VIX Trends Up 9th Biggest 1-day Move

About a week after a hedge fund manager who is popular with the media but has a poor track record of managing risk said “please stop talking about the low VIX”, it gains 44.4% in a single day – its 9th biggest 1-day move. He was suggesting the low VIX wasn’t an indication of high risk. If you have followed my observations, you know that I disagree. I’m one who has been talking about the low VIX and suggesting it is one of many indications of complacency among investors. That is, investors hear “all time new highs” and get overly optimistic instead of reducing their risk or being prepared to manage downside loss.

VIX biggest moves

I point out the hedge fund manager’s comment because I believe a low VIX is an indication of complacency because it measures expected implied volatility for options on the S&P 500 stocks. When implied volatility gets to historical low points, it means options traders aren’t paying high premiums for hedging “protection”. Others can believe what they want to believe. I don’t just point out observations at extremes. I actually do something.

As I pointed out recently in “No Inflection Point Yet, But… ” the VIX was at an extreme low. About a week later this other fund manager implies it may not be meaningful. That’s exactly what we expect to hear when the expected volatility gets to such an extreme low. We expect to see it shift the other direction at some point. I like to follow trends until they reach an extreme – and reverse.

Here is what it looked like.

VIX 9th biggest one day move

More importantly, here is what the stock indexes looked like on Google Finance after the close:

Stock market down Korea

Another observation I shared in “No Inflection Point Yet, But…” is that leading stocks can sometimes be more volatile and yesterday was no exception. While the stock indexes were down around -1.5% some of the most popular stocks were down about twice as much:

FANG stocks downSource: Google Finance

Of course, this is all just one day. We’ll see if it continues into a longer trend.

It’s always a good time to manage risk, but sometimes it’s more obvious than others.

Essence of Portfolio Management

Essence of Portfolio Management

“The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”

– Benjamin Graham

The problem is many portfolio managers believe they manage risk through their investment selection. That is, they believe their rotation from one seemingly risky position to another they believe is less risk is a reduction in risk. But, the risk is the exposure to the chance of a loss. The exposure is still there. Only the perception has changed: they just believe their risk is less. For example, for the last thirty years, the primary price trend for bonds has been up because interest rates have been falling. If a portfolio manager shifts from stocks to bonds when stocks are falling, bonds would often be rising. It appears that trend may be changing at some point. Portfolio managers who have relied on bonds as their safe haven may rotate out of stocks into bonds and then their bonds lose money too. That’s not risk management.

They don’t know in advance if the position they rotate to will result in a lower possibility of loss. Before 2008, American International Group (AIG) carried the highest rating for an insurance company. What if they rotated to AIG? Or to any of the other banks? Many investors believed those banks were great values as their prices were falling. They instead fell even more. It has taken them a long time to recover some of their losses. Just like tech and telecom stocks in 2000.

All risks cannot be hedged away if you pursue a profit. If you leave no chance at all for a potential profit, you earn nothing for that certainty. The risk is exposure to an unknown outcome that could result in a loss. If there is no exposure or uncertainty, there is no risk. The only way to manage risk is to increase and decrease the exposure to the possibility of loss. That means buying and selling (or hedging).  When you hear someone speaking otherwise, they are not talking of active risk management. For example, asset allocation and Modern Portfolio Theory is not active risk management. The exposure to loss remains. They just shift their risk to more things. Those markets can all fall together, as they do in real bear markets.

It’s required to accomplish what the family office Chief Investment Officer said in “What a family office looks for in a hedge fund portfolio manager” when he said:

“I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what’s ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I’ve heard people who’ve lost as much as 25% of investor capital argue that they preserved capital… but I don’t believe you can claim that.Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it’s a it’s a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.”

I made bold the parts I think are essential.

If you are like-minded and believe what we believe, contact us.

The Volatility Index (VIX) is Getting Interesting Again

In the last observation I shared on the CBOE Volatlity index (the VIX) I had been pointing out last year the VIX was at a low level and then later started trending up. At that time, many volatility traders seemed to think it was going to stay low and keep going lower – I disagreed. Since then, the VIX has remained at a higher average than it had been – up until now. You can read that in VIX® gained 140%: Investors were too complacent.

