What are UCITS?

UCITS are funds that comply with the European Directive for retail open-ended investment funds, are incorporated and authorised by the regulator in an EEA member state and can be distributed throughout the European Economic Area.

UCITS is a framework to standardise rules for the authorisation, supervision, structure and activities of collective investment undertakings in the EEA and so to enable them to be marketed throughout the EEA.

To be UCITS a fund must be open-ended, liquid, well-diversified, invest only in certain ‘eligible’ assets (namely quoted securities, money market instruments, deposits, certain derivatives and units in other UCITS) and can only employ limited leverage.

Why would a hedge fund manager offer a UCITS version of their fund?

Managers who are able to offer their strategies in UCITS format will be able to access a large universe of investors attracted by the UCITS brand in Europe, globally, and particularly in the Asia.

The transparency, liquidity and regulatory oversight required in a UCITS addresses investor concerns in a post-Madoff, post-credit 2008 crunch environment.

A UCITS lies outside the scope of the European draft Alternative Investment Fund Managers Directive which is likely to impact unregulated offshore hedge funds in yet undefined ways. This is potentially beneficial as the AIFM Directive is likely to impose constraints on European investors investing in third-country funds, which would include those domiciled in offshore jurisdictions such as Cayman Islands and Bermuda.

What is the process of launching a UCITS?

It’s complicated but it can be largely outsourced. Below is a list of the main features of UCITS. It all sounds complicated and laborious but a competent partner will be able to take most of the initial and ongoing burden away so that the fund manager can concentrate on managing money in as uninterrupted and unmodified a fashion as possible.

Fund Structures:

There are several fund structures available to UCITS. These include Unit Trusts, which are familiar vehicles and preferred by certain Asian investors such as Japanese, Variable Capital Companies, which are the OEICs and SICAVs and will look similar to a hedge fund structure with additional segregation of assets ex prime broker and Contractual Funds which are niche structures which are more complex to administer and market.

Management Companies:

The structure and indeed the existence of a management company is based on the tax planning of the investment manager. A Management Company brings with it minimum capital requirements, oversight and accounting and consolidation requirements. Roughly speaking, a UCITS Management Company needs to have 125,000 EUR of capital as a minimum plus 2 basis points per EUR of AUM over 250 million. This capital cannot be held on the group Holdco balance sheet and must be invested in liquid investments.

Sponsors:

There are some onerous capital requirements on Sponsors.

• In Ireland the capital requirement is 635,000 EUR.
• In Luxembourg the capital requirement is 7.5 million EUR.
• These are largely unwritten rules.
• A sponsor can be rented.

 

Legal Documentation:

• There are rules for the prospectus
• There is a simplified prospectus
• Constitutional documentation, memoranda and articles.
• Legal contracts:
  • IMA
  • Administration Agreement
  • Custody Agreement
  • Distribution Agreement
• Business Plan and Substance Application
• Risk Management Process

 

The Business Plan and Substance Application:

• Constitutional documents
• Capital requirements
• Probity and competence of directors
• Suitability of qualifying shareholders and organizational structure
• Conduct of business
  • Board meetings – Frequency and content – minimum of 4 in the domicile.
  • Managerial functions
    • Frequency and content of reporting
    • Exception reporting
    • Escalation measures

 

The managerial functions require at least 2 Conducting Officers or Dirigeants.

These can be:

• Employees (usually not)
• Directors of the UCITS can assume these functions
• UCITS can appoint consultants.
• In Ireland a board can be collectively appointed. In Luxembourg individuals have to be named.

 

The managerial functions include:

• Appointment of Chairman
• Frequency of board meetings
• Distinguishing between decisions for the board versus the conducting officers
• Compliance monitoring.
  • Investment breaches
  • Pricing errors
  • Complaints
  • AML issues
• Risk Management
  • Investment risk
  • Use of Derivatives
  • Pricing issues
  • Reconciliation
  • Failed trades
• Performance Monitoring
  • Performance metrics
  • Benchmarks – especially if VaR relative to benchmark is used as a formal exposure metric
  • Explanation of unusual performance
  • Outlook
  • A bi annual detailed commentary for inclusion in the financial statements
• Finance Control
  • Management company and fund financial statements
  • Annual audit process
  • Monthly management accounts of Management Company and Fund
• Monitoring Capital
  • Monthly review of capital adequacy.
• Supervision of service providers
  • UCITS requires regular ongoing due diligence on the Administrator, Custodian, and other service providers.

