Tuesday, April 17, 2012

Statistics on Hedge Fund Performance versus Markets

Forget about correlations. Here are the conditional probabilities between equity market monthly returns and hedge fund returns as represented by the MSCI World Equity Index and the HFRI Hedge Fund Index respectively.
Since Jan 1997, over 183 months,

  • Hedge funds were positive when equities were positive 98 months or 54% of the time.
  • Hedge funds were negative when equities were negative 54 months or 30% of the time.
  • Hedge funds were positive when equities were negative 24 months or 13% of the time... And
  • Hedge funds were negative when equities were positive 7 months or 4% of the time.
Thus, when equities are down, the chances of your hedge fund losing money are: 54 out of 78 or 69%.
And, when equities are up, the chances of your hedge fund losing money are 7 out of 105 or 7%.
Since Jan 2008, over 51 months,
  • Hedge funds were positive when equities were positive 24 months or 47% of the time.
  • Hedge funds were negative when equities were negative 21 months or 41% of the time.
  • Hedge funds were positive when equities were negative 5  months or 10% of the time. And...
  • Hedge funds were negative when equities were positive 1 month or 2% of the time.
Thus, when equities are down, the chances of your hedge fund losing money are: 21 out of 26 or 81%.
And, when equities are up, the chances of your hedge fund losing money are 1 out of 25 or 4%.  
Post 2008, the markets have begun to behave in a very volatile and erratic fashion that has confounded many hedge fund managers who had previously navigated market crises such as 1998 and 2001 successfully.

Sunday, April 15, 2012

Speech Notes: Howard Marks at NYSSA

On April 5, Howard Marks, legendary investor and Chairman of Oaktree Capital Management, spoke at New York Society of Securities Analysts.  He is also the author of the book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor.” Distressed Debt Investing was in attendance as he presented his views on the topic of “Human Side of Investing.”

According to Howard Marks, the discipline that is most important is not accounting or economics, but psychology.  He started off with a quote from Yogi Berra, “In theory, there is no difference between theory and practice; but in practice, there is.”  And this difference is what is at the essence of the human side of investing.  Even though the business schools teach that the markets are objective and efficient, and generally follow the “Capital Market Line (CML) curve (“riskier assets always provide higher returns”), it was handily disproved in both contrasting time periods of Q2 2007 and Q4 2008. Essentially, the upward sloping CML does not work in practice.  In practice, riskier assets must appear to provide higher returns, else they won’t attract capital.  But that does not mean that those promised returns arrive in reality.  If the risky assets provided higher returns, then they can’t be deemed risky after all.  In Q2 2007 the risk premium was very inadequate, whereas in Q4 2008 it was overly excessive.  The truth is that market is made up of people with emotions, insecurities, and foibles, and they often make mistakes.  They tend to swing to erroneous extremes.

One has to be very careful about the value and price relationship.  If you buy without discernment to the price, the returns would be all over the place – sometimes good, and sometimes bad.  In theory, people want more of something at lower prices and less of something at higher prices.  However, in practice, people tend to warm to investments as they rise and shun them when they fall.  In markets, the demand curve looks the opposite of how it looks in microeconomics theory based on supply and demand.

The normal investor behaves like a pendulum with constant swings between optimism and pessimism, between risk tolerance and risk aversion.  Although, the statistical “mean” location for the pendulum swing is in the middle, that happy medium is rarely seen in the markets, just as the pendulum spends almost no time at its “mean” during the swing.

Next, he talked about the 3 stages of bull market.  The first stage occurs when few smart people begin to believe that there will be improvement.  The second stage occurs when most people recognize that improvement is actually taking place.  The third stage occurs when everybody and their brother believe that things will continue getting better forever.  And that’s how bubbles come into existence.  The belief becomes that the price of a particular asset will only rise forever, that it can’t go down.  But when the pendulum swings like it did in 2008-09, bear market happens.  The 3 stages of bear market, conversely, are: first, when few people realize that things are overpriced and will prices likely will fold; second, when most people see that he decline is taking place; and third, when everybody believes that things will only get worse forever.  That last stage was the apt description of the credit markets in fourth quarter of 2008 and equities in first quarter 2009.  Any asset can be attractive or unattractive depending on the stage in which it is bought, i.e. depending on how much optimism or pessimism is embodied in the price.  The adage we should remember is: “What a wise man does in the beginning, the fool does in the end.”  What we should be is a contrarian.  We should be a seller in the third stage of the bull market, and buyer in the third stage of the bear market.  He quoted Mark Twain: “When you find you are on the same side as the majority, it is time to reform.”

