Very High cost for Asset Allocation Advice

Most investors in hedge funds must be looking at them totally marginally.  Certainly that is the way that hedge fund managers would suggest.

What that means is the ther investor should not look at the details of what the hedge fund is doing, it should only look at the returns.  Those returns should be looked upon as a unit.

Certainly that is the only way to think of it that matches up with the compensation for hedge fund managers.  They get paid their 2 and 20 based solely upon their performance.

But think for a moment about how an investor probably looks at the rest of their portfolio.  They look at the portfolio as a whole, across all asset classes.  The investor will often make their first investment decision regarding their asset allocation.

While hedge fund managers have argued for treating their funds as one or even several asset classes, they are almost always made up of investments, long and short, in other asset classes.  So if you are an investor who already has positions in many asset classes, the hedge fund is merely a series of moves to modify the investors asset mix.

So for example, if the hedge fund is a simple leveraged stock fund, the hedge fund manager is lowering the investor’s bond holdings and increasing the stock holdings.

So if an investor with a 70% 30% Stock bond mix changes their portfolio to 65%, 25%, 10% giving 10% to a hedge fund manager who varies runs a leveraged stock fund that varies from all cash to 4/3 leveraged position in stocks, then they have totally turned their asset mix over to the hedge fund manager.

When the hedge fund is fully levered in stocks then their portfolio is 65% long Stocks, 25% long bonds, plus 40% long stocks and 30% short bonds.  Their net position is 105% stocks with  5% short bonds.  But that is not quite right.  If you only get 80% of your performance, your position is 97% stocks and 1% bonds.  That is right, it is less than 100%.  Only it is really worse than that.  That is the allocation when performance is good.  When the stock market goes really poorly, you get the performance of the 105%/(5%) fund. 

Other funds go long and short large and small stocks.  The same sort of simple arithmetic applies there. 

It is really hard to imagine that anyone who thinks that there is any merit whatsoever to asset allocation would participate in this game.  Because they will no longer have any say in their asset allocation.  What you have done is to switch to being a market timer.  In the levered stock example, you now have a portfolio that is 65% long stocks and 35% market timing.  

So in most cases, what is really happening is that by investing in a hedge fund, the investor is largely abandoning most basic investment principles and shifting a major part of their portfolio asset allocation to a market timer. 

At a very large fee.

TANSTAAFL

Hedge funds were the darlings of the past decade.  The 2 and 20 compensation lure of hedge funds is a major factor in the over compensation of bankers.  The argument was that if the banks did not match the hedge fund money, they would lose all their most talented people.
In 2011, 67% of hedge funds were below their high water marks according to a study by Credit Suisse.

What hedge funds promised was a Free Lunch.  But There’s No Such Thing As A Free Lunch!

The Economist summed it up perfectly in this letter to investors from the Zilch Capital Hedge Fund:

Dear investor,

In line with the rest of our industry we are making some changes to the language we use in our marketing and communications. We are writing this letter so we can explain these changes properly. Most importantly, Zilch Capital used to refer to itself as a “hedge fund” but 2008 made it embarrassingly clear we didn’t know how to hedge. At all. So like many others, we have embraced the title of “alternative asset manager”. It’s clunky but ambiguous enough to shield us from criticism next time around.

We know we used to promise “absolute returns” (ie, that you would make money regardless of market conditions) but this pledge has proved impossible to honour. Instead we’re going to give you “risk-adjusted” returns or, failing that, “relative” returns. In years like 2011, when we delivered much less than the S&P 500, you may find that we don’t talk about returns at all.

It is also time to move on from the concept of delivering “alpha”, the skill you’ve paid us such fat fees for. Upon reflection, we have decided that we’re actually much better at giving you “smart beta”. This term is already being touted at industry conferences and we hope shortly to be able to explain what it means. Like our peers we have also started talking a lot about how we are “multi-strategy” and “capital-structure agnostic”, and boasting about the benefits of our “unconstrained” investment approach. This is better than saying we don’t really understand what’s going on.

