Look Both Ways

Throughout my childhood I owned and rode a bike. In the 70s and 80s, no one gave two figs whether I did so wearing a helmet or not. Seriously, we drank out of the garden hose and trick or treated at houses where we didn’t know people, too. Those were wild and crazy years.

In the 1990’s, however, someone decreed that biking was entirely too dangerous to be attempted without a helmet. I promptly stopped biking. For those of you that have met me, or who have even seen my picture, you probably recall one critical fact about my appearance: I have Big Hair Syndrome.’ And it ain’t fitting under a bike helmet.

Flash forward 20 years and we’re discovering some interesting facts about the bicycle helmet craze. In places where bicycle helmets were required by law, bike trips decreased by 30-40% across all demographic groups and by 80% across secondary school aged girls.

Unfortunately, when people gave up their bikes, they also gave up the health benefits of riding. One study by the Brits suggested that the health benefits (in terms of increased longevity) of riding outweighed the risk of injury by 20:1. A study done in Barcelona put this figure at 77:1. In Australia, they found 16,000 premature deaths caused by lack of physical activity dwarfed the roughly 40 cycling fatalities that occurred each year.

And that’s the curious thing about risk. You can focus on a single risk (in the case of biking, that a head-on collision will occur at 12.5 mph) to the exclusion of all else and actually increase your risk of other types of injury.

This is especially true in investments, where there is no single definition of risk. There are a multitude of risks against which to guard, and most of them have corresponding risks they introduce. For example, if you maximize the risk of illiquidity (the risk that you can’t get to your money when you need it) you may compromise returns. Private equity has been the best performing strategy over the last 10 years, but locks up capital for 5-10 years depending on the fund. Likewise, venture capital, which has been on fire for the last few years, has a 10 plus year lock up.  Requiring high liquidity restricts the types of investments you can make, which can impede diversification. More liquid investment structures can have lower returns than less liquid investments because they allow for people to trade at exactly the wrong times. Don’t you know someone who sold his or her mutual funds or index funds at the exact bottom of the market? In addition, there can also be a lower premium on more liquid instruments.

Or consider headline risk. Remember the Chicago Art Institute and Integral Capital? When Integral blew up and the Art Institute was a large, and the only, institutional investor in the fund, the headlines abounded. Since that time, there’s been an acknowledged risk of being in the headlines for losing money. For this reason, many investors stick to the same small group of funds so that they’re not alone should the ‘fit hit the shan.’ Unfortunately, this leaves a lot of smaller, less-well-known managers in the cold, and can compromise returns as well.  It also increases concentration in a small number of managers, funds and strategies.

And what about fee risks? Being ‘penny wise and pound foolish’ can block access to some of the most successful (read: non-negotiable) managers and funds. It can also cause investors to eschew entire asset classes (private equity, hedge funds) increasing correlations and concentrations and reducing diversification. Or what about the risk of not beating a benchmark like the S&P 500? Chasing returns is not very productive in the long run, and it can cause investors to take unnecessary risks in order to beat a rising benchmark. It’s also difficult to outperform on both the up- and down-side, so targeting outsize bull market returns can lead to bear market catastrophes.

In short, there’s no such thing as a free lunch. Protect yourself single-mindedly from one risk, and you just increase your odds of obtaining a different type of injury.

The Honey Badger

One night last weekend, I was in bed reading when I was distracted by a noise coming from the bookcase in my master bedroom. I heard a thump and then scratching. Convinced it was one of my pets messing with my suitcase, which was out and packed for a trip the next day, I ignored the sounds. Thump, scratch. Thump, scratch. Thump, scratch. Finally I sat up in bed to admonish my cat for being a pest, however I quickly noted that said cat was on the other side of the room. And he was staring intently at the bookcase.

Thump, scratch.

Thump, scratch.

