Earworms and Investing

In 1965, the Byrds released Turn! Turn! Turn! The song’s lyrics were taken almost directly from Ecclesiastes and promises: “to everything there is a season.” After reading that Macro funds made an overdue performance comeback in September 2014, I walked around my office singing that hippie ditty all day. While it was an annoying earworm in less than an hour, after nearly four years of market gains, maybe we could all use a little repetitive reminder that investment strategies fall in and out of favor.

If you look at Hedge Fund Research’s top performing strategies for the last 14 years, for example, you can easily see where investors might have some short-term memory loss when it comes to performance. After all, the S&P 500 has taken top performance honors for the last 3 out of 4 years. If you look at the last decade, however, you can see that Emerging Markets strategies have been at the top of the charts for three years as well. In fact, the S&P 500 and Emerging Markets hedge funds have been as equally likely to lead the pack as to end up in the bottom half of investment strategies over the past decade. And Macro/CTA funds, which have been both maligned and heavily redeemed from in past months, were the number two performing strategy in 2007 and 2008 at the height of the financial crisis. Many investors were extremely happy to have allocations to those strategies at that time, and flows into CTA/Macro surged in the 12 to 18 months that followed the market meltdown. Interestingly enough, however, Macro’s top-notch performance was preceded by, you guessed it, bottom half performance rankings in the years immediately prior to the crisis.

And hedge funds aren’t the only alternative investments to fall into cyclical patterns.  While venture capital is positively on fire now, it has been a long road to recovery in the wake of the tech wreck. According to data from Cambridge Associates, US Venture Capital funds returned 26.1% over 15 years, but only 8.6% over the past 10 years and 7.5% over the past 5 years. Now venture capital is coming back with a vengeance, with a three-year return of 14.4%. There is even talk of a new VC bubble, which was probably pretty unimaginable just a few years ago.

Even private equity, which seems untouchable at this point, has its good and bad performance periods. With a 15-year return of 12.0%, according to Cambridge, a five-year return of 11.0% and a one-year return of a whopping 17.2%, private equity is clearly not immune to some degree of strategy cyclicality.

Why does this matter? We all have a tendency to chase winners and sell losers, whether they are strategies or managers, and even when we know that investment philosophy doesn’t often work. For example, a study by Commonfund Hedge Fund Strategies Group in August 2014 showed that chasing returns was not a long-term strategy for success. The study concluded that “there may be a natural tendency for hedge fund investors to gravitate toward managers that have captured a significant share of the market’s upside. However, since such equity upside capture is not common or persistent among hedge fund strategies, using it as a selection criterion may lead to adverse selection.”

Investing isn’t easy. It can be a fight against your instincts and ingrained behavior. So it’s healthy to take a moment every once and a while to remember that markets change and that strategies come in and out of favor. A relentless chase of returns is not only exhausting, but often suboptimal. And by definition, if you’re chasing returns, you’re already behind. 

Alternative Investment Good News/Bad News

Good News

According to HFR, emerging managers performed best during last 12 months, gaining 11.3% through 1H2014.

Diversity funds (women and minoirites have outperformed the HF universe at large during the last 12 months, gaining 11.1% through 1H2014

Marco/CTA funds led performance in August 2014. The beginning of a comeback?

Pattern recognition helps PE and VC firms recognize successful investments?

Seven high quality hedge fund start ups launching in London

CALPERS sticking with Private Equity despite "complexity and fees."

Companies founded by women yeild 12% more for their VCs and use 1/3 less capital

IFK will welcome two women to the stage in 2014, Nehal Chopra and Nancy Prial.

Hedge fund liquidations declined in 2Q2014 according to HFR.

Skill is back? Fed says "moderately active" outperforms passive investments.

NY Common's equity hedge managers exhibit "above averages stock selection skill.

Bad News

The largest, most established U.S. based hedge funds control more assets than ever before, with $1.8 trillion as of July 2014.

Many women and minority led hedge funds continue to struggle with AUM, and therefore face the same fund flow problems as other emerging funds.

156 trend following CTAs liquidated, the first decline in the number of CTAs since 2005.

But keeps VCs from hiring women & minority staff and investing in diverse founders?

Not a single female manager listed among them.

CALPERS decision to exit hedge funds used as a club in the fee war.