Some parts of the lexicon will not see style drift. We are still trying to keep alive “two and twenty”, the industry’s shorthand for 2% management fees and 20% performance fees. It is, we’re sure you’ll agree, important to keep up some traditions. Thank you for your continued partnership.

Zilch Capital LLC

There probably are a handful of money managers who are actually worth the 2 & 20.  But think about it, someone has to be on the other side of all of those trades where the hedge fund managers are winning.  Eventually, everyone who has money that is invested with a manager (or themselves) who loses every time either runs out of money or hires another manager, until more and more of the money is managed by people who are aware of all the ways that the hedge funds have changed the investment markets.

And the hedge fund tricks no longer work.

Prop Trading – Do Not Try This at Home

The GAO last week released a report on Proprietary Trading of banks. The headlines feature a conclusion from the report that the six largest US banks did not make any money our of Prop Trading over the 4.5 years of the study period.

The analysis looks pretty straightforward.  But it is difficult to see if the conclusions are quite so obvious.

First and most important for a risk manager to notice is that this is a post facto analysis of a risky decision.  Risk Managers should all know that such analysis is really tricky.  Results should be compared to expectations.  And expectations need to be robust enough to allow proper post facto analysis.  That means that expectations need to be of a probability distribution of possible results from the decision.

Most investments had performance that was vaguely similar to the pattern shown above during that time.  Is the conclusion really anything more than a 20-20 hindsight that they should have stayed in cash?  That is true everytime that there is a downturn.   Above is a graph of a steady long position in the S&P.

On the other hand, traders in such situations seem to generally get paid a significant portion of the upside and share in very little, if any of the downside.  In this case, the downside cancelled out all of the upside.  The good years had gains of over $15.6 B.  If the traders were getting the usual hedge fund 20% of the gains, then they were paid 3.9 B for their good work.  In the bad years, banks lost $15.8 B.  That means that the gains before bonus were $3.7B.  Incentives were over 100% of profits.

The one other question is why investors need banks aas intermediaries to do prop trading?  Why can’t investors do their own prop trading?  Why can’t investors go directly to the hedge funds or mutual funds or private equity funds?

Ultimately, the report says that prop trading was not really significant to bank earnings and not a real diversifier of bank volatility.  So in the end, is there any reason for banks to be doing prop trading?

It seems that the banks are reaching that conclusion and exiting the activity.

Black Swan Free World (10)

This is the final post in a 10 part series.

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Of the ten suggestions, this one has the most value by far.  Unfortunately, this one may be the suggestion that has the least chance of being taken up.  No one is talking about any part of this.  We seem to be moving to try to set the world back into the place that is was, or very close to it.

We should be asking “What should be the place of banking in our economy?”  This is not a question of allowing the free market to choose.  The free market has nothing to do with this.  The role of the banking sector is entirely determined by the government.  The banking sector had grown to eat up a huge percentage of all of the profits of the entire economy.  Does that make any sense to anyone?  Banking can be a symbiont with the economy or it can be a parasite or it can be a cancer.  Before the crisis, banking had definitely moved beyond the level of parasite to becoming a harmful cancer.  Too much of all of the profits of all of business activity in the entire economy were being diverted to the banks and with the pay structure of the banks, into the pockets of a very small number of bankers.  Did that make any sense whatsoever?  Is there any way that anyone can show that situation makes for a healthy economy?  The bubbles that happened twice could be seen as the way that bankers justified their huge take from the economy.  If values were growing rapidly, no one seemed to mind that bankers took so much out of the deals.

Source:Evolution of the US Financial Sector Thomas Philippon

However, if the economy and the values of businesses and assets in the economy grow at only a sane pace, and bankers try to go back to the level of take from the economy that they have grown accustomed to, then the amount of total profits left for the rest of the economy are bound to be negative.  So unless we re-think things and figure out how to muzzle the banks, then we are headed for more bubbles that will justify their stratospheric incomes.