Contrarianism is very important but very difficult.  To make his point, he quoted David Swenson who runs investments for Yale’s endowment fund: “Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolio which frequently appear to be downright imprudent in the eyes of the conventional wisdom.”  However, if one wants to be a successful contrarian, one has to believe that conventional wisdom by itself is a bit of an oxymoron because what is conventional is often not wise because most people start believing in something only when it is the third stage of either market extreme.

What is it that permits bubbles and crashes to happen frequently?  Howard Marks pointed the reason to be failure of investor memory especially since when the investor’s memory is faced with greed/fear, memory loses.  When people forget the past, they tend to repeat the same mistakes done previously.  He recommended reading his latest memo, “Déjà vu all over again” in which he discusses contrarian signals. He went on to say that behaving pro-cyclically is one of the greatest, most frequent mistakes.  We should strive to be anti-cyclical, but it requires strong memory and contrarian bent.

Another important thing is understanding and knowing what you don’t know.  A lot of people do not know what they don’t know, and essentially overestimate what they know.  Investing is a business full of testosterone and they think that you are not a man if you don’t know what’s exactly going to happen in say, five years.  In fact, some people think they know everything, some people think they are supposed to know everything, and a lot more act as if they know even when they don’t.  Mark Twain put it the best: “It ain’t what you don’t know that gets you in trouble.  It’s what you know for sure that ain’t so.” 

He then referred to the memo he wrote 8-10 years back, “Us Versus Them,” describing two schools – the “I Know” school, and the “I Don’t know” school.  He is a proud, card carrying-member of the latter.  It is very important to understand the difference between the two schools.  “I Know” school is confident about its forecast of the future, and “I Don’t Know” school is skeptical about that forecast.  The former can only prepare for one outcome, whereas the latter hedges against uncertainty and prioritizes avoidance of losses over the maximization of gains.  The latter approach is more likely to result in a successful investment career.  Therefore, the motto at Oaktree is to “Avoid the losers; the winners will take care of themselves.”  As long as the portfolios are built to avoid losers, they will do okay.

Most of the times, investors think that only the most likely thing is going to happen and they really only  prepare for just one outcome.  Howard Marks doesn’t seem to think highly of economists as they do not draw ranges or probabilities of the forecasts they give out, and are more often than not proven wrong.  He implored that while investing one should never forget the story of the 6 feet tall man who drowned in a stream which, on average, was five feet deep.  It is not enough to know what the average outcome will be; instead one has to have an idea of the likely shape of the outcome distribution curve.  One of the things investors should always be ready for is the unlikely disaster and should not ignore the “tails.”  Unlikely things happen all the time, and the likely things do not happen all the time; we need to build our portfolios to account for that.  This is not easy as Charlie Munger says, “None of this is easy, and if anyone thinks it is easy, he is stupid.”  It is not easy in investing to make above average returns as most of the people do single scenario investing which ignores that more things can happen than will happen.  The most likely outcome does not happen that often.  And that is what Howard Marks thinks risk actually is.  It is not standard deviation or volatility of returns; for him it is losing money. 

There are 3 ingredients for success in investing: aggressiveness, timing, and skill.  If you have the first two, you don’t need the third.  But that’s unlikely to remain the case in the long run as it is very hard to do the right thing, at the right time consistently in the investing business.  He then went on to talk about the two twin imposters in investing: Short term outperformance, and Short term underperformance.  They really don’t tell anything about an investor’s ability to outperform in the long run.  He referred to the memo he wrote in 2006 after the melt down of the hedge fund, Amaranth, in which he dissects the events from his vantage point.  He thinks that Amaranth’s problems didn’t start in 2006 when it went down a 100%; the problems started in 2005 when it went up a 100%.  Going up or down 100% can be two sides of the same coin, and can be result of combination of sheer aggressiveness and luck/timing.  If a person goes up a 100% one year, it does not guarantee that he will go up significantly again next year. 