Women run companies received just $1.5b out of a possible $50.8 billion from VC firms

In the previous five years, only one woman, Meredity Whitney, had been included.

Trailing 12 month liquidiations was still the highest it has been since 2009.

Blackrock research shows "alpha trades" don't work.

Articles on HFs still act as if beating the S&P 500 is relevant.

Mi Alpha Pi – A Look At The Sources of Alpha

While at the Grosvenor Small and Emerging Managers Conference last week in Chicago, I started thinking about alpha. Despite all of the naysayers out there quick to announce the death of alpha, I would actually suggest that alpha is alive and well and living in many portfolios. I think maybe investors, quick to flock to a very concentrated handful of extremely large funds, have forgotten where alpha lives and what drives alpha. 

For that reason, I’d like to announce the formation of a new co-ed fraternity. A fellowship, if you will, called Mi Alpha Pi. Mi Alphas have no dues and no secret handshake. We are merely called upon to remember that alpha comes in different size funds, diverse managers, life cycle investing and from innovators. 

MI ALPHA PI

WHERE DOES ALPHA COME FROM?

Skill – Obviously, this is what we want in all of our hedge fund managers: the ability to find and make the most of investment opportunities. Skill comes from a variety of sources. Intelligence, experience, intuition, emotional awareness and other factors contribute to manager skill. Skill is long-term and must be judged in a variety of market environments, good and bad. And in Mi Alpha Pi, we don’t believe that short-term losses necessarily are indicative of loss of strategic acumen. We even have special hazing for investors that think that way.

Cognitive Alpha – Cognitive alpha comes from being able to think about the markets and investing differently than your investing peers. Instead of looking at Apple and AIG along with every other large hedge fund, these managers look outside the box. Many investors have a tendency to be heavily influenced by market news and earnings and, over time, buying attention-grabbing stocks has a tendency to diminish returns. How do you find cognitive alpha? Look to contrarians, women and minority run funds for less homogenized thinking.

Structural Alpha – There has been a plethora of research, including my own at PerTrac, that suggests smaller, emerging managers outperform larger, older funds. One of the reasons why this may occur is what I will call “structural alpha.” When a fund is small it can take advantage of niche plays and club-sized deals that larger funds may ignore. They also may have fewer issues with liquidity, volume and short-squeezes. As a result, emerging funds may be able to exploit their smaller structures to produce outsized gains.

Behavioral Alpha – Although it’s difficult to separate behavioral alpha from cognitive alpha, I think it is an important distinction. Cognition is how you think about the world, while behavior is what you do with that information. Behavioral alpha may be created by less frequent trading, less inopportune trading and infrequent return chasing. Young funds and women and minority owned funds may be fertile grounds for behavioral alpha.

Luck/Chance – It is difficult to admit that sometimes what we think is alpha is really just luck or chance at work. For example, in the late 1990’s when I first began researching hedge funds, there were a number of funds that had no real shorting skills but that, at the time at least, didn’t need those skills. The rising tide of the bull market lifted all ships, so to speak. However, when the markets broke during the tech wreck, it was quickly evident which hedge fund managers were wearing no clothes, luckily figuratively and not literally. This is why it’s always critical to ascertain whether a manager is riding a good strategy or a good market.

It’s time to look a little further than the 500 largest hedge funds to find excess returns. Finding alpha isn’t always easy, but the 2014 pledge class of Mi Alpha Pi is looking forward to welcoming you. 

Investing and The Law of Unintended Consequences

In Nashville, we have a weekly paper called “The Contributor” that is sold exclusively by badged homeless individuals on various street corners around town. The paper costs $2, and I make it a point to stop and buy one once a week or so. Now before the bleeding heart liberal accusations start flying, let me explain. “The Contributor” contains some of the world’s best advice couched in its “Hoboscope,” written by one Mr. Mysterio. It’s worth the price of admission every time.

In a recent Hoboscope, Mr. Mysterio provided the following nugget: “Assuming the worst will happen might make you cautious, but it never really makes you safe.” In investing, at least, truer words may never have been spoken.

We all know investors are motivated by fear and greed. I would postulate that our fear wins every time. Maybe it’s the fear of losing money. Perhaps it’s the fear of not keeping up with investing peers. It could be the fear of headline risk, or of paying “too much” for an investment. But our fears feed our investment decision-making, creating cautious investors who somehow remain far from safe.