Here it is again, closing at 12.45 yesterday, a relatively low level for expected volatility of the S&P 500 stocks. Investors get complacent after trends drift up, so they don’t price in so much fear in options. Below we observe a monthly view to see the bigger picture. The VIX is getting down to levels near the end of the last bull market (2007). It could go lower, but if you look closely, you’ll get my drift.

Chart created by Shell Capital with: http://www.stockcharts.com

Next, we zoom in to the weekly chart to get a loser look.

Chart created by Shell Capital with: http://www.stockcharts.com

Finally, the daily chart zooms in even more.

Chart created by Shell Capital with: http://www.stockcharts.com

The observation?

Options traders have priced in low implied volatility – they expect volatility to be low over the next month. That is happening as headlines are talking about stock indexes hitting all time highs. I think it’s a sign of complacency. That’s often when things change at some point.

It also means that options premiums are generally a good deal (though that is best determined on an individual security basis). Rather than selling premium, it may be a better time to buy it.

Let’s see what happens from here…

Asymmetric Nature of Losses and Loss Aversion

Loss Aversion:

“In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman.”

For most people, losing $100 is not the same as not winning $100. From a rational point of view are the two things the same or different?

Most economist say the two are the same. They are symmetrical. But I think that ignores some key issues.

If we have only $10 to eat on today and that’s all we have, if we lose it, we’ll be in trouble: hungry.

But if we have $10 to eat on and flip a coin in a bet and double it to $20, we may just eat a little better. We’ll still eat. The base rate: survival.

They say rationally the two are the same, but that isn’t true. They aren’t the same. The loss makes us worse off than we started and it may be totally rational to feel worse when we go backwards than we feel good about getting better off. I don’t like to go backwards, I prefer to move forward to stay the same.

Prospect Theory, which found people experience a loss more than 2 X greater than an equal gain, discovered the experience of losses are asymmetric.

Actually, the math agrees.

You see, losing 50% requires a 100% gain to get it back. Losing it all is even worse. Losses are indeed asymmetric and exponential on the downside, so it may be completely rational and logical to feel the pain of losses asymmetrically. Experience the feeling of loss aversions seems to be the reason a few of us manage investment risk and generate a smoother return stream rather than blow up.

To see what the actual application of asymmetry to portfolio management looks like, see: http://www.asymmetrymanagedaccounts.com/global-tactical/

 

asymmetry impact of loss

Absolute Return: an investment objective and strategy

Absolute returns investment strategy fund

Absolute Return in its basic definition is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation (expressed as a dollar amount or a percentage). For example, a $50 stock drifts to $100 is a 100% absolute return. If that same stock drifts back from $100 to $50, its absolute return is -50%.

Absolute Return as an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, an absolute return objective of positive returns on investment over a market cycle of both bull and bear market periods irrespective of the direction of stock, commodity, or bond markets. Since the U.S. stock market has been generally in a uptrend for 6 years now, other than the -20% decline in the middle of 2011, we’ll now have to expand our time frame for a full market cycle to a longer period. That is, a full market cycle includes both a bull and a bear market.

The investor who has an absolute return objective is concerned about his or her own objectives for total return over a period and tolerance for loss and drawdowns. That is a very different objective than the investor who just wants whatever risk and return a benchmark, allocation, or index provides. Absolute returns require skill and active management of risk and exposure to markets.

Absolute return as a strategy: absolute return is sometimes used to define an investment strategy. An absolute return strategy is a plan, method, or series of maneuvers aiming to compound capital positively and to avoid big losses to capital in difficult market conditions. Whereas Relative Return strategies typically measure their success in terms of whether they track or outperform a market benchmark or index, absolute return investment strategies aim to achieve positive returns irrespective of whether the prices of stocks, bonds, or commodities rise or fall over the market cycle.