When I got up to look more closely at the bookcase, the door actually opened a little bit. The thump of it shutting was followed immediately by scratching noises. I stared at the door. Thump, scratch. I wondered if I should open it and see what was in there. Thump, scratch. I was pretty convinced it was an animal. Thump, scratch. A squirrel perhaps. Thump, scratch. Maybe even a honey badger.

Thump, scratch.

Whatever it was, I was sure it had rabies.

Thump, scratch.

I called the wildlife removal company and asked if they could come in the morning. They assured me that they would be at my house at 8:00 am, and I went to bed downstairs – after taping the doors shut and barricading the rabid honey badger in the cabinet with an ottoman.

THUMP, SCRATCH!

The wildlife people came to my house after I left for the airport, but called me to report on their findings before my flight took off.

“Ma’am, we’ve contained the situation,” they said.

“Was it a honey badger?” I asked.

“No, ma’am. Your DVD player turned on and was trying to open, which bumped the door. Then it spun and scratched the door, before shutting and trying to open again.”

Yes, the wild animal in my house was a vicious DVD player.

Why am I telling you this pretty humorous but somewhat embarrassing story? Because every person to whom I’ve told the story in person asked me the same question: “Why didn’t you open the cabinet door and look?” My answer? At the end of the day, I knew I had two long-term solutions to the problem. Either the wildlife folks would show up in 24 hours and remove the critter, or it would die and I could safely remove it myself with gloves and a shovel. I didn’t need to act right away, and doing so could actually have caused more damage.

The same thing is going on in the markets right now. The thumps and bumps of market volatility have a lot of folks spooked. But some people are checkers – they look at what the market is doing daily and try to develop a short-term solution. They are convinced if they act now, they can save themselves from whatever may be lurking in the dark. Other people are waiters. These folks develop a long-term solution and trust that their plan will work out for them in a defined period of time.  I’ll let you guess who sleeps more soundly through the thumps and scratches.

The key to surviving volatility, hysterical commentators, and even market corrections (which will happen), is to have a long-term plan. To be able to disengage enough from the noises in the night to ask the following questions:

“Would I buy this stock/invest in this manager/choose this strategy today?”

“Has anything fundamentally changed with this stock/manager/strategy or is this purely market movement?”

“Do I need liquidity from this investment now or in the immediate future?”

“What conditions would need to be in place for these undesirable changes to become the new status quo? Are those conditions likely to occur?”

By logically thinking through what might be causing the noise, it is possible to develop and stick to a plan that reduces reactivity and focuses on long-term goals and objectives. After all, in the words of Warren Buffett, “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

 Don’t get me wrong. I am a fan of active investing and I’m not saying, “let it ride no matter what!” I am not, however, a fan of re-active thinking. I believe successful investments require discipline. And while you might jump when you hear noises in the market, you need a plan and conviction to avoid letting the rampaging honey badger into your portfolio.

Earworms and Investing

In 1965, the Byrds released Turn! Turn! Turn! The song’s lyrics were taken almost directly from Ecclesiastes and promises: “to everything there is a season.” After reading that Macro funds made an overdue performance comeback in September 2014, I walked around my office singing that hippie ditty all day. While it was an annoying earworm in less than an hour, after nearly four years of market gains, maybe we could all use a little repetitive reminder that investment strategies fall in and out of favor.

If you look at Hedge Fund Research’s top performing strategies for the last 14 years, for example, you can easily see where investors might have some short-term memory loss when it comes to performance. After all, the S&P 500 has taken top performance honors for the last 3 out of 4 years. If you look at the last decade, however, you can see that Emerging Markets strategies have been at the top of the charts for three years as well. In fact, the S&P 500 and Emerging Markets hedge funds have been as equally likely to lead the pack as to end up in the bottom half of investment strategies over the past decade. And Macro/CTA funds, which have been both maligned and heavily redeemed from in past months, were the number two performing strategy in 2007 and 2008 at the height of the financial crisis. Many investors were extremely happy to have allocations to those strategies at that time, and flows into CTA/Macro surged in the 12 to 18 months that followed the market meltdown. Interestingly enough, however, Macro’s top-notch performance was preceded by, you guessed it, bottom half performance rankings in the years immediately prior to the crisis.

