What do Investors Want?

2008 was a traumatic year for investors in pretty much any asset class or strategy. In 2009, I’ve been reading a number of investor surveys seeking to discover what investors want. I am as usual focusing in particular on the hedge fund industry.

Key findings:

Investors continue to favour larger hedge funds in the 1 to 5 billion USD range.
There is a decided preference for managed accounts.
Investors are against leverage of any sort.
Investors require better risk management and transparency from their managers.
Performance remains the number one factor in assessing a hedge fund manager.
Investors expect global macro, CTAs and equity long short to perform best going forward.
In terms of what they intended to invest in, investors preferred global macro, distressed credit, CTAs and credit long short.

It is difficult to comment on these findings without knowing the history and context of the investors. One can make a couple of simplistic observations.

If larger investors favour larger hedge funds, you will end up with the larger investors having more hedge funds in common. Also, you will end up having more hedge funds with investors in common. This creates a very interesting and amusing correlation through instrument variables. The investors are each others’ hidden instrument variables with the dual situation that the hedge funds are each others’ hidden instrument variables.
The case for and against managed accounts is best dealt with in more detail in another article. With a managed account one gets validation of assets, better liquidity, better transparency, no gating, independent valuation, ability to be the sole investor. Yes, maybe, yes, yes, yes, and yes. Validation of assets is unparalleled in a managed account especially if the managed account is established by the investor. Independent valuation is available through appropriately structured hedge funds. Better transparency is also unparalleled through a managed account but can be available through an appropriately structured hedge fund. No gating is definitely a plus. But better liquidity is not so clear. If the underlying assets are illiquid, the ability to sell them is really the ability to fire-sell them. Then it becomes, I want a managed account where I am the only investor who can fire-sell assets but I want everyone else in the fund to be gated or suspended. Not really feasible. If the assets are indeed liquid, a managed account means that the investor has full benefit of the liquidity of the underlying market. On the other hand, there are costs associated with managed accounts that require a minimum size which can be quite sizeable. The performance of the managed account may not track the performance of the commingled fund for all sorts of reasons. Some assets are not divisible. Timing issues can result in managed accounts not having the same portfolio compositions as the commingled fund. And there are a host of other issues which may be neither good nor bad but complicate the implementation and analysis of managed accounts.
See my article on Leverage on 17 March 2009: Leverage: Nothing is Good or Bad…
Investors require better risk management and transparency from their managers. Transparency is one of the most important factors in the investment decision because at its heart is the ability to verify the representations made by a manager pre-investment. It allows investors to see if managers are doing as they say they would. Transparency goes beyond mere position level reports. Position level reports are useful to prove the assets and the strategy. Risk reports are useful and reduce the complexity of the position level reporting to a more manageable form. Having access to the manager and to the various people in the team are important elements of transparency as they provide not just the static snapshot of risk, or the historical trading behaviour but they also provide an insight into the views and intentions of the manager on a forward looking basis.
Performance is a difficult one. Everyone loves a fund that is generating good returns whether they are high or stable. But how does one distinguish between skill and luck? Track record is but one measure. (See my article 22 Jan 2008 about The Importance of Track Record in Hedge Fund Investing) See also my articles Skill and Luck 1, and Skill and Luck 2.
I find it quite interesting that investors expect global macro to do well going forward. At risk of being circular, the call that global macro should do poorly or well in a given year is a global macro call in itself. Thus, the only people who can claim that macro will do well at any particular point in time is someone qualified enough not to need to outsource macro to some guys who charge 2 and 20 to take your money to have a go at Roulette. If you don’t know whether macro will do well or not then you outsource to a macro manager whose head of marketing will tell you that macro will do well this year.
It is interesting to note that investors want to increase their allocations to credit hedge funds, a strategy which they do not have a strong opinion about in terms of returns.

Obviously there are more interesting things going on behind these findings and my comments are on the output without the benefit of the underlying data.

The Blame Game

I’ve been thinking about who is to blame. The first answer that comes to mind is my parents, because they are usually to blame for just about everything else, but I am not sure I can pin Madoff or the Credit Crunch on them.

So, the first question is “blame for what?” That’s easy. According to the news media and the common man on the street,everything seems to be such a big mess.

To get to the bottom of it all, I went on the G20 protest march on Saturday here in London. It was called Put People First. People were really upset, and I was determined to figure out why. But even the name confused me. Put people first before what? The consensus answer seemed to be before giant multinational corporations, particularly banks. But aren’t banks run by people? It’s like the whole “guns don’t kill people, people kill people” thing. What are the protestors suggesting, to put people first, except for the people that run banks? “Yes,” was the answer. And, unsurprisingly, put some people before other people that own guns. Oh, and use plastic bags at the grocery store.

I still wasn’t making any headway on figuring out who was to blame. This is where Madoff comes in. Not because he is to blame for the world’s financial crisis, mind you, but because blame seems to be much easier to assign in this case than in many, at least for me. Needless to say, Madoff is a criminal and is to blame for behaving as such. But no investors were forced to invest. And, let’s face it, the signs were there.

The purpose of due diligence is not to confirm that you have made the right investment decision. If every single result of due diligence does not clear hurdles of the highest standard, the purpose of due diligence is to allow an investor to say “No.” Investors should always be looking for reasons to say no, not yes, and then be willing to do it.

Does this shed any light on the “big mess?” Well, to a certain extent.

