies have shown that, in theory, active management thrives during periods of time when stocks are less correlated – when the so-called “cross-sectional dispersion” between stock returns is highest (i.e. their average correlation is lowest).
Back in late 2008, we covered a presentation by Steve Sapra of Analytic Investors that contained the following chart showing the average stock-by-stock correlation of US equities (blue line)
Note that correlations were low around the turn of the century. This makes intuitive sense for anyone investing around then. Stocks seemed to have a mind of their own as some sectors bubbled, then blow-up while others held the line. Indeed, as the orange line shows, average stock volatility peaked in the Halcyon days of March 2000. This combination provided unprecedented opportunities for those who could read the tea leaves at the time.
But does high volatility always lead to opportunities for the most active managers of all, hedge funds? A report published by Moody’s recently contains an interesting appendix that seems to say “yes.”
The following chart from the report ranks monthly hedge fund industry returns from lowest to highest and shows the corresponding change in the VIX for that month. (Click to enlarge)
If anything, this chart shows that hedge funds have performed better in times of relative calm – that as a whole, they are “short vol.” When the markets get wonky, hedge fund managers apparently have just as much trouble as the next guy. Explains Moody’s:
“…although it is true that risk exposures of funds can vary substantially, they are participants in the financial markets and a sudden re-pricing of risk across the board can catch managers off guard, in the same way as other market participants…”
Still, as Moody’s points out, hedge funds are quick learners and are able to adjust their positioning faster than traditional managers. As a result, they don’t stumble as far and their cumulative performance tends to recover quicker (as the following chart from the report shows – click to enlarge).
So hedge funds may thrive in relative stability. But they also seem to perform “less poorly” during market upheavals. This seems to support the argument that active management beats passive management in times of chaos.
However, as Sapra points out, that chaos must be accompanied by cross-sectional dispersion in order for active management to fully realize its potential.
During the ‘99-’03 pop in average stock volatility, hedge funds did okay. But during the 2008 jump in vol, hedge funds took a pie in the face.
The difference? Average stock correlation was low in the ‘99-’03 time period and was astronomical in 2008.
So the bottom line seems to be that high volatility might only be bad for hedge funds when cross-sectional volatility is also high. Unfortunately the Moody’s report did not account for this variable.
Thursday, March 11, 2010
Bank of America Merrill Lynch is out with their weekly summary of hedge fund exposure levels so we thought we'd take a look. They note that hedge funds in general were buying the Nasdaq and oil. Also, we see that some hedge funds began to cover short positions in the Euro. There has been a big deal made lately about hedge funds "ganging up" on the euro. So, it appears that some funds have covered now after the currency had been heavily shorted over a two-week period.
Let's now take a look at their findings regarding market exposure levels. In the past, we had pointed out how long/short equity hedge funds had reduced their exposure to below historical levels. There was a multi-week period where hedge funds were largely de-risking and it appears that trend has reversed. They have slowly started adding back exposure and are around the 34-35% net long level (approaching the historical average of 35-40%).
BofA also outlined how hedge funds are proceeding in their specific strategies. Turning to market neutral funds, they find that these funds are favoring growth names and still have positive inflationary expectations. While their market exposure has fallen, it still remains above the average levels. Long/short equity hedge funds, on the other hand, continue to increase market exposure and have growth & high quality tilts. This is largely what we've seen out of hedgies lately as they see more compelling opportunities in 'high quality' stocks. In fact, the vast majority of the most important stocks for hedge funds fit this description.
Embedded below is Bank of America Merrill Lynch's hedge fund trend monitor report in its entirety:
You can directly download a .pdf here.
In the end, this data largely draws the same conclusions we've seen in recent weeks: hedgies love growth names and are partial to high quality stocks. We've seen this exact sentiment long echoed in our hedge fund portfolio tracking series. Some of the most prominent managers have sizable stakes in strong bluechip type companies like Microsoft (MSFT), Pfizer (PFE), Wells Fargo (WFC), etc. And, on the growth front, many funds favor stocks like Apple (AAPL), DirecTV (DTV), Mastercard (MA), & Monsanto (MON). These findings fall largely in line with the stocks listed on Goldman Sachs' VIP list as well.
For more research from BofA, we've previously posted up their research from the beginning of the year as they recommended to overweight equities and underweight bonds.