And hedge funds aren’t the only alternative investments to fall into cyclical patterns.  While venture capital is positively on fire now, it has been a long road to recovery in the wake of the tech wreck. According to data from Cambridge Associates, US Venture Capital funds returned 26.1% over 15 years, but only 8.6% over the past 10 years and 7.5% over the past 5 years. Now venture capital is coming back with a vengeance, with a three-year return of 14.4%. There is even talk of a new VC bubble, which was probably pretty unimaginable just a few years ago.

Even private equity, which seems untouchable at this point, has its good and bad performance periods. With a 15-year return of 12.0%, according to Cambridge, a five-year return of 11.0% and a one-year return of a whopping 17.2%, private equity is clearly not immune to some degree of strategy cyclicality.

Why does this matter? We all have a tendency to chase winners and sell losers, whether they are strategies or managers, and even when we know that investment philosophy doesn’t often work. For example, a study by Commonfund Hedge Fund Strategies Group in August 2014 showed that chasing returns was not a long-term strategy for success. The study concluded that “there may be a natural tendency for hedge fund investors to gravitate toward managers that have captured a significant share of the market’s upside. However, since such equity upside capture is not common or persistent among hedge fund strategies, using it as a selection criterion may lead to adverse selection.”

Investing isn’t easy. It can be a fight against your instincts and ingrained behavior. So it’s healthy to take a moment every once and a while to remember that markets change and that strategies come in and out of favor. A relentless chase of returns is not only exhausting, but often suboptimal. And by definition, if you’re chasing returns, you’re already behind. 

Alternative Investment Good News/Bad News

Good News

According to HFR, emerging managers performed best during last 12 months, gaining 11.3% through 1H2014.

Diversity funds (women and minoirites have outperformed the HF universe at large during the last 12 months, gaining 11.1% through 1H2014

Marco/CTA funds led performance in August 2014. The beginning of a comeback?

Pattern recognition helps PE and VC firms recognize successful investments?

Seven high quality hedge fund start ups launching in London

CALPERS sticking with Private Equity despite "complexity and fees."

Companies founded by women yeild 12% more for their VCs and use 1/3 less capital

IFK will welcome two women to the stage in 2014, Nehal Chopra and Nancy Prial.

Hedge fund liquidations declined in 2Q2014 according to HFR.

Skill is back? Fed says "moderately active" outperforms passive investments.

NY Common's equity hedge managers exhibit "above averages stock selection skill.

Bad News

The largest, most established U.S. based hedge funds control more assets than ever before, with $1.8 trillion as of July 2014.

Many women and minority led hedge funds continue to struggle with AUM, and therefore face the same fund flow problems as other emerging funds.

156 trend following CTAs liquidated, the first decline in the number of CTAs since 2005.

But keeps VCs from hiring women & minority staff and investing in diverse founders?

Not a single female manager listed among them.

CALPERS decision to exit hedge funds used as a club in the fee war.

Women run companies received just $1.5b out of a possible $50.8 billion from VC firms

In the previous five years, only one woman, Meredity Whitney, had been included.

Trailing 12 month liquidiations was still the highest it has been since 2009.

Blackrock research shows "alpha trades" don't work.

Articles on HFs still act as if beating the S&P 500 is relevant.

Mi Alpha Pi – A Look At The Sources of Alpha

While at the Grosvenor Small and Emerging Managers Conference last week in Chicago, I started thinking about alpha. Despite all of the naysayers out there quick to announce the death of alpha, I would actually suggest that alpha is alive and well and living in many portfolios. I think maybe investors, quick to flock to a very concentrated handful of extremely large funds, have forgotten where alpha lives and what drives alpha. 

