New Year’s Resolutions for Investors & Managers (Part One)

As we enter 2015 refreshed from vacations, overstuffed with tasty victuals and perhaps even slightly hung-over, it’s time for that oh-so-hopeful tradition of New Year’s resolutions. Many of you probably resolved to spend more time with your family, eat better, exercise more, floss daily, or to give more to charity. Despite what the research says, some of those resolutions may even stick. So before the holiday afterglow completely fades, I would like to turn attention to some investing resolutions, designed to bring more (mental) health, wealth and happiness in 2015. Without further ado, here are my top three New Year’s resolutions for investors. (Due to the length of this post, I’ll cover money manager New Year’s resolutions in next week’s blog.)

Investor Resolutions for 2015

I resolve to not confuse absolute and relative returns – When you profess to want “absolute returns” you do not get to invoke the S&P 500 in the same breath. In 2014,  “absolute return” came to mean “I expect my investments to absolutely beat the S&P 500” or “My investments absolutely cannot lose money (or I will redeem them at my first opportunity).”  

Absolute returns actually means you make an investment in an asset class or strategy and then you judge whether you are happy with those returns based on absolute standards. Did the strategy perform as expected, based on returns, volatility, drawdown, and/or diversification? Do I still believe in this strategy or asset class going forward? If there was a loss, do I believe this is a substantial, long-term problem or is this a buying opportunity? Trying to turn absolute investments into relative investments after the allocation fact causes a lot of knee-jerk investment decisions, leads to return chasing and, ultimately, underperformance.

I resolve to not get tied up in my investing underpants – This probably needs some explanation because I do not want any of my blog readers to Google “tied up in underpants”  - the answers you get will absolutely not be suitable for work.

Instead this (quaint?) colloquial saying basically means that you shouldn’t get so wrapped up in perfecting the small things (underpants) that you can’t get to the big stuff (getting dressed and leaving the house).  For example: “That meeting was worthless. We spent all morning tied up in our underpants about where to get lunch and we didn’t address the sales quotas.” For non-Tennesseans, the less colorful turn of phrase would involve forests, trees and all that.

When it comes to investing, there are any number of “underpants issues” with which to deal. Fees are a great example. Every time someone wants to argue with me on Twitter about alternative investments, they inevitably start with “You don’t have to pay 2%/20% to [get diversification, manage volatility, achieve those returns, etc.]."

It’s always interesting to chat with these folks about what they think an appropriate fee structure would be. Most people say they are willing to “pay for performance.” And in fact, perhaps with the exception of investments into a small number (less than 500) of “billion dollar club” funds, you are.

Since more than half of all funds have less than $100 million in AUM, it’s pretty difficult for the bulk of funds to get rich from a management fee alone. Management fees tend to be, on average, around 1.6%. In comparison, mutual funds charge between 0.2% (index funds) and 2% in management fees, with the average equity mutual fund charging, according to an October 6, 2012 New York Times article, around 1.44%. Not that different, eh? As for the incentive fee, that only gets paid if the manager makes money. It’s designed to align interests (“I make more if you make more”), not steal from the “poor” and give to the rich. Perhaps a hurdle makes sense, but why dis-incent a manager entirely?

At the end of the day, this laser focus on fees hampers good investment decision-making. We run the risk of focusing too much on what we don’t want others to have than on what we might get in return (diversification, a truly unique or niche strategy, reduced volatility, expertise, returns). We run the risk of negative selection bias (with managers and with strategies) if we choose only low fee funds. We also risk dis-incentivizing smaller, niche-y and more labor-intensive start-up funds, which could completely homogenize the investment universe.

Is there room for fee negotiation? Of course. I am a big proponent of sliding scales based on allocation size or overall AUM. However, making fees your sole decision point is, I believe, penny wise and pound foolish over time and will leave you, well, tied up in your underpants.

I resolve to take a holistic approach to my portfolio – Say this with me three times “I will not chase returns in 2015. I will not chase returns in 2015. I will not chase returns in 2015.”

Why should auld performance be forgot? Let’s look at managed futures/commodity trading advisors. It hasn’t been an easy ride for macro/futures funds. In 2012, they were the worst performing strategy according to HFR. In 2013, they were edged out of last place in HFRs report by the Barclays Aggregate Bond Index, but still under performed all other hedged strategies. The last two years saw heavy redemptions, with eVestment reporting outflows from Managed Futures funds for 26 of the last 27 months.

And in 2014? Managed Futures killed it.