 

Eligible Markets and Securities:

List of Eligible Assets

• Transferable Securities (TS)
• Money Market Instruments (MMI)
• TS and MMI with a derivative element (example Convertible Bonds)
• Financial Derivative Instruments (FDI)
• Open ended Collective Investment Schemes (CIS)
• Deposits with credit institutions
• Ancillary liquid assets
• Financial indices
• Repos, reverse repos, stock lending

 

List of non eligible assets

Direct or indirect investments in

• Commodities
• Real estate
• Private equity
• Hedge funds
• Non financial indices
• Short selling of MMI
• Anything that circumvents the investment limits of the UCITS directive

 

Note that exposure to the above can be gained through financial indices on the underlyings.

Transferable Securities:

Generally:

• Max loss limited to cost
• Liquid
• Regular, accurate reliable pricing
• Negotiable

 

Closed end funds:

• Corporate governance has to be robust
• Asset manager subject to national regulation

 

Money Market Instruments

Generally:

• Normally dealt in on the money markets
• Liquid
• Can be accurately valued

 

If not dealt in on a regulated market:

• Meet certain issue/issuer criteria
• Information available for a credit assessment
• Freely transferable

 

Derivatives:

• Underlyings consist of:
  • TS, MMI, CIS, FDI, deposits, financial indices,
  • Interest rates
  • FX rates
  • Currencies
• Do not expose UCITS to risks it could not otherwise assume
• Does not cause deviation from investment objectives
• Does not result in the delivery of underlying which is not an Eligible Asset

 

Shorting comes in under derivatives on TS and financial indices. It will allow shorting equities and bonds via CDS.

OTC derivatives are allowed. There are requirements on the counterparty.

• The counterparty must provide valuations
• The counterparty must provide unwind

 

Collective Investment Schemes:

UCITS funds can invest in Collective Investment Schemes provided

• The underlying CIS does not itself invest more than 10% of NAV in another CIS (UCITS or otherwise)
• The CIS is diversified
• The CIS is liquid
• There is a 30% limit on exposure to non UCITS CIS even if they comply with the above
• Non UCITS CIS must be subject to some form of supervision equivalent to UCITS, with sufficient investor protection

 

Financial Indices:

• Automatically eligible if the constituents are themselves eligible
• All other indices require separate regulator approval
  • Requires sufficient diversification
  • Be an adequate benchmark for the reference market
  • Appropriately published
  • Must have independent management from the management of the UCITS

 

A number of bespoke indices have emerged that appear to game this rule. The indices resemble bespoke, alpha optimized portfolios instead of an index representative of some class of assets.

Hedge fund investable indices are eligible provided:

• No backfill used in their construction
• No payments are made to the index provider from the index constituents
• Index construction is objective and systematic
• UCITS must perform adequate due diligence on the quality of the index

 

Repos, Reverse Repos and Stock Lending

• UCITS can enter into repos and reverse repos and stock lending. Conditions apply.
• Collateral must be posted.

 

Diversification:

Unsatisfied with the almost universal concept of diversification, UCITS has adopted the term Risk Spreading.

Unlisted Securities:

• Limit of 10% of NAV in unlisted securities.
• Additional 10% of NAV in recently unlisted securities destined to list in less than 12 months
• Limit does not apply to certain 144A securities provided they list within a year
• Bonds with a liquid market traded between regulated broker dealers and are subject only to general limits

 

5/10/40 Rule:

• 10% NAV issuer limit across capital structure.
• For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 40% of NAV.

