Tuesday, August 26, 2014


Forget questions about whether liquid alternative funds are here to stay. The surge of inflows to liquid alternative funds suggests that debate is over.
According to McKinsey & Company projections, inflows to liquid alternative funds will reach $900 billion by the end of 2015. That surge is likely coming at the expense of traditional hedge fund investments. 
A study by Barclays Prime Services shows that capital flows into liquid alternatives—also known as hedge-like mutual funds—are outpacing dollars going into hedge funds. Liquid alternatives grew by 43% last year, while hedge fund assets increased by 15%. 
Liquid alternatives are the fastest growing category of ’40 Act structures, even though they comprise a tiny part of the mutual fund industry. Recent data shows that the amount of capital controlled by alternative ’40 Act structures stands at $154 billion, which is just 1% of the entire mutual fund industry. In comparison, hedge funds control $2.7 trillion of capital.
The trend is picking up, particularly as conservative institutional investors like pension funds enjoy ’40 Act funds due to the lack of performance fees, reduced leverage, and beta-centric returns.
The alternative ’40 Act fund universe is in its infancy, with the most mature funds being no more than five years old. While industry watchers like McKinsey predict the industry will continue its exceptional growth, only time will tell if these vehicles can weather a storm.
Rather than debate the permanence of alternative funds, investors should instead ask a more important question:
Do increased liquidity and the lower fees provided by hedge-like mutual funds outweigh the lower expected returns?


The hedge fund versus alternative funds is a false debate thanks to industry advocates who are attempting to promote their products and services. They’ve said alternative funds don’t provide strong returns, aren’t managed properly, or that investor sentiment is dwindling. 
But there is no shortage of optimism surrounding the launch of alternative ’40 Act funds.
“Clearly, this is the fastest growing category,” said Victor Viner, president of V2 Capital, which specializes in volatility-based equity derivative strategies. V2 Capital manages $500 million in a hedge fund vehicle, but is rolling that money over into a ’40 Act fund later this year. 
“We are seeing more funds that can provide liquidity going into the liquid alternatives space for all of the obvious reasons from an investor perspective,” said Viner, adding that the main benefits of liquid alternatives include transparency, liquidity, and lower fees. But despite V2’s move into the liquid alternatives space, Viner warns that most hedge funds cannot be shoehorned into mutual fund structures.
“Not all, and not most, of traditional hedge fund strategies can exist in these structures. In our case, we’re lucky because everything we do and have done for four years falls well within the framework of what can be done in a ’40 Act fund,” said Viner. 
The ’40 Act rules include limiting leverage to 33%, having less than 15% exposure to illiquid assets, and in most cases a prohibition on charging performance fees.
Adam Patti, CEO of IndexIQ, a pioneer in the liquid alternatives space, agrees that only certain strategies will work in a ’40 Act structure. 
“The major hedge fund categories—long/short, market neutral, global macro— can [be] provided in a ‘40 Act fund fairly efficiently,” he said. “Strategies that require a significant amount of leverage won’t work. Strategies that tend to depend on illiquid, arcane asset classes won’t work.”
Instead of having a “one of the other philosophy” when comparing hedge funds and liquid alternatives, investors could see them as complementary products.
“The majority of our assets ($1.4 billion) are in a multi-
advisory product that is basically the S&P 500 of the hedge fund market,” said Patti. “It is designed to give you the risk/return profile of a universe of a hedge fund of funds…. You would use that as a core product in your portfolio and then
go out and find alpha-seeking hedge funds as satellites around it.”


One of key selling points of liquid alternatives is transparency. 
But while transparency may seem like an obvious benefit, Bill McBride, executive vice president at quantitative research and technology specialist Markov Processes International (MPI), wonders whether having access to the underlying investments does any good. 
“The Securities and Exchange Commission (SEC) says investment advisers are fiduciaries and need to verify that a fund is executing its stated strategy based on available data,” explained McBride. “How many advisers can internally price and net the exposures of the thousands of positions (including complex derivatives) in an unconstrained long/short bond fund?”
McBride added that technology to tackle the data issue is rapidly being developed.
“There is room to mature and we think it will happen quickly. Investors will seek advanced systems and analytical techniques to process liquid alternatives’ holdings data, net exposures and grasp a fund’s strategy and potential risks, while managers will seek ways to enhance communication to investors, all potentially facilitated by SEC mandates as attention is increased on this rapidly growing space.”
Patti, who touts transparency, also thinks it is important for advisers and investors to “look under the hood” and get a better understanding of what is in each product.
“Advisers don’t know what they are getting and that’s a big problem,” said Patti, who believes educating advisers and investors should be a top priority for the industry as a whole.
Andrew Ross, associate director of Pacific Alternative Asset Management Company (PAAMCO), which has approximately $9 billion in discretionary assets under management, points out that transparency is not unique to the ‘40 Act fund structure. 
“Institutional investors can receive transparency and independent oversight of their hedge fund investments in their traditional private placement hedge fund investments,” said Ross. “Some institutional investors are already receiving all of their positions on a monthly basis with a less than 30-day lag, which is far superior to the required 60-day lagged, quarterly transparency of liquid alternatives.”
Of course both pale in comparison the managed futures, which offers daily transparency in the typical managed account structure. 
PAAMCO, specializes in fund of hedge fund structures and caters almost exclusively to institutional investors, and has no plans to enter the ’40 Act space. 
“At this point we do not feel that this product is appropriate for institutional investors and we do not have a view on its suitability for retail investors,” said Ross.


