Forget about correlations. Here are the conditional probabilities between equity market monthly returns and hedge fund returns as represented by the MSCI World Equity Index and the HFRI Hedge Fund Index respectively.

Since Jan 1997, over 183 months,

• Hedge funds were positive when equities were positive 98 months or 54% of the time.
• Hedge funds were negative when equities were negative 54 months or 30% of the time.
• Hedge funds were positive when equities were negative 24 months or 13% of the time… And
• Hedge funds were negative when equities were positive 7 months or 4% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 54 out of 78 or 69%.

And, when equities are up, the chances of your hedge fund losing money are 7 out of 105 or 7%.

However:

Since Jan 2008, over 51 months,

• Hedge funds were positive when equities were positive 24 months or 47% of the time.
• Hedge funds were negative when equities were negative 21 months or 41% of the time.
• Hedge funds were positive when equities were negative 5  months or 10% of the time. And…
• Hedge funds were negative when equities were positive 1 month or 2% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 21 out of 26 or 81%.

And, when equities are up, the chances of your hedge fund losing money are 1 out of 25 or 4%.  

Post 2008, the markets have begun to behave in a very volatile and erratic fashion that has confounded many hedge fund managers who had previously navigated market crises such as 1998 and 2001 successfully.

In investing and trading, easy to identify strategies are rare. Asian convertible bonds in late 2008 are an example, the QE2 liquidity infused rally of 2010, the first LTRO rally, the rebound in RMBS in 2009, are others. The massive relief rally on early 2009 was harder to identify and caught most investors off guard. The rally in US treasuries in the last 3 years, the rally in gold, the implications of the second LTRO, all have been diabolically hard to call and trade.

Even worse, what is obvious to one investor is unclear to another. And of the events listed above as ‘obvious’, most were only obvious well after the fact.

In the best of times, markets are risky places for investors; in the worst of times they are treacherous waters, graveyards of fortunes lost.

1. Directional investing is vulnerable to market risk. Whether it is in equities, credit, commodities or FX, taking directional bets on asset prices exposes one to the general direction of markets. Even the multi-directional nature of global macro investing is not spared. Fund managers express directional views on asset prices based on their understanding and analysis of macroeconomics and policy. Most fail to deliver consistent returns, but some are uncannily consistent. These rise to become the premier global macro hedge funds we come to know. Soros, Brevan Howard, Caxton, Tudor, Moore, et al. Long only funds are examples of directional funds where one direction (short) has been denied them.

2. Relative value investing is less vulnerable to market risk but exposes one to idiosyncratic risk. In relative value, basis risk is actively sought. The manager seeks to express a view on one security doing better than another, one company, commodity or currency outperforming another. Market risk is reduced, not eliminated. It is also transformed into a more complex risk. The relative value manager seeks to assume a specific risk, while hedging out other risks. Buying GM and selling Daimler is a bet on the quality of management, but it also includes bets on the relative fortunes of luxury versus regular automobiles, the relative strength in the economies of Europe, or Asia or North America depending on the relative exposures of each company to each area. Some risks can be hedged away, some cannot. Be that as it may, relative value represents a more targeted way of assuming risk, and seeking returns, than making open ended long only wagers on the fates and fortunes of companies, commodities, or countries.

3. Arbitrage is the Holy Grail of investing. Most of the time it does not exist. On those rare occasions when it does, it is hideously difficult to identify and capture. Most arbitrage trades are quasi arbitrage in that there are risks, but they are remote or have been missed by the arbitrageur. True arbitrage involves buying something, simultaneously selling it or its equivalent for less and picking up the difference without assuming any risk. Most of the time, risk in quasi-arbitrage leaks into the operational, settlement, delivery, legal and regulatory aspects of the trade.

The financial crisis of 2008 is now 4 years behind us. Yet its ripples haunt us over time. This period arguable represents one of the most important turning points in recent history. The main themes surrounding this turning points are:

A. Reversal of US current account and trade balance deficits.

B. Reversal of the falling savings rates in the West.

C. Reversal of weak USD.

D. Reversal of falling USD interest rates and bond yields.

E. Global wide debt reduction with implications for economic growth.

F. Regulatory and Policy responses to the past abuses of the Principal Agent relationship.

The short term perturbations around these reversals will confuse and confound investors. It is necessary to have a specialized skill set in asset market in order to navigate these difficult investment conditions. The logical implication is to outsource investment decisions to experts, to dedicated fund managers.

Even here there is a dilemma.

1. Private investors who are not full time dedicated investors often lack the expertise to invest in certain markets, or indeed the expertise to asset allocate across a range of investment opportunities. Professional fund managers have the experience, expertise and resources to invest money in their areas of expertise. This is the strongest argument for investing in funds. And yet…

2. Professional fund managers are restricted in their function. There are certain norms and accepted practices in fund management which create certain biases in manager behavior even if they are sub-optimal. One example is that managers feel that they need to be fully invested even when conditions are unclear or they are unable to find sufficient compelling investment opportunities. The behavior of investors in the past (who believe that managers should earn their fees) have driven managers into this type of irrational behavior. A rational investor may decide to refrain from investing for not insubstantial periods of time if the outlook is unclear or there is a dearth of investment opportunities.