Absolute Return Investment Manager

Whether you think of absolute return as an objective or a strategy, it is a skill-based rather than market-based. That is, the absolute return manager creates his or her results through tactical decision-making as opposed to taking what the market is giving. One can employ a wide range of approaches toward an absolute return objective, from price-based trend following to fundamental analysis. In the ASYMMETRY® Managed Accounts, I believe price-based methods are more robust and lead to a higher probability of a positive expectation. Through my historical precedence, testing, and experience, I find that any fundamental type method that is based on something other than price has the capability to stray far enough from price to put the odds against absolute returns. That is, a manager buying what he or she believes is undervalued and selling short what he believes is overvalued can go very wrong if the position is on the wrong side of the trend. But price cannot deviate from itself. Price is the judge and the jury.

To create absolute returns, I necessarily focus on absolute price direction. Not relative strength, which is a rate of change relative to another moving trend. And, I focus on actual risk, not some average risk or an equation that oversimplifies risk like standard deviation.

Of course, absolute return and the “All Weather” type portfolio sound great and seem to be what most investors want, but it requires incredible skill to execute. Most investors and advisors seem to underestimate the required skills and experience and most absolute return strategies and funds have very limited and unproven track records. There is no guarantee that these strategies and processes will produce the intended results and no guarantee that an absolute return strategy will achieve its investment objective.

For an example of the application of an absolute return objective, strategy, and return-risk profile, visit http://www.asymmetrymanagedaccounts.com/

Absolute Return as an Investment Strategy

Absolute Return Investment Strategy Fund Manager

In “Absolute Return: The Basic Definition”, I explained an absolute return is the return that an asset achieves over a certain period of time. To me, absolute return is also an investment objective.

In “Absolute Return as an Investment Objective” I explained that absolute return is an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, it is focused on the actual total return the investor wants to achieve and how much risk the investor will willing to take, rather than a focus on what arbitrary market indexes do.

Absolute return as a strategy: absolute return is sometimes used to define an investment strategy. An absolute return strategy is a plan, method, or series of maneuvers aiming to compound capital positively and to avoid big losses to capital in difficult market conditions. Whereas Relative Return strategies typically measure their success in terms of whether they track or outperform a market benchmark or index, absolute return investment strategies aim to achieve positive returns irrespective of whether the prices of stocks, bonds, or commodities rise or fall over the market cycle.

Whether you think of absolute return as an objective or a strategy, it is a skill-based rather than market-based. That is, the absolute return manager creates his or her results through tactical decision-making as opposed to taking what the market is giving. One can employ a wide range of approaches toward an absolute return objective, from price-based trend following to fundamental analysis. In the ASYMMETRY® Managed Accounts, I believe price-based methods are more robust and lead to a higher probability of a positive expectation. Through my historical precedence, testing, and experience, I find that any fundamental type method that is based on something other than price has the capability to stray far enough from price to put the odds against absolute returns. That is, a manager buying what he or she believes is undervalued and selling short what he believes is overvalued can go very wrong if the position is on the wrong side of the trend. But price cannot deviate from itself. Price is the judge and the jury.

Of course, absolute return and the “All Weather” type portfolio sound great and seem to be what most investors want, but it requires incredible skill to execute. Most investors and advisors seem to underestimate the required skills and experience and most absolute return strategies and funds have very limited and unproven track records. There is no guarantee that these strategies and processes will produce the intended results and no guarantee that an absolute return strategy will achieve its investment objective.

For an example of the application of an absolute return objective, strategy, and return-risk profile,  visit http://www.asymmetrymanagedaccounts.com/

Absolute Return as an Investment Objective

Absolute Return objective fund strategy

In Absolute Return: The Basic Definition, I explained an absolute return is the return that an asset achieves over a certain period of time. To me, absolute return is also an investment objective.

Absolute Return as an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, an absolute return objective of positive returns on investment over a market cycle of both bull and bear market periods irrespective of the direction of stock, commodity, or bond markets.

Since the U.S. stock market has been generally in a uptrend for 6 years now, other than the -20% decline in the middle of 2011, we’ll now have to expand our time frame for a full market cycle to a longer period. That is, a full market cycle includes both a bull and a bear market.