Early estimates from Newedge show that Managed Futures funds returned an average of 15.2% in 2014. January 2015 predictions are that Managed Futures will either win or place amongst top strategies for 2014.

It’s always tempting to dress for yesterday’s weather, but savvy investors look not just at what’s performed well, but where there are future opportunities and potential pitfalls. Even an up-trending market, maybe especially in an up-trending market, it’s important to look to out-of-favor and diversifying strategies, niche players and contrarians to create a truly “all weather” portfolio.

Stay tuned for money manager resolutions next week, and in the meantime, best wishes for a Happy Investing New Year.

In Case You Missed Them - 2014 Blogs By Topic

In case you missed any of my snappy, snarky blogs in 2014, here is a quick reference guide (by topic) so you can catch up while you gear up for 2015. My blog will return with new content next Tuesday – starting with my "New Year’s Resolutions for Managers and Investors."

“How To” Marketing Blogs

http://www.aboutmjones.com/blog/2014/12/8/anatomy-of-a-tear-sheet

http://www.aboutmjones.com/blog/2014/11/12/emerging-manager-2015-travel-planner

http://www.aboutmjones.com/blog/2014/10/21/conference-savvy-for-investment-managers

http://www.aboutmjones.com/blog/2014/9/11/ten-commandments-for-pitch-book-salvation

http://www.aboutmjones.com/blog/2014/7/18/emerging-managers-the-pitch-is-back

Risk

http://www.aboutmjones.com/blog/2014/11/10/look-both-ways

http://www.aboutmjones.com/blog/2014/11/3/the-honey-badger

General Alternative Investing

http://www.aboutmjones.com/blog/2014/10/25/earworms-and-investing

http://www.aboutmjones.com/blog/2014/10/7/alternative-investment-good-newsbad-news

http://www.aboutmjones.com/blog/2014/9/17/pay-what

http://www.aboutmjones.com/blog/2014/7/21/investing-and-the-law-of-unintended-consequences

 “The Truth About” Animated Blogs – Debunking Hedge Fund Myths

http://www.aboutmjones.com/blog/2014/10/13/the-truth-about-hedge-fund-correlations

http://www.aboutmjones.com/blog/2014/9/6/the-truth-about-hedge-fund-performance

http://www.aboutmjones.com/blog/2014/8/8/the-truth-behind-hedge-fund-failures

Diversity Investing

http://www.aboutmjones.com/blog/2014/12/8/getting-an-edge-in-private-equity-and-venture-capital

http://www.aboutmjones.com/blog/2014/11/21/the-simple-case-for-emerging-managers

http://www.aboutmjones.com/blog/2014/9/29/mi-alpha-pi-a-look-at-the-sources-of-alpha

http://www.aboutmjones.com/blog/2014/7/21/affirmative-investing-putting-diverse-into-diversification

Private Equity and Venture Capital

http://www.aboutmjones.com/blog/2014/12/8/getting-an-edge-in-private-equity-and-venture-capital

Emerging Managers

http://www.aboutmjones.com/blog/2014/11/21/the-simple-case-for-emerging-managers

http://www.aboutmjones.com/blog/2014/11/12/emerging-manager-2015-travel-planner

http://www.aboutmjones.com/blog/2014/9/29/mi-alpha-pi-a-look-at-the-sources-of-alpha

http://www.aboutmjones.com/blog/2014/8/25/submerging-managers

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.

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. 

Conference Savvy for Investment Managers

As part of my series on fund marketing, I thought I’d take a moment to talk about conferences. You can’t swing a dead cat without hitting a conference these days. There are events at least weekly, if not more often, all vying for your conference dollars and even more precious time. To maximize your conference experience, consider the following:

DO – Be choosy about conferences. Ask to see attendee lists (current or past, with contact info redacted if the organizer is touchy about sharing). Ensure that the audience matches your target demographic. Sometimes the only family office you will see at a conference is in the title of the event. Also, be aware of how many conferences you attend in a year. It was always a due diligence red flag for me if I saw a manager at too many events during a year, both from the perspective of expense management and time away from investments.

DO – Approach conferences with a battle plan. You should work an event like Sherman marching through Georgia. Make sure you get the conference attendee list with your paid sponsorship or registration and schedule meetings BEFORE the event. Have a target list of people you’d like to see in addition to your scheduled meetings. Bring your pitch book and one pager (if applicable) and plenty of business cards. If you are planning a dinner or lunch or golf outing, have the invites out at least 3 weeks in advance for maximum attendance.