 

For bonds issued by EU credit institutions subject to special public supervision

• 25% NAV issuer limit across capital structure.
• For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 80% of NAV.

 

For Index Trackers, there are looser limits.

• Max 20% NAV issuer limit. 35% in exceptional circumstances. (e.g. 0005 HK in the HSI Index)
• Index must be:
  • Sufficiently diversified
  • Represent an adequate benchmark
  • Published appropriately
  • Independently managed of the UCITS

 

Control Limits:

• Max 10% of non voting shares of any issuer
• Max 10% of debt securities of any issuer
• Max 10% of money market instruments of any issuer

 

Government Securities:

• 35% NAV issuer limit (from 10%) for TS and MMI issued by:
• EU member state and their local authorities
  • Non Member State
  • Public international body of which at least one member state is a member
• Exempt from 5/40 rule

 

Up to 100% of NAV may be invested in TS, MMIs issued by a member state or their local authority, non member state or public international body if:

• Held over 6 or more different issues
• Limit 30% per single issue
• Intention to use these limits and target issuers is disclosed in constitution and offering docs
• Limited to OECD / Investment Grade (quite independent of each other these days)
• Gilt Funds for example can be UCITS compliant and invest in 1 single issuer. (not quite investment grade these days)

 

Investments in Other Collective Investment Schemes:

• Max 20% of NAV in a single CIS
• Max 30% of NAV aggregate in non UCITS CIS (to remain ourselves UCITS)
• Underlying CIS limited to no more than 10% in other CIS in aggregate (prevents FOFOF layering)
• Max 25% of units of a single CIS (control issue)

 

General:

• 20% NAV limit in issuer exposure across their capital structure, net. Includes TS, MMIs, cash, OTC counterparty, exposure via derivatives

 

• Max 5% in warrants

 

• No uncovered short sales

 

• Limits do not apply to the exercise of subscription rights

 

Borrowing Limits:

• The Fund can borrow up to 10% of NAV for temporary purposes.
• Credit balances may not be offset against borrowing in calculating the percent borrowed.
• Leveraged is achieved through derivatives.

 

Risk Management:

Risk Management Process:

• A fund using Derivatives must submit to the Regulator a detailed Risk Management Process (RMP)
• The RMP will set out the list of derivatives that will be used, the controls, processes, systems and personnel involved in the management and monitoring of risk relating to these derivatives.
• Material changes to the RMP need regulator re-approval.

 

Level of Sophistication:

• The Fund may self classify itself as Sophisticated or Non-Sophisticated.
• The Regulator may disagree
• Sophisticated funds are required to implement VaR
• Non Sophisticated funds can use commitment or (delta) notional exposure
• Self classifying as Non Sophisticated exempts a fund from the use of VaR but can impose restrictive notional leverage limits
• Self classifying as Sophisticated allows more latitude in definition of leverage within a VaR framework

 

Global Exposure:

Total gross exposure including derivatives is limited to 200% NAV

Synthetic shorting is allowed

Physical shorting is not allowed

Commitment Approach:

• Notional value
• Global exposure is NIL for funds using derivatives purely for hedging or risk reduction purposes
• Options can be treated on delta adjusted basis
• Purchased and sold derivatives can be netted only if there is explicit netting arrangements with the Custodian or counterparties

 

VaR:

VaR model based on:

• 99% confidence interval
• Max 1 month holding period
• Min 1 year historical observations
• Stress tests and back tests must be applied
• Adequate internal controls, staffing and experience are required
• Description of VaR model and 3^rd party verification
• VaR may be specified as a multiple of a benchmark. That multiple is limited to 200%.

 

Position Exposure:

• Limits are defined on total exposure aggregating direct, indirect and derivative exposure.
• Except for certain Index based derivatives.

 

Counterparty Exposure:

• Counterparty risk is limited to 5% of NAV for OTCs and 10% for EU or equivalent credit institutions.
• All derivative exposures to the same OTC counterparties must be aggregated and an “add on” for future credit exposure based on Market Value (Ireland) and Notional (Luxembourg).
• Counterparty risk can be reduced by the fund receiving collateral from the counterparty.
• Positive and negative positions can be netted but only if there are formal netting agreements with the counterparty.