The investor who has an absolute return objective is concerned about his or her own objectives for total return over a period and tolerance for loss and drawdowns. That is a very different objective than the investor who just wants whatever risk and return a benchmark, allocation, or index provides. Absolute returns require skill and active management of risk and exposure to markets.

Rather than a long article, this is going to be a series of smaller parts, building up to what absolute return really means.

For an example of the application of an absolute return objective, strategy, and return-risk profile,  visit http://www.asymmetrymanagedaccounts.com/

Top Traders Unplugged Interview with Mike Shell: Episode 1 & 2

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

As I approach the 10-year milestone of managing ASYMMETRY® Global Tactical as a separately managed account, I wanted to share my recent interview with Top Traders Unplugged. Niels Kaastrup-Larsen is the host of Top Traders Unplugged in Switzerland. Niels has been in the hedge fund industry for more than twenty years, working for some of the largest hedge funds in the world. He asks a lot of outstanding questions about life and how I offer a global tactical strategy that is normally only offered in a hedged fund in a separately managed account. And with experience comes depth of knowledge, so our conversation lasted over two hours and is divided into two episodes.

Click the titles to listen.

Episode 1

Why You Don’t Want Symmetry in Investing | Mike Shell, Shell Capital Management | #71

“It’s not about trying to make all the trades a winner – it’s about having the average win be much greater than the average loss – and that is asymmetry.” – Mike Shell

Episode 2

He Adds Value to His System | Mike Shell, Shell Capital Management | #72

“In the second part of our talk with Mike Shell, we delve into the specifics of his program and why most of his clients have 100% of their investments with his firm. He discusses backtesting, risk management, and the differences between purely systematic systems and systems with a discretionary element. Listen in for an inside look at this fascinating firm.” – Niels Kaastrup-Larsen

Direct links:

Episode 1

http://toptradersunplugged.com/why-you-dont-want-symmetry-in-investing-mike-shell-shell-capital-management/

iTunes: https://itunes.apple.com/us/podcast/why-you-dont-want-symmetry/id888420325?i=335354134&mt=2

Episode 2

http://toptradersunplugged.com/when-systematic-programs-arent-fully-systematic-mike-shell-shell-capital-management/

iTunes: https://itunes.apple.com/us/podcast/he-adds-value-to-his-system/id888420325?i=335582098&mt=2

 

For more information, visit ASYMMETRY® Managed Accounts.

Top Traders Unplugged Interview with Mike Shell: Episode 2

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

“In the second part of our talk with Mike Shell, we delve into the specifics of his program and why most of his clients have 100% of their investments with his firm. He discusses backtesting, risk management, and the differences between purely systematic systems and systems with a discretionary element. Listen in for an inside look at this fascinating firm.” – Niels Kaastrup-Larsen

Listen: Top Traders Unplugged Interview with Mike Shell: Episode 2

 

Direct links:

Episode 2

http://toptradersunplugged.com/when-systematic-programs-arent-fully-systematic-mike-shell-shell-capital-management/

For more information, visit ASYMMETRY® Managed Accounts.

Markets don’t always react the way investors expect, so I focus on what is actually happening

hedge fund market wizards

I noted the below question and answer between Jack Schwager and Ray Dalio in Jack’s book “Hedge Fund Market Wizards: How Winning Traders Win” (2012). Ray Dalio is the founder of Bridgewater, the largest hedge fund in the world and one of the most successful. I saved it when I read the book as a fine example that markets don’t always react the way people expect, and that is why I focus instead on what is actually happening rather than what could or should happen – but may not. Everything is very transient, coming and going, and it’s funny how some of the same kinds of things happen over and over again. As you read comments below you’ll hear it’s always a similar story, different day. 1982 was the end of a 20 year secular bear market made up of huge swings similar to the past decade and the beginning of the largest bull market on record up to 2000.

Below is Jack Schwager asking a question to Ray Dalio:

Any other early experiences stand out where the market behaved very differently from what you expected?