The choice of manager becomes extremely important.

The erratic path taken by macro economic data and by asset prices such as stocks, bonds, commodities etc are the confluence of long, medium and short term cycles. The long term cycle took a turn in 2008 and remains decidedly poor.

 A substantial relief rally in 2009 and an LTRO and BoJ morphine induced rally in the last 4 months do not indicate a healthy global economy. They are indicative of a poorly global economy, one which is over-levered and still in the process of being de-levered, which policymakers have kept afloat by further credit creation, much like putting a fire out with gasoline, and infrastructure build in emerging markets. The long term picture is the following: we have collectively spent more than we earned and created a disproportionately large hoard of debt which will need to be paid down over time. Given the strange way we measure and account for GDP, credit creation adds to GDP growth and now as we reduce the size of the global balance sheet, credit destruction will detract from GDP growth. The long term is therefore fairly simple to understand and remains gloomy.

Does the short or medium term cycle reinforce or contradict the long term cycle? Large scale debt monetization and fiscal reflation can and has buoyed the economy and asset markets for short periods of time and can be credited for the local bull markets in 2009, 2010 and 2011. The last significant reflationary policy was the 3 year LTRO operated by the ECB in Dec 2011 and Feb 2012. The liquidity injection has supported sagging asset markets and indeed propelled some of them to local highs. This is likely to have run its course.

The economic recovery in the US which took everyone by surprise, and which began in Sep 2011 if you were watching closely, was triggered and driven by exports which indirectly can be traced to the infrastructure binge undertaken by China as its export markets dried up. China’s credit driven infrastructure binge is over. This will reveal local weaknesses in the Australian economy, weaken demand in the resource economies, and with a lag, depress the US economy once again.

Long Term Prospects

• The long term trend in economic growth is weak.
• A significant part of this is due to the need to de-lever stretched private and public balance sheets across the globe.
• Asia’s balance sheets are not as healthy as many believe if shadow banking statistics are consolidated. That is, off balance sheet credit creation has been more than we understand it to be.
• The West will be in savings mode for longer than many expect. Also, the West will evolve into export economies while EM countries evolve into consumption economies. This will put upward pressure on the USD.
• An international shortage of USD and the lack of external demand for US government debt will likely place upward pressure on USD interest rates. A 30 year bull market in bonds is likely over.
• Risk is likely to decline generally as carry trades and leveraged investments decline due to rising costs of debt.

Medium term view:

• Equities remain cheap but valuations are sensitive to bond yields. Equities are therefore vulnerable. High yield is also vulnerable on both duration and spread bases. The risk reward in any case is poor. Sell.
• Carry trades are riskier now than ever since the mark to market impact on borrowing short and lending long is likely to be negative. Pull in duration.
• China’s economy is slowing and will have global impact via commodities. Sell.
• China may not have room to lower interest rates as much as the market expects due to food price inflation. Don’t count on a rally in Chinese stocks.
• Commodities likely to suffer from a slowdown in China.
• Prospects for a US QE3 rise but it is not clear how the Fed will expand its balance sheet. The most likely asset is US treasuries. This could delay rising rates. Sell receivers.
• The ECB is likely to be done with its QE. Sell receivers.
• BoJ has begun its cycle of QE and Japan equities likely to outperform.
• USD likely to strengthen against majors as well as EM currencies.
• USD curve to steepen relative to EUR, GBP and JPY curves.

Who knows if the above will work out. But here I can time stamp my own expectations. And this serves me more as a aide de memoire than anything else.

Insanity

• The US credit rating gets downgraded and US treasuries rally.

• The ECB shoots morphine into an insolvent European banking system and it is the banks that rally most.

• China leads global economic growth and its stock market performs most poorly.

• Europe is in a serious recession whereas the US is in a mild recovery, yet European stocks rally as much as US stocks.

• Global risk levels remain elevated and investors are increasingly jumpy yet VIX and other measures of risk aversion signal calm.

• Italy, Spain and Greece are still on the Euro. And the currency is appreciating despite a massive round of quantitative easing. Its even more surprising that Germany is on the Euro.

• With the BoE, BoJ, ECB all frantically monetizing debt and printing money, gold has weakened. And inflation has not accelerated. Since output has not recovered, this must imply an acute deceleration in the velocity of money.

For the global macro trader and the fundamental investor alike, these are confusing and treacherous times. The logical thing to do, is often to do nothing. Go to cash and hold mostly one’s accounting currency, with a small allocation to gold and a bigger one to USD.

The professional money manager, however, very often cannot or is not incentivised to hold cash. Do investors want to pay fees to a fund manager to carry cash? Would investors pay fund managers for their decision to carry cash? Yet investors are often happy to pay fund managers to carry consistent, chronic negative levels of cash. This is effectively what one gets in a levered investment fund or product.