 

Liquidity:

• A UCITS must re-purchase or redeem its units at the request of the unit holder.
• Minimum frequency is twice a month. (Note that there is no specification on when in the month.)
• Maximum notice until payout of cash is 14 days.
• A UCITS can have a 10% gate per redemption date, thus a maximum 20% gate per month.

 

Feasible Strategies:

The following strategies are feasible under UCITS:

• Long short equity
• Long short credit – liquid markets only
• Convertible arbitrage
• Global Macro
• Fixed income arbitrage – definitions of leverage need to be addressed
• Commodity index funds – there is no question of physical of derivatives on underlying commodities. Only commodity indices are eligible.
• CTA and Managed Futures
• Event Driven
• Funds of UCITS Funds
• Structured and guaranteed products
• ETFs

 

The following are not recommended for UCITS and fall foul of UCITS liquidity and valuation requirements: Less liquid credit strategies, distressed debt, mezzanine, private equity strategies, small and micro cap strategies.

A Final Word:

For the hedge fund manager, UCITS provides a delivery channel to a different investor base diversifying business risk. It also addresses investor concerns about the operational and fraud risks that plagued parts of the offshore unregulated industry in 2008. In addition, it provides a potential means of dodging the AIFM directive. There will be managers who see UCITS as a convenient dodge and an easier path to raising capital, and there will be those who see it for what it is; the evolution of European mutual fund legislation to ensure better investor protection while providing investors more choice. It is important that managers comply with the spirit of the law as well as the letter. The risk to UCITS as a brand is that it is abused by some managers which abuse the market uncovers in the usual discontinuous fashion and the fallout tars all UCITS with the same brush.

UCITS is designed for liquid strategies. Shoe-horning illiquid strategies into UCITS is a very bad idea. Not many people are aware that UCITS has a gating facility. This is an emergency feature for when normally liquid markets seize up. To run an illiquid portfolio in a UCITS in the hope that the gate provision is never needed is irresponsible on the part of the manager and the service providers who help to bring that UCITS to market.

UCITS is designed for low to moderate leverage strategies. The Sophisticated Fund classification which measures leverage in terms of VaR allows liquid strategies where delta notional exposure is not an appropriate measure of leverage admission as a UCITS. It is not there so that a highly levered and risky strategy can be slipped into a UCITS.

UCITS is designed for portfolios of eligible assets which are eligible by virtue of their liquidity, price discovery and transparency. It is designed so that the UCITS can feasibly supply the represented liquidity, provide an accurate and representative valuation of assets and not carry surprisingly large liabilities on the balance sheet which unexpectedly erode the value of the Net Asset Value.

Use with care.

Market volatility tends to fade and spike over time. Sharp corrections in financial markets occur more frequently than predicted by statistical theory. How do we explain these phenomena?

It seems to me that as a broad rule, and in particular where risk management is based on Value at Risk, that leverage is a function of underlying realized or historical volatility. In order for a portfolio to maintain a roughly constant level of risk, as represented by second moments, that is correlation and volatility, the level of leverage varies inversely with volatility. Intuitively this is prudent. Solvency requires that leverage is applied only to assets exhibiting low variability and that highly variable assets should not be highly levered.

Leverage is a function of the expected net excess returns and the volatility of the investment strategy pre leverage. As more arbitrageurs enter the market they reduce the level of mispricing between securities so that the return on capital employed in the trade is diminished and more leverage is required to produce the same return on equity. As arbitrageurs also enforce market efficiency they reduce price variation. Reduced volatility and reduced arbitrage encourage increased leverage. Increased leverage increases the probability that an unexpected data point violates the volatility assumptions leading to the need to reduce leverage.