While liquidity is usually touted as a benefit for investors, McBride feels that just like transparency, investors may be relying too much on the idea of it rather than the reality.
“How can you have daily liquidity in a $4 billion equity long-short fund?” McBride asked. “The senior hedge fund managers I have spoken with have expressed serious concern that large liquid alternatives vehicles could have trouble raising cash very quickly if executing a truly hedge fund like strategy.”
The SEC is also voicing its concern. The regulatory agency has already begun investigating 25 liquid alternative funds on structural matters of leverage and daily liquidity and the associated risks. PAAMCO’s Ross also believes that promises of daily liquidity are overstated.
“The daily liquidity of liquid alts can create ‘bank-run’ risks because of the asset-liability mismatch problem created. Although liquid alternative funds have stated daily liquidity, current rules actually allow these funds to operate without the ability to liquidate all underlying investments in a day,” explained Ross. “Although ‘bank-run’ risk exists in all mutual fund structures because the investors in them have daily liquidity, the risk is heightened with liquid alts due to the relative novelty of the strategy to the retail investor.”
The regulatory efforts aren’t likely to end just on concerns about liquidity. In fact, liquidity fears will likely generate expanded efforts by agencies to dig deeper into how these funds generate returns, their risk management strategies and their marketing practices.


Despite concerns about increased regulation in the space, liquid alternative funds provide one big benefit that isn’t going unnoticed. Lower fees. 
The question investors must ask is:  
Will the lower fees be enough to offset the difference in
One recent study by advisory firm Cliffwater found a 1% drag on performance for hedge funds going into ‘40 Act structures. But that isn’t shaking faith in these funds.
“Call it the liquidity penalty,” said Viner, who despite the potential lag in performance believes the lower fees will more than offset gains that can be made in a hedge fund vehicle.
“A lot of managers are highly correlated to the S&P and they are producing beta, but they are charging 2% management fee and 20% on profits,” said Viner.
Over time, one can expect that alternative funds and their hedge fund cousins will be debating the merits of their structures and ultimately their performance. For now, the jury remains out. As for solid, historical evidence on the long-term returns of hedge funds versus those of liquid alternatives, there isn’t any.
As the industry takes shape, time will tell which side is able to earn the bulk of new asset flows. For now, it’s up to investors and the media to do the diligence.

Wednesday, August 20, 2014

Pershing Sq. Quarterly Letter (+25% YTD)

How The Largest Actively Managed Mutual Funds From 15 years Ago Performed

You can't go long without reading an article about the death of active management. Somewhere in a discussion like that you will also hear that the larger a fund gets the more likely it is to under-perform. My purpose of this post is not to get into either of those issues but I thought it would be interesting to take a glimpse back in time to the largest funds of 1999 (15 years ago).

For this exercise I decided to screen for the largest actively managed funds 15 years ago (8/1999) which had the S&P 500 as their prospectus benchmark. The top 10 results looked like this

So how did they do? Were they too big to outperform?
Indeed, the largest fund did manage to under-perform. However, as a whole, these large funds did quite well. Over the last 15 years the largest 10 funds which were benchmarked to the S&P 500 managed to return an average of 5.47% compared to 4.47% for the S&P 500.

What's also interesting is that despite the fact that I compared them all to their prospectus benchmark of the S&P 500, a few of them tend to have a known growth tilt (Vanguard Primecap, Growth Fund of America, Fidelty Contrafund) but they all managed to significantly beat the S&P 500 despite the fact that growth significantly underperformed the S&P during this time (Russell 1000 Growth returned only 3.18% compared to 4.47% on the S&P 500).


There’s a recurring theme emanating from nearly every permanently bullish pundit right now. I’m sure you’ve heard it. It goes something like this: “I was around in 1999-2000. You have no idea how crazy it was back then. We are nowhere near that level of mania today. We therefore have much, much further to go.”