He recommended reading the book “Fooled by Randomness” by Nassim Taleb, and understanding not only black swan phenomenon but also the concept of “alternative histories,” especially as it pertains to judging investors for the long term given that there is a lot of randomness in the world.  Just because something should happen does not mean that it would happen.  One of the things Howard Marks believes is that the correctness or the quality of a single decision can’t be judged by one outcome alone because of that randomness.  One has to assess the decision-makers outcomes over a somewhat longer period of time to assess that person’s skill.

Lastly he concluded by saying that forces that influence investors also push them towards mistakes.  Investing in obvious things, things that are easily understood, things that are doing well, etc. – these are all easy to do.  These things become names everybody wants to invest in.  But just by that virtue, most of the times these assets become overpriced and unlikely to be bargains.  Bargains that investors find in their lifetimes are likely to have hidden appeal, not be easily understood, and be unpopular.  Things that appear hard to invest in are where bargains are found.  Bargains do not appeal to herds.  Any given asset can be a good buy or a bad buy depending on the price.  There is no such thing as a “good idea” until you know the price. 

In the Q&A session, he shared his view that he did not believe that equities currently have excessive optimism built into the prices. He also thought that the high yield is relatively more attractive now than it was in 2007 despite the similarly low yields as the spreads are generous right now versus the treasuries.  It is hard for investors to get away from the business of relative selection.  Next, he suggested that as a professional investor you should not let the clients put you up on a pedestal, but rather should set reasonable expectations with them.  On the question of why CEOs of companies consistently overestimate performance, he felt that a lot of CEOs are good salesmen who might belong to the “I Know” school.   (By the way, unsurprisingly, he thought CNBC is big on that school as well.)  On how to protect against black swans, he suggested using portfolio diversification, basically buying those assets that would behave differently in a certain environment.  However, this can be hard to do especially if one is mandated to only be in a particular asset class, but one has to nevertheless try to reduce the correlation.  Finally, currently he is reading Sebastian Mallaby’s book, “More Money than God.”

Friday, April 13, 2012

When the tail-event becomes the standard risk

If anyone can bring metaphor and illustration to the market in volatility,  it’s Chris Cole at Artemis Captial Management, a volatility-focused investment firm.
Take the intro of his latest note as an example:
Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation.

Today the existential fear of world’s end deflation is so powerful investors are willing to pay the highest prices for portfolio insurance in nearly two decades.
The market for forward volatility has become unhinged as the SPX variance and VIX futures curves sustain historically high premiums over low spot vol.
My argument is not that this extreme fear is misplaced but that it is mispriced.
Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From one world’s end to the next sometimes I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.
Cole has been arguing for a while that the injection of huge amounts of QE-money into the system — the equivalent of a giant put option –  has undoubtedly had an impact on volatility markets, and most likely in ways we don’t really understand. Yet.
For one thing, Cole observes that since early 2009 volatility spikes have consistently occurred shortly after the end of central bank balance sheet expansion.  “The greater the level of monetary expansion the calmer the Vix and the higher the gains in the S&P 500 index (and vice versa). Volatility markets know this and that game theory expectation has contributed to the steepest SPX volatility curves in over two decades.”
Note the following chart to observe the shift in the volatility curves:

What’s more, there’s even been a correlation between central bank balance sheet expansion and short interest build-up in the VXX, one of the most popular Vix-linked exchange traded notes, observes Cole:
Short interest levels on VXX typically climb during Fed balance sheet expansion and continue to do so well after the printing ends until the inevitable VIX spike causes rapid short covering. The dynamic was most evident during the 2011 summer correction when VXX short interest tracked with Fed balance sheet expansion through April and continued to climb all the way until the VIX hit 43 in August. During VIX spikes in both May 2010 and August 2011 traders shorting the VXX overstayed their welcome at the stimulus punchbowl failing to recognize the Fed had left the party and the reality police were knocking on the door.
So where does this leave us?
According to Cole the world is now in the midst of a new volatility regime,  a regime that’s defined by investors’ willingness to pay almost anything to shield themselves and their portfolios from the next deflationary apocalypse. All of which is translating to abnormally steep volatility curves, overpriced tail risk, high implied volatility of volatility, and underperformance of portfolio insurance.
Investors are consequently losing sight of what might really be considered a black swan event.
As he notes:
Tail risk insurance is at the most expensive relative levels in over two decades of data reflecting a profound emotional fear of deflationary collapse.