In 1982, we had worse economic conditions than we do right now. The unemployment rate was over 11 percent. It also seemed clear to me that Latin America was going to default on its debt. Since I knew that the money center banks had large amounts of their capital in Latin American debt, I assumed that a default would be terrible for the stock market. Then boom—in August, Mexico defaulted. The market responded with a big rally. In fact, that was the exact bottom of the stock market and the beginning of an 18-year bull market. That is certainly not what I would have expected to happen. That rally occurred because the Fed eased massively. I learned not to fight the Fed unless I had very good reasons to believe that their moves wouldn’t work. The Fed and other central banks have tremendous power. In both the abandonment of the gold standard in 1971 and in the Mexico default in 1982, I learned that a crisis development that leads to central banks easing and coming to the rescue can swamp the impact of the crisis itself.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards (pp. 54-55). John Wiley and Sons. Kindle Edition.

All of this, everything that is happening and expected to happen, will be reflected in the directional trend and volatility of price. The directional price and range of prices (volatility) will overreact at times and under-react at others, but it will reflect what is actually going on. Because the direction and volatility of price “is” what matters.

Madoff wasn’t a hedge fund

Bernie Madoff is back in the news lately as it’s now been 5 years since he was arrested for the largest Ponzi Scheme. For some reason, the name is commonly linked to “hedge funds”. Yet, the Bernie Madoff scam wasn’t a hedge fund, his company was a registered and regulated brokerage firm called Bernard L. Madoff Investment Securities. Madoff founded the Wall Street brokerage firm Bernard L. Madoff Investment Securities LLC in 1960. Some large hedge funds lost money because they had invested in Madoff’s managed account. They had Madoff managing some of their funds money. But Madoff Investment Securities LLC wasn’t a hedge fund.

If you had an account managed by Bernie Madoff at Madoff Investment Securities LLC  you would have had an account owned and titled in your own name. You would have gotten trade confirmations from Madoff Investment Securities LLC when he bought or sold. You don’t get that in a fund. You don’t know when a fund buys or sells. His investment program, then, offered the appearance of transparency – you could see what he was doing at any time.

As it turned out, the appearance of transparency enabled the thief to defrauded customers of approximately $20 billion over several decades. You see, Madoff’s investment program was a fraud, and the reason he was able to do it is that:

1. He was the portfolio manager: he made the trading decisions.
2. He owned the broker that executed the trades (as it turned out, they were fake; he didn’t do trades).
3. He owned the custodian: the custodian and broker was the same company.

Since Madoff Investment Securities LLC was the portfolio manager, broker, and the custodian, that allowed him to pretend to do trades and print trade confirmations and statements with fake information on them. Madoff Investment Securities LLC was regulated and registered as a brokerage firm, just like Wells Fargo Advisors, Edward Jones, Schwab, Morgan Stanley, and other brokers. You can probably see how the real issue was that his program was a fraud and he was able to do it because he controlled the trading decisions, trade confirms, account statements, and custody, because his company did it all. What if he had been required to custody an another company independent of his? he would have had to convince the other company to participate in his scheme which would likely have gotten him busted sooner. Most investment companies aren’t a fraud, so they would likely report him. Madoff was large and respected – but don’t think that made it any safer.