Gross leverage is an important measure of systemic risk, both for individual participants as well as for regulators seeking to better understand system wide risk. However, delta adjusted notional exposure does not provide insight into second derivative effects which might accelerate or dampen any increase or decrease in leverage. To understand second order effects, it is useful to quantify the gamma. In a zero sum market, market net gamma is also zero. Gross gamma is the more interesting and useful quantity. Gamma concentrations at different market levels should be of interest to investors and regulators alike. These are analogous to the rapids, twists and turns along a river. Classifying gamma exposure according to the hedging activity of trader with the exposure is also important. Active delta hedgers are the target of scrutiny in the quantification of gamma since this is the source of feedback when markets begin to spiral out of control.

Realized volatility outside the expectations of historical volatility can trigger an increase or decrease in leverage. As volatility exhibits negative correlation with returns the likelihood is that a volatility breach is associated with fall in market levels. This is likely to trigger deleveraging. As markets trade to lower levels, negative gamma is likely to trigger further selling resulting in sharp corrections. At the same time, volatility rises further due to the market selling off implying a lower level of target leverage, the consequence of which is the need to deleverage. This negative feedback is likely responsible for most catastrophic market corrections.

Regulators should be mapping out gamma concentrations in addition to leverage to understand areas of unstable equilibria in markets. One would expect intelligent traders to seek and monitor the same information in their effort to avoid the landmines on the trading field, or to capitalize on them.

Unfortunately, mapping out gamma concentrations only identifies areas of unstable equilibria. What should regulators and traders do with this information? The answer to this is far away. A sharper definition of the general problem of managing systemic risk is also far away. The above is merely one facet of a vastly richer problem.

A corollary to the above characterization of gamma as a trigger for price movements is technical analysis. Often, technical analysis seems like the reading of tea leaves and other superstitions, but it is possible that investors’ desire to insure profits leads them to buy options at psychological strikes thus creating concentrations of gamma at key levels. This manifests as areas on a chart where prices cannot linger and must either retreat from (a resistance level), or bounce off (a support). A resistance once breached becomes a support, since the price cannot settle there. Maybe, there is a logic to chart reading after all, although one remains sceptical.

The SEC alleges that:

• GS failed to disclose that Paulson was involved in the portfolio construction of ABACUS 2007-AC1.
• GS misrepresented to ACA that Paulson was 200m long in the equity of ABACUS 2007-AC1.
• GS entered into CDS with Paulson that allowed Paulson to buy protection on tranches of ABACUS 2007-AC1s’ capital structure but did not disclose this to investors

The deal closed 2007 04 26. By 2007 10 24 83% of the RMBS had been downgraded and 17% were on negative watch. By 2008 01 29, 99% of the portfolio had been downgraded.

ABACUS 2007-AC1 was a synthetic CDO. Its assets consisted not of RMBS but of CDS referencing RMBS. In the construction of the collateral portfolio ABACUS 2007-AC1 would have to enter into these CDS with counterparties. Was Paulson a counterparty, the major or only counterparty?

It is going to be hard for the SEC to establish that GS defrauded investors by its failure to disclose Paulson’s role and intentions in ABACUS. Why? Paulson wanted to make a bet. A bet is not a sure thing. If Paulson or GS could affect the outcome of the bet then that is another matter. GS was effectively Paulson’s agent. GS got paid 15m to do the deal. GS job for which they were paid was to go find someone who would take the other side of the bet. GS is not bound to tell the other parties who their opposite number was. GS is indeed bound to provide full disclosure of the nature of the bet which they appear to have done. In fact, GS had a fiduciary duty to Paulson who was the paying client, a duty which includes confidentiality. One could argue that GS had a tortuous duty of care to the investors in ABACUS. Certainly there were conflicts. However, these are most certainly circumvented by the fact that IKB and ACA were market counterparties or expert and professional investors. If each party acted with due care as fiduciaries it is hard to obtain a fraud. Paulson acted for his investors. Goldman acted for Paulson and for its own shareholders. ACA and IKB all acted for their shareholders. But a bet was made and there would always be winners and losers. If anything, the quality of due diligence of ACA and IKB and the ratings agencies should be questioned.