Tail risk bets protecting against extreme declines in equity markets are now priced at multiple times the eight decade historical probability of those declines being realized (we can never know for certain true future probability). The evolution of portfolio insurance premium is observable via the implied probability distributions for returns backed-out from S&P 500 index options.
Tail-events are effecively being priced as if they were standard risks. That means you get much better pricing today hedging smaller declines of higher probablity rather than very rare but extreme crashes, says Cole.
Which means one of two things.  The chances of another deflationary crash are really much more probable than before, or deflationary fear is hugely mispriced in the market. Inflationary fear, on the other hand, is massively underpriced.
And none of that changes the fact, says Cole, that when a crash does happen and all these buyers look to cash in on their expensive tail risk insurance, the jackpot will have become a lot smaller.
“All that expensive protection will likely underperform expectations and in the end you would have done better hedging closer to the odds. It is hard to make money knowing what everyone else already knows.”
Maybe the market is correct in buying tail risk insurance … but everyone is just hedging the wrong tail.
That’s to say: Don’t be fearful of a crash. Rather, be fearful of not participating in a mega rally.
But don’t label Cole a paranoid inflationista. He isn’t coming to that conclusion because he’s obsessed with money debasement and the hoarding of gold bullion. His conclusion is based on the market’s own pricing of inflation risk.
Hyperinflation is now the outlier — and as a result it’s very cheap to protect against it in volatility markets.
His conclusion:
I can’t tell you if hyperinflation will ever occur but what I do know is that the single most undervalued asset class to hedge against this rare event is volatility itself. As institutional and retail investors herd into commodities, farmland, and gold they ignore the powerful leverage afforded to them using extremely long-dated call options and model-free variance.
Something for the goldbugs to chew on, at the very least.
For more of his thinking check out the full note in the Long Room.

Whither the Yale model?

David Swensen has been called “Yale’s $8 billion man [1]” for outperforming the average university endowment by that amount during the first 20 years of his tenure as Yale’s Chief Investment Officer. Chalk that outperformance up to the success of what’s become known as the “Yale model,” or the insight that institutional investors like endowments or pension funds can achieve outsize returns by allocating a large chunk of their assets to hedge funds, private equity, real estate, and other alternative investments.
As Swensen explained in a lecture [2] he gave to Yale MBAs in 2008 , the Yale model rests on two core tenets: 1) “an equity bias for portfolios with a long time horizon,” because equities and equity-like alternative investments tend to rise in value in the long run; and 2) diversification, because by spreading investments among several asset classes with varying degrees of liquidity, ”for any given level of risk, you can increase the return.”
These days, though, it seems both of Swensen’s credos have become passé in the community of corporate pension fund managers, as Reuters’ Sam Forgione reported [3] late last week:
For the first time in over a decade, more of the $1.246 trillion assets represented by the 100 largest U.S. corporate pension funds is now in bonds instead of equities, according to pension consulting firm Milliman…
“There will definitely be less demand for equities from corporate pensions if you look out the next several years,” said Aaron Meder, head of U.S. pension solutions for Legal and General Investment Management America. Corporations are “tired of the volatility in the stock market, so they want to de-risk their pensions,” he added.
What’s striking here isn’t that pension funds no longer share Swensen’s fondness for allocating money to hedge funds or private equity — after all, Swensen himself believes [4] that the majority of institutional investors who can’t match the resources or qualifications of Yale’s Investment Office “should be 100 percent passive.” Rather, it’s that Swensen’s golden rules of asset management — stocks for the long run and diversification — seem to be out of fashion. Pension-fund managers that have years to ride out losses on their stock portfolios until they turn into gains are increasingly throwing in the towel in favor of less volatile, lower-returning bonds. The advantage of endowments and pension funds that Swensen has touted for years — a near-infinite time horizon — is being ignored.
This risk aversion among institutional investors is trickling down to the retail level, too. Mom-and-pop investors withdrew $4.43 billion from equity funds last week, the largest amount since the start of the year, data from the Investment Company Institute showed [5] today. These investors are also showing a preference for fixed income: bond funds saw with $6.12 billion in inflows that same week, for a total of over $26 billion in the previous three weeks.
The question institutional investors are now asking is whether the events of the past few years require a re-appraisal of principles underpinning the Yale model. Hedge funds, one of Swensen’s darling asset classes, had a particularly bad 2011 [6], with the average fund down nearly 5 percent and some stock-picking funds down 19 percent. The New York Times published a story [7] earlier this week that claimed that over the past five years, a set of public workers’ pension funds that had more of their assets in hedge funds, private equity, and real estate posted lower returns and paid higher fees than those with stodgier portfolios.
For what it’s worth, Yale’s target allocation [8] for fiscal year 2012 includes having over 70 percent of its portfolio in private equity, real estate, and hedge funds and only around 10 percent in U.S. stocks, bonds, and cash; for fiscal year 2011, Yale’s endowment returned 21.9%.