For that reason, I’d like to announce the formation of a new co-ed fraternity. A fellowship, if you will, called Mi Alpha Pi. Mi Alphas have no dues and no secret handshake. We are merely called upon to remember that alpha comes in different size funds, diverse managers, life cycle investing and from innovators. 

MI ALPHA PI

WHERE DOES ALPHA COME FROM?

Skill – Obviously, this is what we want in all of our hedge fund managers: the ability to find and make the most of investment opportunities. Skill comes from a variety of sources. Intelligence, experience, intuition, emotional awareness and other factors contribute to manager skill. Skill is long-term and must be judged in a variety of market environments, good and bad. And in Mi Alpha Pi, we don’t believe that short-term losses necessarily are indicative of loss of strategic acumen. We even have special hazing for investors that think that way.

Cognitive Alpha – Cognitive alpha comes from being able to think about the markets and investing differently than your investing peers. Instead of looking at Apple and AIG along with every other large hedge fund, these managers look outside the box. Many investors have a tendency to be heavily influenced by market news and earnings and, over time, buying attention-grabbing stocks has a tendency to diminish returns. How do you find cognitive alpha? Look to contrarians, women and minority run funds for less homogenized thinking.

Structural Alpha – There has been a plethora of research, including my own at PerTrac, that suggests smaller, emerging managers outperform larger, older funds. One of the reasons why this may occur is what I will call “structural alpha.” When a fund is small it can take advantage of niche plays and club-sized deals that larger funds may ignore. They also may have fewer issues with liquidity, volume and short-squeezes. As a result, emerging funds may be able to exploit their smaller structures to produce outsized gains.

Behavioral Alpha – Although it’s difficult to separate behavioral alpha from cognitive alpha, I think it is an important distinction. Cognition is how you think about the world, while behavior is what you do with that information. Behavioral alpha may be created by less frequent trading, less inopportune trading and infrequent return chasing. Young funds and women and minority owned funds may be fertile grounds for behavioral alpha.

Luck/Chance – It is difficult to admit that sometimes what we think is alpha is really just luck or chance at work. For example, in the late 1990’s when I first began researching hedge funds, there were a number of funds that had no real shorting skills but that, at the time at least, didn’t need those skills. The rising tide of the bull market lifted all ships, so to speak. However, when the markets broke during the tech wreck, it was quickly evident which hedge fund managers were wearing no clothes, luckily figuratively and not literally. This is why it’s always critical to ascertain whether a manager is riding a good strategy or a good market.

It’s time to look a little further than the 500 largest hedge funds to find excess returns. Finding alpha isn’t always easy, but the 2014 pledge class of Mi Alpha Pi is looking forward to welcoming you. 

Investing and The Law of Unintended Consequences

In Nashville, we have a weekly paper called “The Contributor” that is sold exclusively by badged homeless individuals on various street corners around town. The paper costs $2, and I make it a point to stop and buy one once a week or so. Now before the bleeding heart liberal accusations start flying, let me explain. “The Contributor” contains some of the world’s best advice couched in its “Hoboscope,” written by one Mr. Mysterio. It’s worth the price of admission every time.

In a recent Hoboscope, Mr. Mysterio provided the following nugget: “Assuming the worst will happen might make you cautious, but it never really makes you safe.” In investing, at least, truer words may never have been spoken.

We all know investors are motivated by fear and greed. I would postulate that our fear wins every time. Maybe it’s the fear of losing money. Perhaps it’s the fear of not keeping up with investing peers. It could be the fear of headline risk, or of paying “too much” for an investment. But our fears feed our investment decision-making, creating cautious investors who somehow remain far from safe.

Take me, for example. For the last several months I have been sniffing disaster on the markets like a dog with his nose out the car window. Having lived through LTCM, the tech wreck and 2008 as a professional investor, my thoughts often fly to all the bad things that can happen to my little nest egg. At the moment, and for much of recent history, I’m primarily in cash. In the meantime, however, I’ve missed significant market gains, which compromises both my current and future earnings. I’m certainly cautious, and I’ve avoided my worst-case scenario, but I haven’t made my financial situation significantly safer due to that particular trade.