ACA was engaged to provide an extra set of eyes on the deal. They were engaged by GS as portfolio selection agent, as well as to provide the credibility necessary to distribute the deal. It appears that ACA Capital, ACA’s parent turned up to effectively underwrite the deal as well. The SEC alleges that Paulson was involved in influencing the portfolio. This is trivially true by construction, however, things are not as clear cut as that. Paulson was specifying the bets he was willing to make. Out of the 123 underlying RMBS, ACA admitted 55. The final pool had circa 80 – 90 reference credits. ACA was not compelled to take the bets, and indeed only selected a subset of the Paulson portfolio. If we accept the SEC’s point of view we are accepting as logical behaviour the turning down or accepting of a bet based on the counterparty and not the information about the prospects, outcomes and probabilities of the bet itself.

The fact that the deal would not have placed without ACA as an independent portfolio selection agent, that Paulson had a hand in the portfolio selection, that Paulson made lots of money, are immaterial to the allegation. They are, however, the realities of the industry.

Did GS’s failure to disclose Paulson’s position long or short, constitute fraud, is the question before the courts.

There is the second allegation that is as important if not more. In my mind, this is the SEC’s stronger allegation since the misrepresentation leads to fraud. This is the allegation that GS represented to ACA that Paulson would invest 200m in the equity of ABACUS 2007-AC1. The SEC complaint does not present supporting evidence. It is possible that the evidence exists, however, they have not referred to in the formal complaint at this time. For the time being what they have in the complaint seems to indicate that ACA assumed that Paulson would be long the equity, and GS simply failed to correct them. If so, it was a costly assumption for ACA and their parent.

Why might ACA assume that Paulson was long equity? The Paulson trade resembles a more common and widely executed trade which attempted to profit regardless of the direction of credit spreads in the reference portfolio. The Magnetar trades were of this nature. The trade involves being long the equity or junior tranche of the cap structure while being short the mezz or senior tranche of the cap structure on a delta neutral basis. This trade generates profits if spreads widen or tighten. How? The equity tranche is convex to spread widening. The more senior tranches are relative concave to spread widening. By delta hedging a long equity (convex) position with a short mezz (concave or negatively convex) position, the convexity of the bundle can be very pronounced leading to a long spread volatility position. As this was a common trade at the time, ACA might reasonably assume that the Paulson was attempting the same trade. It appears not, and that Paulson did not have a long equity position against the short mezz. It was in fact an unhedged and highly speculative trade for Paulson and one which could have gone wrong with serious results. ACA had probably assumed more sophistication on the part of Paulson than was the case. Paulson was no expert in structured credit. His background was in risk arb, a very specific hedge fund strategy. Betting on mortgages was a macro call. Using structured credit instruments to leverage this bet was arguably reckless. Fortune shone on Paulson and his bet paid off.

Guilty or innocent, GS has already been condemned by the public. Investor forums are replete with condemnations of Goldman the Vampire Squid. That much is clear. Whether this is justified or not is another matter which is not so clear.

The constructive fraud issue I think is unfounded and in any case will be very hard to prove. The related misrepresentation issue will imply fraud and boils down to the evidence, which has yet to be presented definitively by the SEC.

The lesson in all this is clear. Caveat emptor. What kind of investor are you? In the context of Poker, if you play the hand, then all you are concerned with are the details of the deal. If you play the player then it is your job to find out all about who you are playing against. And do your own homework. Quite how some of the CDO liabilities got rated AAA is a mystery to me. The speed at which the underlying collateral and the tranches were downgraded certainly calls into question the quality and value of credit ratings agencies judgment.

If the SEC is successful in its complaint, it will certainly open a can of worms. Lets just look in one narrow area, retail structured products. See all those retail structured products which are offered by private banks? Some of them are constructed with the needs of the investor in mind, but some of them are constructed because someone wanted to make a bet, and the other side of the deal needed to be found. Look at the disclosure in a structured product. Are you told who designed it? Who had a hand in designing it? Who is on the other side of the trade? Was it initiated by the structurer or their client? How many private investors would even dream of asking these questions?