Jim Chanos: "Long Corruption and Short Property in China" s

Hedge fund manager and renowned short seller Jim Chanos of Kynikos Associates was interviewed on CNBC today from the Delivering Alpha conference. Chanos is known for his short of Enron before it collapsed.

Recent Portfolio Activity

Chanos says that "we're long corruption and short property in China." As such, he's long the Macau casinos. He didn't name names but obviously Wynn (WYNN) has a large presence there via Wynn Macau (1128.HK), as does MGM (MGM) and SJM Holdings (0880.HK), controlled by the family of Stanley Ho.

Conversely, we originally detailed how he was also shorting the property developers in the country.

In the past month, Chanos has pressed his shorts in the renewables sector (green energy) and in particular, solar. We covered Chanos' presentation at the Ira Sohn Conference where he said he was short First Solar (FSLR) as well as wind power play Vestas (CPH: VWS).

Chanos also noted that his fund is not short US banks.

To watch Chanos' interview <<- click.

Friday, April 06, 2012

Passport Capital Sees "Major Retrenchment in Risk Assets"

Passport Capital founder John Burbank recently sent out a letter to investors updating their macro views.

Despite being net short, their Passport Global fund is up 4.1% for the year. Their neutrally-exposed Long/Short fund has returned 7.5% and their net long Special Opportunities fund is up 12.9% for the year.

Burbank writes, "I have strong conviction about our current positioning - perhaps as strong as I have ever felt in the 11+ years that I have been running Passport Capital. Simply put, I believe that the current market environment is setting up for a major retrenchment in risk assets and we are well positioned to benefit from this."

Just a month ago, Burbank made an appearance and said that 2012 is a stockpicker's market.

Passport Capital's Main Views

They feel that Central Bank liquidity has merely boosted prices but has done nothing else constructive. Burbank believes that deflation is the real risk (see the best investments during deflation). The hedge fund also takes the stance that equity markets are misconstruing economic growth in the developed world.

Passport feels a recession is coming in 2012 or early 2013 in the US. They note that average equity declines during recessions is 40%, though even a 20% decline would take the market back to the October 2011 lows.

Burbank's Portfolio Changes

In late 2011, they reduced portfolio illiquidity and have been selling into strength in the equity markets as of late. They've also boosted hedges and shorts "less to reduce net exposure and more to add idiosyncratic risk aligned with our negative economic view."

Burbank's firm also bought more physical gold and also started a position in Brent Crude Oil. These are both plays on increasing Central Bank liquidity. You'll recall that John Paulson originally started his gold fund as a bet against the US dollar as well.

Passport has also started a position in mortgage backed securities which they believe to "have the potential to deliver high risk-adjusted yield irrespective of equity market valuations." Additionally, they initiated a positive-carry position in deflationary rates trade (3yr1yr) which they feel will benefit from either the Fed holding short-term rates low or a risk-off period.

Saudi Equities Most Compelling

Passport has their single largest equity allocation to Saudi equities. Even though that market is up 23% year-to-date, they feel that "Saudi equities constitute the best single asymmetric equity market we can find."

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.