Look at the institutional investor community. One of their greatest fears is that of headline risk a la the Art Institute of Chicago and Integral Investments. As a result, many choose to pile their assets into a very small number of large and established managers (the 500 or so that contain 90% plus of the hedge fund AUM).  Studies, including my own from 2006-2011, Preqin and eVestment, have shown that smaller funds tend to outperform their largest counterparts cumulatively and across more time periods, and that new funds have outperformed cumulatively and across all time periods.  However, just like no one ever got fired for buying IBM, it’s unlikely you’ll be fired for investing in Bridgewater or Paulson. But does sub-optimizing returns in a world of growing liabilities truly protect us, or does it just spare us the humiliation and/or hard work of investing in or potentially being wrong about a smaller or newer fund?

And finally, think about the investors that remain all too focused on fees. Overpaying for an investment is a capital crime for a host of investors. They hope to simultaneously optimize returns by saving a few basis points and avoid the headline describing how much they paid their portfolio managers last year. Unfortunately, their fear can result in negative selection bias (only investing with lower cost funds or funds who will cut fees), going direct in an investment arena where they may not have sufficient expertise, or eschewing certain investments altogether. The illusion of safety is created, where their caution may in fact be creating its own set of risks.

Regrettably, I can’t tell you how to solve this conundrum. Let’s face it: I’m no Mr. Mysterio. I can only advise that when we think through our worst case investment scenario, we focus on all of the factors that need to be in place to make us truly “safe.” Not just on the one or two problems that keep us up at night. 

Adding Diversity to Diversification

A few recent articles got me thinking about diversity vs diversification:

·      June 5 -  Forbes reported that 15 large hedge funds were all in the same stock.

·      June 29 – The Financial Times reported on the alarmingly high correlation of hedge funds to the equity markets (0.93).

·      July 14 – Preqin study shows a mere 500 hedge funds control 90% or more of assets.

In essence, we’ve likely got a bunch of investors concentrated in a very few hedge funds that are highly correlated to the equity markets and who own the same stocks. Picture me making Macaulay Culkin’s face in “Home Alone.”

Diversification is a tricky thing. Investopedia describes it simply as a “risk management technique that mixes a wide variety of investments within a portfolio.” But maybe we need to think of diversification on a deeper level.

Homogeneous groups tend to think alike. They also tend to overestimate their problem solving skills and consider a narrower range of information.

They may also be less open to new ideas. The universe of hedge funds contains more than 10,000 funds. At the present time, there are fewer than 500 hedge funds managed by women and minorities. If you look in the dictionary under “homogenous” I bet there may actually be an illustrative photo taken at a hedge fund conference.

So I’d like to suggest that investors expand their definition of diversification. Maybe it’s not all about the asset allocation mix of stocks, bonds, futures, real estate and other asset classes. Perhaps it’s not even the number of funds you invest in or the mix of strategies you have. Maybe, just maybe, diversification includes the way in which the money managers collect, interpret and evaluate market data and the cognitive alpha they create for you.

You don’t think there’s a difference?

Talk to some women and minority managers about what they own. You might be surprised at how far their portfolios are off the beaten path. And then look at what the indices tell you. The HFRX Global Hedge Fund Index has produced a year-to-date net return of 1.77% through June. The HFRX Diversity Index has produced a 3.61% net return through the same period.

So the next time you’re meeting with a potential (or existing) hedge fund investment, look around the room. If you see a room filled with Matrix-esque Smith replications, you might want to go further down the rabbit hole to think about how market and company information is gathered, processed and acted upon by the fund. What does the fund own and how do those underlying portfolio positions interact with your other funds holdings? Are you really diversified or just in a lot of funds?

Or, of course, you can always take the blue pill. 

https://www.youtube.com/watch?v=uGQF8LAmiaE