Second Quarter 2016

 In Market Commentary

Winners vs Losers in the recent Hedge Fund Fiasco

Hedge funds are currently unloved by the media and investors. While some of this rearview mirror criticism is deserved, some of it simplifies the issues hedge funds face by lumping them all together. We think good funds need the ability to buy when panic breaks out, as opposed to being forced to sell. Therefore, a good hedge fund should concentrate on hitting singles and doubles, and avoid swinging for the fences unless they are given a perfect pitch. Hedge funds have capital that can walk out the door every quarter, similar to bank deposits. Pardon another sport analogy, but try to think of hedge funds in two categories. One that tries to maximize Slugging Percentage (SP) versus the other that maximizes Batting Average (BA). Those SP guys will come in with big numbers and will be the darlings that everyone is talking about because of how great their latest home run was. Investors will get greedy wanting to be in on the next homer. Unfortunately for many funds, returns tend to be mean reverting and investments made following large right tail returns from concentrated bets (big wins, outside of a normal distribution) often lead to real capital loss, when those managers experience left tail returns (losses). The image problems of many hedge funds come when those Slugging Percentage funds, which can do fantastic when the market is generally unloved and undervalued, take on increasing risks as the market rises and valuations become extended. Eventually, most SP funds will lose and the return distribution will normalize. From our point of view, we like the home run hitters in an environment when there are a lot of fat pitch opportunities. But in a market such as we are experiencing today, full of curve balls, the guys who get on base more often are more valuable. Batting Average guys are not going to risk blowing up their business by swinging for the fences. They are going to try to bunt, hit singles and doubles, get on base, and get some RBIs. They are engineering returns. BA funds are rarely going to come in with sexy track records of major >20% annualized gains and they aren’t going to grab your attention with home run numbers, but late in a market cycle, they should outperform with significantly less volatility.

There is a major incentive problem with hedge funds as well. If you make big money quickly, you attract assets quickly. A fund that makes 30% a year for two years is much more likely to raise a billion dollars than a fund that makes 9%, despite the approach they used to achieve those numbers. Those guys that swing for the fences and get lucky are much more likely to win the fundraising game. For instance, one way to win a stock picking competition is to pick the two most volatile stocks you can find that have some sort of catalyst during the competition.[1] If you get lucky you win. If not, you lose like everyone else. As the world has learned, separating luck from skill is incredibly difficult. Warren Buffett, with his 50+ year track record, is most likely skilled. However, for a hedge fund with only 3 years of performance, there is not enough data to make that determination, particularly if it is a concentrated strategy without many at bats. Over the past 8 years, in the post-recession bull market, it has been very easy to get lucky. Therefore, we currently have a preference for strategies that have been battle tested through a crisis and lived to tell the tale.

For the time being, we will concentrate on engineering returns with base hitters, rather than investing with concentrated managers. There may come a time to use big hitters again, but in a world more poised for calamity, that time is not now. This doesn’t mean our returns will be lower, as we can still accept volatility in our funds, as long as the returns are not correlated with the rest of the portfolio and the strategies are paired with sound risk management. We just want to make sure we are benefitting from the one free lunch in investing, diversification. As luck would have it, hedge funds provide much greater diversification benefits than traditional asset classes. They can trade currencies, commodities, freight agreements, emerging market debt and rates, electricity, and even carbon credits. Most importantly, they don’t have to be long only. We need to make sure we benefit from diversification to fulfill our mission to our investors, which is to protect and grow their capital.

Yeah, but don’t you think today’s environment is bad for hedge funds?

The structure of the market has changed and some big asset managers now have shorter time horizons than they used too. This is reflected in the SPDR S&P 500 ETF, which trades its market cap in volume every day.[2] Risk parity funds like Bridgewater and AQR now buy and sell billions worth of bonds and equities based on the level of volatility. When volatility rises, they sell. When it falls, they buy. In the past year, this has been detrimental to their returns, as monetary policy has come to the rescue of every major scare in the markets. However, this same strategy, documented by countless academic papers, has shown to outperform over long time periods, because it helps cut off the periods of massive losses. In fact, these are the types of funds who survived 2008 relatively intact. True hedge funds, as we view them, should not be expected to outperform in bull markets. The way they generate better risk adjusted returns is by minimizing the losses suffered in bear markets, allowing them to compound at higher rates of returns overtime. We cannot predict when the next major event will occur that pains equity and bond investors, but we do know the era of market manias and panics is not over. Therefore, a cautious and astute investor should recognize the value of having hedge funds over a long time horizon and ignore the myopia of the financial press. Because something worked in the past year doesn’t mean it will work in the next. In fact, it is probably less likely to work.

Given that, there is much to fear currently. As equities make new highs in the US, rates across the developed world are at lows not seen in five thousand years (see Chart 1 from the Bank of England below).

Chart 1: Lowest Interest Rates in 5000 Years!

To us, this situation seems dangerous. The financial market uses these rates to discount cash flows for every type of imaginable investment. If these rates mean revert, as they surely will, so will the value of every major investment category, including real estate, stocks, bonds, rail roads, you name it. Looking at long term measures of equities, we find that US Equities are well above historical valuation ranges based on Robert Shiller’s CAPE ratio (see Chart 2). This bodes poorly for forward looking returns in equities over the next 7 to 10 years.

Chart 2: Next 7 Year S&P Return vs Case – Shiller PE Ratio

We believe the time to protect our clients’ capital is now, because most major assets classes are at all-time highs and forward looking return expectations are statistically low. In the meantime, we will continue to find those managers who can protect our capital and get some base hits no matter what pitch is thrown at them.

[1] https://www.quora.com/How-can-I-win-a-stock-market-competition-in-1-month-from-scratch

[2] http://www.bloomberg.com/news/articles/2015-07-30/the-amount-of-etf-shares-being-traded-has-eclipsed-u-s-gdp

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