Whether you invest in a separately managed account or a private investment partnership, require that they use multiple service providers that are independent of each other instead of all one company. For example, your portfolio manager is an asset management firm, the broker is a different company that executes the trades and the custodian is a separate company that holds the securities and handles the cash in and out. Then, require it be audited by even another independent company. For example, if you enter into an investment management agreement with ABC Capital Management, LLC that firm is the portfolio manager and the agreement gives it authority to buy and sell in your account. Your account should then be held at a financial institution registered as a broker or bank like Folio Institutional, Trust Company of America, or JP Morgan. You deposit money to that financial institution that holds your money and they send you statements. ABC Capital Management, LLC is just trading the account independently and shouldn’t have custody of the money. If the investment program is a “hedge fund” instead of a separately managed account then it’s typically structured as a private investment partnership, say: ABC Fund, LP. A private fund is operated like a business – the business is trading for profit. You review a Private Placement Memorandum that explains every detail of ABC Fund, LP. When you invest, you sign a “Subscription Agreement” instead of an investment management agreement. You wire the deposit to the bank account of ABC Fund, LP and that money is then wired to the funds brokerage account. It’s best to require the fund to have a “third party administrator” who acts as the funds controller and accountant. That third party administrator is who accounts for your investment and sends you statements showing the value of your investment. You can probably see why you want the administrator to be a third party – independent from the fund manager. Then, the fund is audited annually to verify the administrators accounting is accurate. When ABC Fund, LP is a private investment partnership, it should be operated like any other major business with multiple investors. It has a bank account that sends/receives wires, a custodian that holds securities, a broker that executes trades, a third party administrator that does the accounting and creates profit and loss statements, and an independent accountant that audits all of it. Those should be separate companies independent of each other, not one.

Unfortunately, most of the smaller scams we hear about are even worse than the Madoff scheme. The investors write a check to “John A. Doe” which isn’t even a company at all. I don’t think any legitimate investment program has you writing a check to the individual portfolio manager. Deposits should be made to an independent bank or custodian and statements should come from that custodian. In fact, it’s even better to wire the funds rather than write a check. But “You can’t fix stupid”. There will always be Madoff-like scams and people stupid enough to write them a check. If you simply require that all the service providers be separate companies you won’t be one of them.

Understanding Hedge Fund Index Performance

I am often fascinated by investor perception and behavior. I notice it everywhere and study it always. What a person believes makes their world what it is and how they see things. It can also explain their own poor results. You see, if the majority of individual investors and professional investors actually have poor performance over long periods (as evidenced by Dalbar and SPIVA®)  they necessarily must be doing and believing the wrong things.

I just came across something that said “Why are hedge fund indexes performing so poorly?”. My first thought was “Are they?”. There are a few different hedge fund indexes, but I use the Barclay Hedge Fund Indices because it can include more than 1,000 funds each month across a wide range of strategies.

The Barclay Hedge Fund Index is a measure of the average return of all hedge funds (excepting Funds of Funds) in the Barclay database. The index is simply the arithmetic average of the net returns of all the funds that have reported that month.

As you can see below, the Barclay Hedge Fund Index, which is the average return of all hedge funds in the Barclay database, has gained 5.22% year to date through August. Is 5.22% a “poor” return when the risk free rate on short-term T-Bills, money markets, and CD’s are near zero? I don’t think so. But, if you compare it to the highest returning index you can find maybe you’ll perceive it as “poor”. For example, the stock market indexes are so far “up” double digits this year, but they can reverse back down and end the year in the red. Stock indexes are long-only exposure to stocks so their results reflect a risk premium earned for owning stocks with no risk management to limit the downside. I don’t know anyone who thinks the stock indexes have created the kind of risk adjusted return they want after declining more than -50% twice the past several years. If they want to compare “hedge funds” to a long-only stock index they should consider focusing on hedge funds that focus on stocks.

As you can see below, the hedge fund index includes a wide range of alpha strategies. The Equity Short Bias is one of only two that are down year to date and that is expected: they are short stocks and stocks have gained this year, so these strategist that short stocks  have lost money. Emerging Markets is the other that is down, which is not terribly surprising since most emerging markets are down. They have still managed risk: through August the Emerging Markets Hedge Fund Index is down -1.73% while the iShares MSCI Emerging Markets ETF is down -13.17%. I’m sure any of those hedge fund managers who are down don’t think that’s “good”, but its just a short period of time.

Barclay Hedge Fund Indices

Source: http://www.barclayhedge.com/

Investment managers are to compare their performance to something to illustrate the general market and economic conditions over a period. Since my investment programs don’t intend to benchmark any indexes, we often use the Barclay Hedge Fund Index as a comparison of this “alpha index” to our programs.