We know that ratings agencies have perverse incentives, due to the way they are compensated. We should say “no.” We know banks were structuring product, stuffing it into unsuspecting client portfolios, only to buy back the underlying in order to free up demand for more product and more fees. We should have said “no.” We know the GSE’s had government guarantees and free license to hyper-leverage their portfolios. We should have said “no.”

The list of those we could blame goes on and on. Who is to blame? As usual, we have nobody to blame but ourselves.

Recovery or Bear Market Relief Rally?

For those of us who have lived through major bear markets there is significant skepticism about the current equity market rally.

Reasons to be optimistic:

· Economic data is improving. The extreme inventory destocking in late 2008 is being reversed. Housing prices are stabilizing. Housing transactions are rising.

· China as an engine of growth. For now domestic consumption is muted and savings rates are too high but the infrastructure spend will boost growth.

· Emerging Asia and Lat Am is replete with healthy companies at distressed valuations.

· Markets have overshot on the downside and are exceedingly cheap.

· Equity earnings yield gap is supportive of equities.

· Government policy is extremely supportive of risky assets. And will continue to be until asset prices recover. TARP, TALF, QE, PPIF and so on.

· The legacy loans program

· Markets turn a good 12 months before the real economy recovers.

· The market panic is over, investors are recovering from the initial panic.

· Inflation will be positive in diminishing the real value of debt and encouraging consumption.

Reasons to be pessimistic:

· TARP. TALF, PPIP, et al won’t work, or at least not as well as intended. The plans are short on detail but long on principles. There are a number of ways the plans might fail, some high probability ones. The government has now provided the capacity to purchase distressed assets from banks. They have not addressed the propensity for banks to sell. The market will likely remain thin and illiquid. The process will take too long.

· Credit markets may be functioning again but the demand for credit is also diminished. There are mixed signals here. Companies are looking for credit to refinance existing debt and the recovery in credit markets is positive for them. Households will benefit from the Legacy Loans Program. The propensity to consume, however will take time to recover.

· There is a crisis of unemployment which will take longer to resolve. The problem is global and likely to be protracted.

· Economic problems become social order problems. Pockets of unrest have arisen in France, Eastern Europe, China.

· The perma bears are waiting to short at around current levels.

· Inflation may become a problem. So far expectation for deflation have not come true. In fact there are incipient signs of inflation.

It is always too early to tell if the market will recover. It is only knowable when the market has already recovered.

Most analysts are graduates with a straight ruler. They are quick to connect the line between two points and extend it indefinitely.

Different analysts have rulers of differing lengths.

My best guess is that the current rally may continue for another month but runs out of steam (1^st quarter results are not going to be pretty), equity markets make new lows in 2H 2009 and then we have a real recovery. Why? I think we have had the panic selloff and it lasted from September 2008 until March 2009. We are currently experiencing a relief rally. Such rallies can be quite strong. However, I do believe that the real economy still faces considerable problems which will take time to resolve. Equities are forward looking and should price a recovery a good 12 months ahead. I simply don’t see a sustained economic recovery before the latter half of 2010 or early 2011. This would put a sustained recovery in equity markets at late 2009 to early 2010. Remember, this is a best guess. Would I trade on it? Ask me every 3 days.

Now equity markets lead recoveries but credit markets don’t. So, now, what was that about wanting to invest in distressed credit again?

The Ultimate Hedger

Someone smarter than me is going to have to figure out where to take the Mother Nature analogy as far as actual modelling goes. From what I can tell, the fractal geometry approach is a good start. The one thing that I would point out though is that even Mother Nature lost 97% of her NAV and it took a long time to make it back. But she did. As will we. Truly horrible things do happen and virtually everyone loses. You do what you can to hedge your bets, learn from your mistakes and get on with life.

Positive Convexity

I remember reading an article about how only hedge funds that exhibited some form of positive convexity, regardless of strategy, survived over the long run.

It was a published academic paper from about 6 years ago. If anyone remembers who the author was, please let me know.

The general idea was that the returns of even funds that trade no options or other inherently convex instruments could behave in a positively convex manner, and, in fact, that these types of funds exhibited significantly superior long-term survival relative to their seemingly negatively complex counterparts. This is intuitively obvious now that we have gone through the extreme market environment of the past year, but the study didn’t encompass this time period. So what’s going on here? And how can equity long-short returns be positively convex and convertible arbitrage returns be negatively convex?

The story is somewhat complicated, but let’s try to keep it simple and break it down to its components. There are many elements to the equity long short positive convexity story, but the simplest way to think about it is behaviorally. If a fund manager generally “cuts his losers and runs with his winners,” he is going to tend to capture larger portions of favorable market moves.

It is vaguely reminiscent of the old Leland Rubenstein Obrien portfolio insurance (for those of you old enough to remember the 1987 Crash). These gentlemen were trying to replicate long options positions by dynamically trading the underlying. It works pretty well in continuous markets, but breaks down when there are gap moves (remember the Black-Scholes requirement of a diffusion process? Something about molecules bouncing off the walls of a beaker). Even so, it works much of the time.

The other problem is illiquidity in the fund’s holdings. This is analogous to gap moves, in the sense that one cannot continuously rehedge. It is likely the reason that long convertible arbitrage strategies became so highly negatively convex. Sell the losers? To whom?

Similar logic may be extended across all strategies. It gets particularly interesting when you start thinking about strategies that actually incorporate options (like volatility arbitrage) or highly convex fixed income securities (like IO MBS). That’s the topic for another post. As is what the implied theta is for behaving in this manner.

Remember, positive convexity is NEVER free.