There is a more interesting although less likely scenario.

Say that the SEC wanted to prosecute Paulson. Why is not important. Say the SEC has no proof. A formal complaint would go nowhere and there would be a risk of a libel countersuit, or a frivolous litigation countersuit.

The SEC might decide that it has a case against GS in a related capacity, that of a conflicted agent. The case is thin but it would allow the SEC to bring allegations against Paulson, that it cannot substantiate, with immunity from libel prosection in the course of prosecuting its case against Goldman.

This is of course mere speculation.

• I want to bet that Club X will lose their next match, he says.
• Sure, says his bookie, let me see if I can find someone to take that bet.
• The bookie makes a few calls and finds little interest.
• We need someone to scrutinize the team, says the agent. It will help in finding the other side of the bet.

Enter Mr R whom the agent has found to scrub down the team. At some stage, with the involvement of Mr R as an independent party in scrutinizing the team, the agent finds Mr Q who is willing to bet that Club X will win their next match.

Club X promptly loses their next match.

• Wait a minute, who arranged this bet? The football association says?
• We did, says the agent.
• You didn’t tell Mr Q that the bet was initiated by Mr P. This is fraud. See you in court. Says the regulator.
• Wait a minute. Mr Q knew what the bet was about. He has been betting for years. We didn’t force him to take the bet. And since when did it matter who was on the other side of a bet? Says the agent.
• Don’t be ridiculous. We all know that Mr P is one of the best punters in the game. It is not wise to bet against him. Says the regulator.
• Not before this bet no you didn’t know that. So, you’re saying you would bet that Club X would win as long as Mr P was not betting that Club X would lose. Says the agent.
• That’s right, says the football regulator. You have to identify both punters. If you did, Mr Q would not have taken the bet. Says the regulator.
• But what you are then saying by implication is that Mr P can influence the outcome of the match. Are you investigating Mr P?
• Well, no, says the regulator.

 

• Are you saying that Mr P can either:

1. Choose the players in the team?

2. Coerce the players to throw the match?

You need both conditions to be true to be able to influence the outcome. You see, choosing the players is one thing, but Mr Q is fully aware of the line up before the bet is made. So on the second point, are you saying that Mr P can influence how the players play? Says the bookie.

• Mr P could choose the players, says the regulator. This is clearly a conflict. The players were terrible.
• But Mr R had the final say in who plays. And by the way, Mr R knows full well that Mr P was proposing the players. Mr R still had the final say. Says the agent.
• But not that Mr P was betting against the team, says the regulator. You said that Mr P would be betting that Club X would win. That’s misrepresentation. Says the regulator.
• How is this relevant? Asks the agent.
• If Mr P was betting on Club X to win, he would hardly also bet on Club X to lose would he?
• No, of course not.
• So what is Mr P doing in all this? Asks the regulator.
• You tell me. Mr R never asked. How is this relevant? Says the agent. Mr R had ultimate say over the team. In fact, Mr R placed a bet on Club X to win.
• Because they thought that Mr P was also betting on Club X to win. You knew that Mr P was betting they would lose. Says the regulator.
• But the team might have won. Mr P might have been wrong. Would you be suing us then? Heck, we placed a small bet on Club X to win ourselves.

 

Is investing a zero or constant sum game? In derivative markets, FX, commodities, the game is trivially constant sum. In equities there is some debate.

Some claim that ownership of equity is a claim on future cash flows and is therefore not a zero sum game. The value of equity is therefore sensitive to growth rates and discount rates extending far into an uncertain future.

The sensitivity of valuations to this uncertain future is too high so that valuations are too uncertain to be of much value. If the valuations were as stable as some proponents of equity investing purport, their models would not be able to explain the volatility in equity prices.

As far as I am concerned, investing is very close to a constant sum game. The pie is growing but at rate close to GDP growth in order of magnitude. It does not come close to the volatility observed in the markets. This volatility must therefore represent the winners and losers around the long term trend growth rate. This trend growth rate is so small relative to the volatility that one may as well regard the game as a constant sum game. So, where there are winners, there are losers, and its all a mighty big game.