Take me, for example. For the last several months I have been sniffing disaster on the markets like a dog with his nose out the car window. Having lived through LTCM, the tech wreck and 2008 as a professional investor, my thoughts often fly to all the bad things that can happen to my little nest egg. At the moment, and for much of recent history, I’m primarily in cash. In the meantime, however, I’ve missed significant market gains, which compromises both my current and future earnings. I’m certainly cautious, and I’ve avoided my worst-case scenario, but I haven’t made my financial situation significantly safer due to that particular trade.

Look at the institutional investor community. One of their greatest fears is that of headline risk a la the Art Institute of Chicago and Integral Investments. As a result, many choose to pile their assets into a very small number of large and established managers (the 500 or so that contain 90% plus of the hedge fund AUM).  Studies, including my own from 2006-2011, Preqin and eVestment, have shown that smaller funds tend to outperform their largest counterparts cumulatively and across more time periods, and that new funds have outperformed cumulatively and across all time periods.  However, just like no one ever got fired for buying IBM, it’s unlikely you’ll be fired for investing in Bridgewater or Paulson. But does sub-optimizing returns in a world of growing liabilities truly protect us, or does it just spare us the humiliation and/or hard work of investing in or potentially being wrong about a smaller or newer fund?

And finally, think about the investors that remain all too focused on fees. Overpaying for an investment is a capital crime for a host of investors. They hope to simultaneously optimize returns by saving a few basis points and avoid the headline describing how much they paid their portfolio managers last year. Unfortunately, their fear can result in negative selection bias (only investing with lower cost funds or funds who will cut fees), going direct in an investment arena where they may not have sufficient expertise, or eschewing certain investments altogether. The illusion of safety is created, where their caution may in fact be creating its own set of risks.

Regrettably, I can’t tell you how to solve this conundrum. Let’s face it: I’m no Mr. Mysterio. I can only advise that when we think through our worst case investment scenario, we focus on all of the factors that need to be in place to make us truly “safe.” Not just on the one or two problems that keep us up at night. 

Adding Diversity to Diversification

A few recent articles got me thinking about diversity vs diversification:

·      June 5 -  Forbes reported that 15 large hedge funds were all in the same stock.

·      June 29 – The Financial Times reported on the alarmingly high correlation of hedge funds to the equity markets (0.93).

·      July 14 – Preqin study shows a mere 500 hedge funds control 90% or more of assets.

In essence, we’ve likely got a bunch of investors concentrated in a very few hedge funds that are highly correlated to the equity markets and who own the same stocks. Picture me making Macaulay Culkin’s face in “Home Alone.”

Diversification is a tricky thing. Investopedia describes it simply as a “risk management technique that mixes a wide variety of investments within a portfolio.” But maybe we need to think of diversification on a deeper level.

Homogeneous groups tend to think alike. They also tend to overestimate their problem solving skills and consider a narrower range of information.

They may also be less open to new ideas. The universe of hedge funds contains more than 10,000 funds. At the present time, there are fewer than 500 hedge funds managed by women and minorities. If you look in the dictionary under “homogenous” I bet there may actually be an illustrative photo taken at a hedge fund conference.

So I’d like to suggest that investors expand their definition of diversification. Maybe it’s not all about the asset allocation mix of stocks, bonds, futures, real estate and other asset classes. Perhaps it’s not even the number of funds you invest in or the mix of strategies you have. Maybe, just maybe, diversification includes the way in which the money managers collect, interpret and evaluate market data and the cognitive alpha they create for you.

You don’t think there’s a difference?

Talk to some women and minority managers about what they own. You might be surprised at how far their portfolios are off the beaten path. And then look at what the indices tell you. The HFRX Global Hedge Fund Index has produced a year-to-date net return of 1.77% through June. The HFRX Diversity Index has produced a 3.61% net return through the same period.

So the next time you’re meeting with a potential (or existing) hedge fund investment, look around the room. If you see a room filled with Matrix-esque Smith replications, you might want to go further down the rabbit hole to think about how market and company information is gathered, processed and acted upon by the fund. What does the fund own and how do those underlying portfolio positions interact with your other funds holdings? Are you really diversified or just in a lot of funds?

Or, of course, you can always take the blue pill. 

https://www.youtube.com/watch?v=uGQF8LAmiaE