On its face, it seems like a reasonable statement. After all, 2000 was the peak of the greatest U.S. stock market bubble we have ever seen. A chart of the CAPE ratio (or Shiller P/E) illustrates just how stretched valuations were back then and how we’re  still far from such levels today.
The issue, though, is that every Bull Market doesn’t go through a 2000-like bubble before it becomes a problem. Since 1929, there have been twenty Bear Market declines in the S&P 500 (roughly one every 4-5 years). Only one of these was preceded by our collective definition of a bubble.
Therefore, to argue that stocks are a good buy today and can’t go down because they have not yet reached the extremes of the greatest bubble in history is to argue two things. First, that there is a high probability of a similar bubble occurring, and second, that you have the ability to time your exposure to the bubble to insure that you get out before it inevitably bursts.
Today, many would argue on the first point that the probability of a similar bubble occurring is indeed high. After all, the Federal Reserve seems to want this outcome as they have maintained the loosest monetary policy in history five years into the recovery. If market participants are correct and the Fed does not raise rates until next July, it will be six and half years of zero percent interest rates at that point. Investors tend to do highly irrational things when money is this cheap. Thus, while I would not go as far as to say the odds of another dot-com like bubble are high, we cannot entirely rule it out.
What I would argue strongly against, though, is ability of the majority investors to effectively time their exposure to such a bubble. If history is any guide, most investors will not fare well as they have a strong tendency to buy high and sell low.
As we are approaching the 90th percentile of historical valuations (CAPE above 26), make no mistake about it, investors getting in here with hopes of another 1999-2000 bubble are indeed buying high. No, not as high as 1999-2000, but high enough where they should be expecting significantly below average returns over the next 7-10 years.
Bottom Line
The permanently bullish camp is correct. It is not 1999-2000.  If that makes you feel better about buying stocks here, great, but it is not an argument based on logic.  As we saw in 2007, just because it is not a once in a hundred years bubble, it doesn’t mean there is no risk of a significant market decline. It also doesn’t mean that valuations are compelling and that investors should be expecting above average long-term returns from here. They should not. Something to think about the next time someone tells you a story about how this mania pales in comparison to the epic dot-com bubble.

What makes Buffett a great investor? Is it the intelligence or the discipline?

I thought this excerpt from Warren Buffett’s 2011 interview in India was relevant to not only investing but also decision making. A member of the audience says to Buffett: “As we all know, you are an extremely intelligent person. At the same time, you are very disciplined with your investing approach. What makes Warren Buffett a great investor? Is it the intelligence or the discipline?”
Here is Warren’s response.
Warren: The good news I can tell you is that to be a great investor you don’t have to have a terrific IQ.
If you’ve got 160 IQ, sell 30 points to somebody else because you won’t need it in investing. What you do need is the right temperament. You need to be able to detach yourself from the views of others or the opinions of others.
You need to be able to look at the facts about a business, about an industry, and evaluate a business unaffected by what other people think. That is very difficult for most people.
Most people have, sometimes, a herd mentality which can, under certain circumstances, develop into delusional behavior. You saw that in the Internet craze and so on. I’m sure everybody in this room has the intelligence to do extremely well in investments.
Moderator: They’re all 160 IQs.
Warren: They don’t need it. I’m disappointed they haven’t sold off some already. The 160s won’t beat the 130s at all necessarily. They may, but they do not have a big edge. The ones that have the edge are the ones who really have the temperament to look at a business, look at an industry and not care what the person next to them thinks about it, not care what they read about it in the newspaper, not care what they hear about it on the television, not listen to people who say, “This is going to happen,” or, “That’s going to happen.”
You have to come to your own conclusions, and you have to do it based on facts that are available. If you don’t have enough facts to reach a conclusion, you forget it. You go on to the next one. You have to also have the willingness to walk away from things that other people think are very simple.
A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.
Moderator: That’s very good advice, to be detached from all the noise. You shouldn’t go with the herd.
Warren: If you don’t know the answer yourself don’t expect somebody else to tell you. If you don’t know the answer yourself and somebody else says they know the answer, don’t let that fact push you into coming to a conclusion about something that you don’t know enough to come to a conclusion on.
Stocks go up and down, there is no game where the odds are in your favor. But to win at this game, and most people can’t, you need discipline to form your own opinions and the right temperament, which is more important than IQ.
Pascal said it best: “All men’s miseries derive from not being able to sit in a quiet room alone.”
Warren: If you look at the typical stock on the New York Stock Exchange, its high will be, perhaps, for the last 12 months will be 150 percent of its low so they’re bobbing all over the place. All you have to do is sit there and wait until something is really attractive that you understand.
And you can forget about everything else. That is a wonderful game to play in. There’s almost nothing where the game is stacked in your favor like the stock market.
What happens is people start listening to everybody talk on television or whatever it may be or read the paper, and they take what is a fundamental advantage and turn it into a disadvantage. There’s no easier game than stocks. You have to be sure you don’t play it too often.
You need the discipline to say no.
Ajit: The discipline to say no, if you have that and you’re not willing to let people steamroll you into saying yes. If you have that discipline, that’s more than 50 percent of the battle.
Warren: Don’t do anything in life where, if somebody asks you the reason why you are doing it, the answer is “Everybody else is doing it.” I mean, if you cancel that as a rationale for doing an activity in life, you’ll live a better life whether it’s in the stock market or any place else.
I’ve seen more dumb things, and sometimes even illegal things, justified (rationalized) on the basis of “Everybody else is doing it.” You don’t need to do what everybody else is doing. It’s maddening, during the Internet craze when the bubble was going on.
Here’s your neighbor who’s got an IQ of 50 points below you, and he’s making all this easy money and your wife is telling you “This jerk next door is making money, and you’re smarter than he is. Why aren’t you making money?”
You have to forget about all those things. You have to do what works, what you understand, and if you don’t understand it and somebody else is doing it, don’t get envious or anything of the sort. Just go on and wait until you find something you understand.
From this video

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.