DON’T – Stalk people. While this may seem counter to targeting attendees, there is a difference between seeking people out or asking mutual contacts for introductions and tailing people through an event. Once upon a time, there was a conference that offered homing devices to all attendees. It was not unusual to see an investor darting through the exhibit hall with 10 asset managers hard on their heels. It’s like Wild Kingdom - No one wants to be the antelope at the watering hole. Don’t approach people in bathrooms or lie in wait for them outside of lunches or other conference activities.

DO – Practice your elevator speech in advance. You need to be able to clearly articulate your value proposition in a NON-SALESY way. Rehearse a 2-minute and a 5-minute version. Role play with your colleagues how to seamlessly move from talk about a lunch speaker/panel/weather/golf outing into a quick summary of what you do.

DO – Ask questions when talking to your prospects. No one wants to hear a monologue about you or your firm. When practicing your elevator pitch, think of some questions to ask attendees to make the conversation more interactive. If you’ve done your homework on the attendees in advance this should be easy. Search Google for news or their website for RFPs and other information prior to the event.

DON’T – Commandeer your speaker spot (panel or standalone) to talk about your fund. Seriously. People will pass notes or text each other about you in the audience if you do this. Others may walk out. You’ll be known as “that speaker.” If you are lucky enough to get a speaking slot, think about how you can educate the audience. What is happening in the markets? What makes a particular investment strategy interesting? What is the outlook for a strategy? Always educate, never sell. Exception to the rule? Meet the manager, speed dating type of pitch events.

 DON’T – Sit behind your exhibit table if you have one. Stand up and move around in front of your exhibit so you can engage with people. If you sit, the only people that come up will be people that either know you or who want to have a serious conversation. You can miss more casual opportunities if you’re sitting down.

DO – Delegate effectively. If you aren’t a good public speaker and you have one in the firm, select him or her for speaking roles. If someone is better at marketing or capital raising, put them at cocktail parties or at the booth. There shouldn’t be a lot of ego involved in conferences – it’s a job function just like any other. Select the best person for roles to generate the most interest and effectively raise assets.

DO - Agree to follow ups during your conversations. The goal is to move the ball forward and have a plan (and buy in) to send follow-up emails including pitch books, monthly updates, commentary, white papers or other information. If you don't have a plan to continue forward momentum, you might as well not have gone to the conference at all. 

Stay tuned in November for more unsolicited fund raising advice!

The Truth About Hedge Fund Correlations

There are high correlations all around us. For example, there is a very high correlation between the per capital consumption of cheese and the number of people who are killed by their bedsheets each year. Hedge funds currently have historically high correlations to the indices. Is this a tragedy waiting to happen? Time will tell, but it's really too early to call.

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. 

Will Accreditation Changes Turn Emerging Managers into Submerging Managers?

Most of my non-industry friends don’t know what I do. They all know that I do research in finance, but to most, my alternative investment research focus is as mysterious as if I was a pre-Snowden NSA operative. This is in part because many of them consider finance to be frightfully dull. However, the primary reason for their lack of knowledge is something called "accreditation."

The SEC restricts data on and investments in hedge and PE funds (as well as other private investments) to those folks that are “accredited investors.” For decades, being an accredited investor has meant either having a million dollar net worth (excluding your primary residence) or an income of $200k/$300k (single/married). These income and net worth standards are used as a proxy for financial savvy. If you have enough in the bank, then you must understand money, the SEC reasons, and therefore you are allowed to take more risks with your cash.

However, even as I type, the Securities and Exchange Commission Investor Advisory Committee is weighing changes to accreditation standards. Some of the considerations on the table include raising the income threshold to $500,000 and the net worth threshold to as much as $5 million. In addition, there has been mention of a financial literacy requirement, such as passing the Chartered Financial Analyst exam. The monetary requirements would wipe out a huge portion of the HNW investor community, while a CFA requirement would take out a significant portion of the rest. For example, increasing the net worth requirement from $1 million to just $2.5 million would reduce the accredited HNW investor base from 8.5 million to 3.4 million people according to some studies. (http://www.cnbc.com/id/101933881)

While I understand the urge to “protect” investors, I happen to think these changes are unwarranted and may potentially have a significantly negative impact on innovation and diversity, and ultimately returns, within the alternative investment industry. And frankly the proposed changes just raise a lot of questions for me.

Why this particular threat?