In the chart below, we have compared over a full market cycle the Barclay Hedge Fund Index, Dow Jones Global Moderate (a monthly rebalanced index of an allocation across 14 global indexes that are 60% global stocks, 40% global bonds), and the S&P 500 stock index The blue line is the Barclay Hedge Fund Index. Keep in mind that the hedge fund index is net of hedge fund fees while the S&P 500 stock index and Dow Jones Global Moderate does not reflect any fees.  If an investor used an adviser, they would pay a management fee, index fund fees, and trading cost, so the net return would be less. Recently, it has “lagged” the other two, but over the full cycle, its risk/reward profile is significantly superior. Though they all ended with about the same total return, the Barclay Hedge Fund Index declined -24% peak to trough during the 2007 – 2009 bear market. That -24% is compared to -38% for the Dow Jones Global Balanced 60/40 index and -55% for the S&P 500 total return (including dividends). That is the advantage of “active risk management” many hedge funds attempt to apply. Look closely at the chart below and decide which experience you would have rather had. And then, consider that it’s important to view the full picture over a full market cycle rather than focus on short-term periods.

Hedge Funds vs. Asset Allocation and Stock index

As to why the Barclay Hedge Fund Index has lagged stocks lately?

They are supposed to. Hedge funds as a group, as measured by a composite index, are investing and trading long and short multiple strategies across multiple markets: bonds, stocks, currency, commodities, and alternatives like volatility, real estate, etc.

You may also consider that hedge funds are generally risk managers (though not all have that objective). If you look at the end of the last bull market in stocks (late 2007) the hedge fund index lagged 100% stock indexes then, too. You may consider that risk managers are actively managing risk and they could be right in doing it now considering the stage in the cycle.  It’s probabilistic, never a sure thing. It worked the last time. Some hedge fund strategies begin to reduce their exposure to high risk markets like stocks after they have moved up to avoid even the early stage of the decline. By doing that, they “miss out” on both the final gains but also the initial decline after a peak. Others wait until stocks actually reverse their trend, which means they’ll participate in some of the initial decline when it happens.

You may also consider that people bragging about the gains to long-only stock indexes that have no downside protection may be another sentiment indicator. Historically, it seems that about they time they get to bragging and become complacent the trend turns against them…

Note: you cannot invest directly in any of these indexes.

Hedge funds charging highest performance fees provide best returns

A performance incentive fee is the key compensation for a hedge fund manager. Many people may not understand the concept of “alignment of interest”. For example, an investor recently told me they only invest in private funds because of alignment of interest. Essentially they want the fund manager to profit when they do. For example, if a $50 million private fund earns a 10% net return, the fund manager would earn $1 million of the profit as a performance incentive. If the fund manager earned a 100% return, his compensation would be $10 million. If the fund manager has a loss he gets no performance incentive fee until the loss is fully recovered and the fund reaches a new high. You can probably see why some money managers focus on growing the fund through the process of trading rather than trying to find more and more new investor money. I know people across various sides of the money management industry – the incentives and motivations are vastly different depending on their business structure and specialization. A wealth manager that measures success by assets under management will focus on gaining new clients. An alternative portfolio manager pursuing asymmetric investment returns may have an incentive to focus more on the profits they generate. That is, if you really believe you’ve got some skill, you’ll want to align your rewards in that direction. At least, that’s what an entrepreneur who sells a business for $100 million may tell you.

And believe it or not, Pensions & Investments Magazine shows these performance incentive fees may indeed matter in Hedge funds charging highest performance fees provide best returns. They say:

A comparison by Preqin of hedge fund net returns categorized by the performance fees they charge shows that funds charging more than 20% in performance fees actually outperform those that charge 20% or less. Funds charging higher fees appear to be producing higher, and more consistent net returns…

And the chart speaks for itself:

Hedge funds charging highest performance fees provide best returns

Source: Pensions & Investments

The Little Book of Hedge Funds by Anthony Scaramucci

 The Little Book of Hedge Funds by Anthony Scaramucci

I read The Little Book of Hedge Funds over a weekend. It’s an easy read and an excellent choice if you want to get a good overall understanding of hedge funds and the general industry of hedge fund management, selection, or absolute return strategies in general. It doesn’t get into detailed strategies, but instead a high level overview of the pursuit of asymmetric returns. My favorite part of the book was Anthony’s section on selection of hedge fund portfolio managers and how he defines “pedigree”. As he puts it (pp. 149-150):