The financial sector, once it exceeds a certain share of the economy, should be viewed as a tax on the economy.  Many protest the taxes that the government imposes because the money is not well spent.  Well, the money from this tax goes to personal expenditures of the bankers themselves.  There is not even any pretense that this tax will be spent for the common good.

One question that really needs to be answered is how much of this financial “innovation” that is touted as the result is really beneficial to the economy and how much of it is just unnecessary complexity that hides that take of the bankers and hedge funds.  The excuse that is always given is that all of this financial innovation helps to provide lubrication for businesses.  But that is more like an excuse than a reason.  Mostly the financial innovation has fueled bubbles.  It has led to the excessive leverage that feeds into one sided deals for hedge fund managers.

More often than not, financial innovation has helped to fuel the extreme fixation on short term gains in the economy.  Financial innovation has featured hollowing out companies to maximize short term values.  Quite often the companies “helped” by this process turn into worthless shells somewhere along the process.  This destroys that productive capacity of the economy to allow for the extraction of the maximum amount of short term profits.

Financial innovation helps to turn corporate assets into profits and to take those profits out of the firm through leverage.

So Taleb’s suggestion that we think through Capitalism 2.0 is a good and timely one.  But we need to start asking the right questions to figure out what Capitalism 2.0 will be.

Black Swan Free World (9)

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Black Swan Free World (6)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

It is my opinion that many bubbles come about after a completely incorrect valuation model or approach becomes widely adopted.  Today, we have the advantage over observers from prior decades.  In this decade we have experienced two bubbles.  In the case of the internet bubble, the valuation model was attributing value to clicks or eyeballs.  It had drifted away from there being any connection between free cashflow and value.  As valuations soared, people who had internet investments had more to invest in the next sensation driving that part of the bubble. The internet stocks became more and more like Ponzi schemes.  In fact, Hyman Minsky described bubbles as Ponzi finance.

In the home real estate bubble, valuation again drifted away from traditional metrics, the archaic and boring loan to value and coverage ratio pair.  It was much more sophisticated and modern to use copulas and instead of evaluating the quality of the credit to use credit ratings of a structured securities of loans.

Goerge Soros has said that the current financial crisis might just be the final end of a fifty year mega credit bubble.  If he is right, then we will have quite a long slow ride out of the crisis.

There are two aspects of derivatives that I think were ignored in the run up to the crisis.  The first is the leverage aspect of derivatives.  A CDS is equivalent to a long position in a corporate bond and a short position in a risk free bond.  But few observers and even fewer principals considered CDS as containing additional leverage equal to the full notional amount of the bond covered.  And leverage magnifies risk.  Worse than that.

Leverage takes the cashflows and divides them between reliable cashflows and unreliably cashflows and sells the reliable cashflows to someone else so that more unreliable cashflows can be obtained.

The second misunderstood aspect of the derivatives is the amount of money that can be lost and the speed at which it can be lost.  This misunderstanding has caused many including most market participants to believe that posting collateral is a sufficient risk provision.  In fact, 999 days out of 1000 the collateral will be sufficient.  However, that other day, the collateral is only a small fraction of the money needed.  For the institutions that hold large derivative positions, there needs to be a large reserve against that odd really bad day.

So when you look at the two really big, really bad things about derivatives that were ignored by the users, Taleb’s description of children with dynamite seems apt.

But how should we be dealing with the dynamite?  Taleb suggests keeping the public away from derivatives.  I am not sure I understand how or where the public was exposed directly to derivatives, even in the current crisis.

Indirectly the exposure was through the banks.  And I strongly believe that we should be making drastic changes in what different banks are allowed to do and what different capital must be held against derivatives.  The capital should reflect the real leverage as well as the real risk.  The myth that has been built up that the notional amount of a derivative is not an important statistic and that the market value and movements in market value is the dangerous story that must be eliminated.  Derivatives that can be replicated by very large positions in securities must carry the exact same capital as the direct security holdings.  Risks that can change overnight to large losses must carry reserves against those losses that are a function of the loss potential, not just a function of benign changes in market values and collateral.