There are a number of financial arenas in which enhanced knowledge, wealth or sophistication could make a material difference in outcomes. For example, according to one study, 15% of all bankruptcies are caused by credit debt, including credit cards, large mortgages, and car payments (http://assets.clearbankruptcy.com/infographics/leading-causes-of-bankruptcy.jpg).

In 2010, there were nearly 1.6 million bankruptcies. So approximately 240,000 Americans potentially could have avoided bankruptcy if the government controlled how much credit one could obtain, how much creditors could extend, or how well people have to understand credit before taking on such burdens.

Likewise, look at day traders. In order to manage a pattern day trading account, one must maintain a mere $25,000 balance. Yet, one study showed that four out of five day traders lose money, while another determined only one out of every 100 day traders consistently make money. Let’s assume that roughly 10,000 people in the U.S. day trade as their primary job. Of those professional day traders, 100 consistently make money and the other 9,900 consistently lose. Why not regulate this more closely? Maybe require a CFA?

And don’t get me started about gambling or the lottery. According to a Gallup Poll on Gambling, 57% of American adults reported playing the lottery in the last 12 months, with 65% of those falling into the $45,000 to $75,000 income bracket (http://www.naspl.org/index.cfm?fuseaction=content&menuid=14&pageid=1020#LotteryOdds) Your chances of winning the lottery? Less than getting injured by your toilet this year, according to National Geographic. How many folks do you think really understand those odds?

Hell, the average investor can contribute to a Kickstarter campaign for potato salad (over $40,000 raised) or a Chipolte burrito ($1050) which are both completely stupid investments AND utterly unregulated. Or what about Bitcoins? Mt. Gox lost over $409 million for its clients.

In short, there is no end to the ways you can “invest” your money. And any way you slice it, there are plenty of ways that these investments can destroy your wealth. Why doesn’t the federal government care about the “sophistication” required to understand, withstand and mitigate other "investment" risks, particularly ones that have a lot lower chance of success?

Isn’t this a self-limiting problem?

 If this is aimed specifically at hedge funds and private equity, the issue of high net worth investors putting all of their cash into “risky” investments is somewhat limited by the structure of the funds themselves. With high investment minimums (generally between $250,000 to $1 million), it is unlikely that a “lower level” high net worth investor will be able to make more than one investment, if that. For some who are early stage “friends and family” money, those investment minimums may be waived, but then the potential “damage” is mitigated as well. Most managers don’t want a fund filled with small investors (more work, less capital), so they tend to limit small investments. The market forces alone seem to be pretty efficient at limiting the hedge fund investments of your average millionaire in this case.

Won’t this submerge emerging managers?

 One of the arguments to make these accreditation changes is that no one has really squawked about them yet. Of course, this doesn’t take into account that the funds that have the financial wherewithal to actually make a fuss probably won’t even notice. There are about 500 funds that have more than $1 billion or more under management. There are about 5,000 funds that manage less than $100 million. As you look across this size spectrum of funds, the importance of the high net worth investor decreases as the size of the fund increases. Generally speaking, larger funds tend to be better influencers and squeaky wheels. Its likely HNW investors just aren’t a very important part of a large fund's business model any more.

And for those that say HNW isn’t important to the entire industry, it is true that about 65% of the AUM in the hedge fund industry now comes from institutional investors. It’s also true, however, that virtually none of that is in the emerging fund (small, new, women or minority owned) manager category. The 35% of assets that are controlled by HNW and family offices remains vitally important to this group of fund managers. Without access to a significant pool of HNW capital, and specifically early stage “friends and family” capital, many emerging funds might never, well, emerge.

Why do we care? Smaller managers can produce higher returns. Smaller managers can provide liquidity to parts of the market that are ignored by larger funds. Smaller funds may innovate where larger funds may care-take. Limiting opportunities in the emerging manager space is a key step towards the homogenization of the industry.

Will there be any unintended consequences?

Angel investors who help small businesses launch, fund innovation and create jobs would be swept up in this as well.

Of course, I imagine the SEC cares about as much about my opinion on accreditation as my non-industry friends do. So after today's blog, I'm only talking about beer, boats and BBQ. At least until after Labor Day. Enjoy the long weekend, y'all!

The Truth Behind Hedge Fund "Failures"

A recent Financial Times article entitled "Most Hedge Funds Fail" got me thinking about hedge fund failure rates and the reasons that hedge funds close. To put some perspective around the topic, I've created a quick video blog that talks about the different kinds of hedge fund "failure" and encourages perhaps a bit more moderation in our choice of terms.

aboutmjones.com blog post - analyzing hedge fund failures from Meredith Jones on Vimeo.

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