“To make a long story short, the investment research and due diligence process is focused on determining or not a manager can: Generate attractive absolute and relative returns. Manage risk. Produce uncorrelated returns, with relatively attractive liquidity. Evolve as market conditions evolve. Perhaps most important, we have to understand how they will behave when the shit hits the fan in market debacles like LTCM, September 11th, the summer of 2002, 2008, the European financial crisis, and so on.”

He goes on to say he breaks the manager selection process into two categories. The first is Pedigree (pp. 150-151):

Pedigree:

“Pedigree is an all-encompassing term we use to assess whether a manager possesses the right experience and skill to execute a particular strategy in a particular market environment. Typically, an investor should strive to find a manager with many years of real “buy-side experience,” that is, the manager should have actually managed a reasonable amount of capital over a reasonable period of time. The exception to this rule is a new, cutting-edge manager who is implementing strategies that may not have existed three years ago. You would be surprised at how many hedge funds fail the basic “experience” test. For instance, if a manager’s only prior experience is that he was a fixed-income salesman, you could undoubtedly find someone with more relevant experience and skills. For whatever reason, a lot of hedge fund investors tend to be drawn like moths to a flame to big-name sell-side guys who come out and launch a new hedge fund. A general rule of thumb: Avoid these guys like the plague as history has shown that they tend to always fail. After all, managing capital for private investors is completely different from running market making/prop trading outfits. Pedigree also includes a manager’s temperament and qualitative judgment. Is he a loose cannon or thoughtful and deliberative? Has he experienced personal and professional setbacks in his career and how has he responded? Has he treated his investor capital with prudence or has he viewed it as a tool to make a name for himself and get rich quick? Answering these questions takes a lot of work. But, if you want to invest with a hedge fund manager you have to be willing to roll up your sleeves and analyze that manager’s pedigree.”

I thought his explanation of pedigree is outstanding. He points out that pedigree is more about a persons actual experience and skill as evidenced by track record rather than the things we would  see on a resume like college alumni, GPA, and places they’ve worked. It shows Anthony Scaramucci is the real deal. That is especially true because Anthony himself is a Harvard MBA graduate and began his career at Goldman Sachs before staring his own firm. Getting in and out of Harvard’s MBA program and landing a job at Goldman is an accomplishment, but says nothing about ability to manage money. A portfolio managers pedigree is about executing with an edge and is evidenced by a track record.

 The Little Book of Hedge Funds description from Amazon:

The Little Book of Hedge Funds that’s big on explanations even the casual investor can use. An accessible overview of hedge funds, from their historical origin, to their perceived effect on the global economy, to why individual investors should understand how they work, The Little Book of Hedge Funds is essential reading for anyone seeking the tools and information needed to invest in this lucrative yet mysterious world. Authored by wealth management expert Anthony Scaramucci, and providing a comprehensive overview of this shadowy corner of high finance, the book is written in a straightforward and entertaining style. Packed with introspective commentary, highly applicable advice, and engaging anecdotes, this Little Book:

  • Explains why the future of hedge funds lies in their ability to provide greater transparency and access in order to attract investors currently put off because they do not understand how they work
  • Shows that hedge funds have grown in both size and importance in the investment community and why individual investors need to be aware of their activities
  • Demystifies hedge fund myths, by analyzing the infamous 2 and 20 performance fee and addressing claims that there is an increased risk in investing in hedge funds
  • Explores a variety of financial instruments—including leverage, short selling and hedging—that hedge funds use to reduce risk, enhance returns, and minimize correlation with equity and bond markets

Written to provide novice investors, experienced financiers, and financial institutions with the tools and information needed to invest in hedge funds, this book is a must read for anyone with outstanding questions about this key part of the twenty-first century economy.