In the meantime investors become ever more disenchanted with professional fund managers who seem to be as confused as everybody else.

In the long run markets cannot stray too far from fundamentals. Yet there is a paradox. The further we look forward, the less certain is our view of the world.  And in the short term, psychology, greed and fear, errors in judgment, conspire to drive markets in chaotic fashion…

Hedge Fund manager skill versus the rising tide lifting all boats: We all understand how a rising market can make a long only equity fund manager look like a star. But what about a hedge fund manager operating an equity long short strategy? Sometimes, a long term, non-directional theme can provide a hedge fund manager with an edge. What initially starts out as skill can with time become a repeatable strategy. Take the Euro for example. Since the early 1990s, European rates began to converge and European stocks began to trade along industry and sector lines more than national ones. This has been a
20 year theme which has only unraveled in the financial crisis and only when European country risk began to dominate idiosyncratic and sector risk.

An even longer term theme has been the 30 year trend in (falling) interest rates and bond yields. Yield curve dynamics around this secular theme have provided hedge funds very profitable opportunities over the years. Again, what began as skill in identifying the trend, and recognizing its underlying causality, over time has become a repeatable strategy.

The risk to these strategies arises when a significant or important secular theme ceases or wanes and a new one begins. Initially, fund managers who traded in blind ignorance to the causality of the old theme, but who understood the local trends and dynamics around it, lose money. Their returns at best are likely to become highly inconsistent. This is because they never understood the environment they used to be in, they only knew what it looked like, or had a feel for its rhythms.

The world post 2008 certainly looks like this for a great many fund managers. At the same time, there is an emerging group of managers who ‘get it’ and whose returns will gain in consistency over time.

Identifying these new managers is the key to a successful alternatives investment program. Sticking with the establishment is likely to result in poor risk adjusted performance.

The skills and the approach to finding new talent are uncommon. The current approach of interviewing managers ad nauseum, digging into their track record and their past careers is of limited use. By definition, if a new theme has taken hold and one seeks the best new managers to monetize that theme, past track record is of limited relevance. Being able to detect new talent requires an open mind and a closeness to markets and an understanding of economics at the level of the managers one engages.

In Nov 2011 I warned that the Chinese economy was headed for a slump. This is an update. In the past quarter, manufacturing data has supported the view that the Chinese economy was decelerating rapidly.

 The much watched inflation numbers have come off as well providing policy makers room to ease. However, despite recent weakness, food prices remain elevated and may stay the hand of policymakers from outright interest rate cuts.

The real estate sector has also cast a pall on the economy. Here, the slump is the result of government policy to cool an overheating housing market. Rising house prices do not increase welfare; to the contrary, at lower levels of home ownership, they decrease welfare, something surely not missed by a Communist country. Policy has therefore been steadfastly tight on the real estate sector resulting in falling land and property values. The flipside to this policy is that the value of collateral falls and the construction industry slows.

The most interesting sign that China is in the grip of a serious slump, however, lies in the anecdotal evidence that the number of factory workers returning after the Chinese Lunar New Year to work in the coastal cities and traditional manufacturing centres has slumped. What is interesting is that this has been interpreted as workers having found employment in the provinces and therefore not returning.

By speaking to a number of businesses and investment managers in the mainland, the feedback I received late last year was that the slump in workers returning to work after the Chinese New Year was to at the time expected, but for a different reason. The expectation then was that employers would take advantage of the annual pilgrimage to lay off staff.

Laying off workers at any other time involved paying for their train ticket home. Moreover, the risk remained that workers would picket factories instead of going quietly. During the Chinese New Year, workers pay their own fare home to meet with family. If they were let go then, they would also be less likely to travel back to their factories to demonstrate their disaffection. This thesis having been built last October / November has seen empirical support.

The performance of stock markets has been instructive. In the last quarter, Japan stocks rose because the BoJ is printing funny money. European stocks are also rising because the ECB is printing funny money in vast quantities. US stocks rallied since 4Q 2011 in a delayed reaction to economic recovery begun in 3Q 2011. Of the BRICs, China and India have underperformed despite rallying early in the year. In India, political parties attempt mutual and often self destruction with the private sector as hostage. China’s problems are similarly difficult with a change of management on the near horizon as the economy begins to look slightly unhinged.

China suffers from rising wages, rising food prices, an overleveraged shadow banking system established to finance the massive Keynesian infrastructure binge just post 2008 and export partners who are retrenching and increasing their savings rates. Economic growth based on investment and government expenditure can only go so far. And it appears that it has.

Some people believe that whatever happens anywhere in the world tends to impact Asia, sometimes disproportionately. Given the rise of China in the past decade the converse is also true. One has to question the robustness of the US recovery if it has been based on capital goods exports to resource countries supplying Chinese infrastructure build. The US equity bull market may last a bit longer on momentum in new orders on the back of backlogs in inventory restocking but it is hard to see a broad based recovery based on internal consumption. The US bull market is unlikely to persist more than a further 3 to 6 months. How you trade it, is a matter of personal trading style.