Fundamentals are only of value in their impact on investors expectations and behavior.

A minority non-control investor in a public company can talk all day about their claim on assets and cash flow and still be no more closer to being an owner or operator of the business.

A minority non control investor in a private company beyond receiving dividends owns little more than a concept of charity.

Investment can sometimes seem like just one big casino, and for many it is. For the house and the card counters, the size of the markets makes it fertile hunting ground indeed. One overriding principle in all games of strategy, even where chance plays a hand, is that you always play the players, not the cards. Games of pure chance are for mugs, and the house. The house always wins.

Its a jungle out there and the majority of the players are sheep. There are professional traditional investors who may be more sophisticated, although many of them believe that fundamentals drive prices and analyse companies to that end. The more sophisticated investor realizes that fundamentals drive prices through mass psychology and thus take a more trading oriented approach, reacting to the reactions of others.

At the top of the food chain are the lions, wolves, hyenas and cheetahs. They realize that fundamentals are meaningless beyond the impact it has on the sheep, the cattle, the intermediate predators, the scavengers and the top of the food chain, themselves.

Their job is to figure out how all the other herds, packs and prides behave. Their objective is to pick out the weaklings from the herd. Occasionally there will be the opportunity to take down an entire herd, or better, a pack or even better, another pride. The sharp investor or trader is not only aware of fundamentals but who owns the stock, who trades the stock, what are their instincts and trading habits, how do they react to good news and bad, how quickly they act and who runs and who fights. Market impact is all that counts, so one has to know all the players and their firepower and thus marginal impact.

There are examples of successful retail punters. Sheep are after all not extinct. There are enough sheep to feed the wolves and still propagate the species.

Hyenas prey on the weak, foxes prey on the stupid, cheetahs on the slow. Each predator has qualities and strategies suited to their prey.

Betting on a deal closing or breaking. If you know the water is poisoned, all you have to do is take lots of antidote and wait by the water. Eventually there are lots of carcasses that are energetically free to devour.

Front running volatility. Watching structured products issuance in the retail investment market gives clues as to chronic demand supply imbalances in the vol market. A professional vol trader may look at vol surfaces and technicals to trade. The predator watches the root source of demand and supply and trades ahead of even the professional vol trader.

Knowing who is in play, what do they need, what are their instincts, what they will likely do next, what is their impact, is ultimately more important than knowing companies. The only time knowing companies is important is when you have control, or if not control then significant influence, or if you have the staying power to match the maturities in the fixed term securities issued by the company. If you have neither, knowing the company may be intellectually satisfying, but of little value otherwise.

In a constant sum game the number and nature of the players is very important. You can’t have more wolves than sheep. When convertible arbitrage suffered in 2005 it was preceded by a period when over 90% of new issuance went to hedge funds and only the scraps fell to non-arbitrageurs. When equity quant strategies hit a speed bump in 2007 they had all crowded into a small cap value overweight position. When trades get crowded, the traders get burnt. Not enouigh sheep. Diversifying among managers doesn’t help in zero sum games. You only pick up the transaction costs. When a strategy gets crowded there are only two things to do, get out of the strategy, or concentrate your bet to one manager who will be top dog. You can recognize this manager, he is the contrarian in a crowded strategy. The contrarian in an uncrowded strategy is a difficult bet. You just don’t know.

Favour environments where there are lots of sheep and a few wolves. Just make sure you are betting on the wolf, or are yourself one. If you are unsure, you are the sheep. Its a theorem. Part time investors are excellent prey.

Strategies are cyclical, even absolute return ones. The cyclicality arises often from the balance of sheep to wolves. As the wolves gorge they deplete the sheep and end up crowding each other out. Some sheep learn and become wolves. At the height of the feeding frenzy the wolves are eating each other. Get out of the way. But cycles are precisely that. The sheep never learn, they only need time to regenerate. There is always another generation of sheep for the slaughter.