In insurance regulatory accounting, there is a concept called a non-admitted asset.  That is something that accountants might call an asset but that is not permitted to be counted by the regulators.  Dealings that banks have with unregulated financial operations should be considered non-admitted assets.  Transferring something off to the books to an unregulated entity just will not count.

So i would make it extremely expensive for banks to get anywhere near the dynamite.  Or to deal with anyone who has any dynamite.

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Risks, Not Risk

From David Merkel in Aleph Blog

There is no generic risk.  There are many risks.  Are you getting fair compensation for the risks that you are taking?  If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.

To this end, it is better to think in terms of risk factors rather than some generic formulation of risk.  Ask yourself, am I getting paid to bear this risk?  Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.

Modern Portfolio Theory has done everyone a gross disservice.  It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray.  These figures are not stable in the intermediate term.  The past is not prologue, and unlike what Sallie Krawcheck said in Barron’s, asset allocation is not a free lunch.  With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.

Any risk reward strategy that is developed by looking backward at historical performance will no longer work well when everyone knows and uses it.  See the Law of Risk and Light Riskviews

Black Swan Free World (2)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

Most assuredly the socialization of losses and privatization of gains is what has anyone outside of the banking sector furious. Within the sector, everyone seems to believe that they earned their share of the gains. Think about what you hear about the bonus scheme at the banks – the investment banks are said to be paying out about 50% of gains before bonus. I imagine that puts them approximately on par with the hedge funds, if the banks profit figure takes out overhead before calculating the 50% ratio. So the bank incentive comp is based upon the hedge fund incentive comp. Amazingly, the hedge fund managers manage to convince investors to give them their money and lenders to advance them funds to leverage without any hint of a bailout ever in their future. The hedge fund managers generally walk away from the fund when things go wrong and they are no longer have a chance for outsized gains.

Do the bank shareholders understand that they are really investing in a highly leveraged hedge fund? The folks getting those bonuses surely understand that.

Is this the worst of capitalism and socialism? Probably so.

How do we get out of this? It seems that rather than limiting compensation, we ought be assuring shareholders and debt holders of any firms that structure their compensation like hedge funds that they should expect to be treated like hedge funds in the event of failure. Goodbye, no regrets.

One way of looking at the compensation issue is to focus on time frame.  There are four time frames to consider:

1.  The employees – the recipients of the bonuses.  Their time frame looks backwards.  They want to be paid for the value that they created for the firm.  They want to be paid in cash for that value.

2.  The Short Term shareholders.  Their time frame is in quarters.  They are most interested in what will be posted as the next quarterly earnings.  They want to be able to cash out their investment at the point where they believe that the next quarter’s earnings will not grow enough to support future price increases.

3.  The Long Term shareholders.  Their time frame is in years – probably 3 – 5 years.  Which is the expected holding period for a long term shareholder.  They are looking for growth in value compared to share price and will usually sell when they believe that the intrinsic value of the firm starts to catch up with the market value.

4.  The public.  Our time frame is our lifetime.  We need to have a financial system that works our entire lifetime.   The public gets nothing from the changes in value of the financial system but ends up paying off the losses that exceed the capacity of the financial system.

The compensation and prudential capital for banks is a trade-off between the interests of all four of these groups.  In the run up to the crisis, the system tilted in the favor of employees and short term investors to the extreme detriment of the long term shareholders and public.

So the solution is likely to be best if the interests of the long term shareholders are made more important.  Right now, a large, possibly most of the long term shareholders are index funds.  Index funds are extremely unlikely to want to have any say in corporate governance or compensation.

So you could surmise that the compensation aspect of the crisis and the drift of all things corporate to fall under the sway of short term investors is a result of the prevalence of index funds.

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