By ANDY KESSLER
A year ago yesterday, the world almost ended. The stock market was in free fall, with the Dow Jones Industrial Average bottoming out at 6547, down from its Oct. 9, 2007 peak of 14164. Financials were in a death spiral and there was even talk of nationalization. Citigroup hit $1.05, GE traded at $7.41 and golden Goldman Sachs was given away at $73.95. A bear market extraordinaire.
Contrast this with 10 years ago today, when the dot-com-laden NASDAQ peaked at 5048. Then we had the opposite mentality—companies like Pets.com were going to fundamentally reshape the economy in the new millennium through a nirvana of spectacular growth and well being. Or something like that. A bull run extraordinaire.
No one would blame you for thinking the market is a textbook delusional-paranoid-schizophrenic, not knowing the difference between the real and unreal. And you'd be right. But you'd miss a valuable lesson. Misallocation of capital is everywhere and anywhere a fallout of bad government policy. The South Sea Company, a government sponsored entity with a monopoly on trade, caused the South Sea Bubble in 1720.
The late '90s Internet love fest was crazy enough, driven by former FCC Chairman Reed Hundt's misguided telecom reform that had the effect of keeping data rates artificially high. This created a gold rush to install fiber and build applications that didn't make economic sense (though electronic commerce, online banking, as well as wireless and broadband deployment would eventually prove productive over the next decade). Bad policy meant capital got overallocated and too quickly, as momentum mutual funds (momos) and day traders furiously drove up stock prices of every company with dot-com in its name for no fundamental reasons. Wall Street trading was broken.
Then, adding insult to injury, Alan Greenspan and the Federal Reserve flooded the system with money, fearing that banks would face a run brought on by the Y2K problem. The problem and the run never happened. The money ended up in the market. Mopping up that money burst the bubble. The market bottomed out on Oct. 9, 2002, when the Nasdaq hit 1114.
And the world after 9/11? Unfortunately, the accounting scandals at Enron, WorldCom and elsewhere brought us the costly Sarbanes-Oxley law, adding a complex regulatory burden so that many companies fear going public. We also got a decoupling of research from investment banking because of an alleged conflict of interest, and a Federal Reserve whose nightmare fears of deflation ushered in a long era of cheap credit.
Instead of finishing what the dot-com era started to deliver—a productive, wealth-producing economy—capital was seduced into the financial lair of private equity and real-estate mortgages. Trillions were pumped into unneeded housing stock. Fannie and Freddie fanned the flames, and then fizzled and failed. And leveraged buyouts reigned. Even in 2007, one Blackstone private equity fund raised almost as much money as all of the venture capital industry.
And now? The bear market of a year ago may have ended because of the Geithner Plan, Treasury stress tests and TARP money injected onto bank balance sheets. You can go with that narrative if you'd like. Or maybe it was a change in the mark-to-market rules so banks no longer had to write down their toxic subprime loans. But the reality is that on March 18, 2009, Ben Bernanke and the Federal Reserve began their $1.2 trillion quantitative easing, buying Treasurys and mortgages and pumping dollars into a deleveraging economy. Hair of the dog. More cheap credit that again ended up in the market, helping banks refinance.
Today, we are still left with almost no initial public offerings. While private equity fund-raising was down 68% in 2009 to $96 billion, venture capital barely raised $13 billion.
Capital gains taxes are set to return to 20% on Jan. 1, 2011. And worse, investing is as uncertain as ever. No one wants to fund health care, medical devices or even much biotech if they can't figure out how they are going to be paid via reimbursements from ObamaCare. Energy investing is also a mess. And while "green" investing is booming, with few exceptions that is about efficiency rather than productivity. There's a big difference: You can make the Post Office more efficient while email makes us more productive and wealthier.
Big regulated oligopolists control our communications infrastructure. Startups are nowhere to be found. Few are willing to take the risk of true venture investing.
It's been 10 long years since the economy has created real wealth, as opposed to easy-credit induced real-estate or paper wealth. Amidst all the current confusion over health care and tax rates and energy and banking reforms, maybe it's time that the market transitions back to investments that drive productivity and increase living standards rather than just paper profits.
I'm not saying the market should transition or it ought to—you don't tell the market what to do. As we know from one and 10 years ago, the market works in weird ways and makes these transitions in the fog of something else, in this case it's the Fed's life support that is misallocating capital. When that ends, look for new eras to begin.
Mr. Kessler, a former hedge fund manager, is the author of "How We Got Here" (Collins, 2005).