Investing at The Hedge Fund Saloon
By David Rudd, Chairman, Sigma Analysis & Management Ltd., a firm of mathematicians, data scientists and market professionals delivering high alpha investment solutions to Pension plans via custom built cash efficient, liquid and cost- efficient vehicles.
An investor strides into the Hedge Fund Saloon and walks up to the bar. The bartender asks “What’ll you have?” The investor replies “Some of that alpha,” so the bartender reaches back for a bottle. Before pouring the bartender says, “this is volatile, but I hear that you feel really good after a while” and pours for the investor, who proceeds to take a full drink and spits it out. “This isn’t alpha, it’s a trend follower. When there are no trends I get killed…. And volatility is already very high…and there will be some mean reversion and give back. I am not risking my health and wealth waiting for a trend.”
The bartender looks at the drink menu and replies “OK, I’ve got this trend follower who has a significant risk reduction process and moves to the sidelines very quickly when no trends are present. Their returns are sharply better than their peers so far. Their model anticipates trends via proprietary pattern recognition and generally moves into a short vol strategy via option writing while reducing exposure to trend. The problem is it’s a young strategy and hasn’t been seasoned.”
“The investor replies, “OK. Let’s watch them, maybe we might do a managed account. What else do you have?”
The bartender says, “How about some mean reversion? It’s usually good, but sometimes it’s really funky when markets are unidirectional/hyperbolic. It’s basically a snooze bet; if the markets are normal, you will like the return.”
The investor replies, “I don’t want to have more market dependencies.”
The bartender replies, “Well, I have a nice blend of momentum and mean reversion. This drink is smooth and doesn’t have surprises, but we don’t know if it can be consistent over the long haul as the high notes sometimes cancel out the low notes. Some of these hedge funds say they can distinguish between the two.”
The bartender and investor both look at the drink section labeled Sharpe Rated. The investor says “OK. I’ll try some Sharpe recommendations. What have you got?”
“Well, the Sharpe guides rate some of them highly, but they are often biased to a certain blandness and there are no high notes; they don’t often deliver the oomph! Know what I mean?”
The bartender pours a Sharpe selection, saying, “Nice, but might not age well as there will be a market condition that will sour it very quickly. For instance, this one is an illiquid leveraged credit strategy. Since we don’t open these bottles very often, we don’t necessarily have insight to know when they are going bad.” The bartender adds, “You know, I think you might be looking for skill, not alpha. Most investors want skill, but they end up with some kind of a beta.”
The investor replies, “Yeah, skill, what do you know about skill?”
The bartender says, “Well, it’s expected to make money in all markets, not relative to a benchmark. I might have skill in one of these $1,000 bottles, but I’d have to open it first. Everybody says these are great and some have developed a very loyal following who will pay up. Availability is scarce.”
The investor says, “Like Madoff??…. always making money? Who always makes money?”
The bartender replies, “Yes, in hindsight, like Madoff; skill seems to be elusive and hard to identify.” He prepares to open the bottle and says, “If I open this, you own it. Remember, every guru has his Waterloo moment.”
The investor says, “Wait, don’t open it yet. How can I understand skill?”
The bartender replies, “Maybe you have to look at where the returns come from and eliminate what you can. Examine insider info, front running, fraud, market condition, dependencies, frequencies and concentration. Concentration is a huge bomb that needs constant defusing. Remember Ed Lampert? He was the darling of the hedge fund industry until Sears sunk him. His fund was $16 billion in 2007; now it’s $650 million. At the peak, Sears was 72% of his hedge fund portfolio. Conviction and pride equal deadly hubris. David Geffen thought Lampert was god-like. Guess he doesn’t have that opinion anymore. “
The bartender reaches behind him. “How about this manager? She is an event driven/distressed manager with a global view and takes advantage of market dislocations; tends to be long, but at advantageous prices. You know…. they buy at a large discount or are very early. The biggest risk is concentration risk. Hard to pin down as opportunity can come from a lot of places. Sometimes they’re inactive, sometimes fully engaged. Then I’ve got this merger arb manager. As long as markets are stable to higher they will make good money. When a deal breaks, they will lose something. When the market breaks badly, you’ve got a sudden beta bet.”
The investor sighed, “Look the market goes up 80% of the time. Why can’t I be happy with that? Bet on growth and asset inflation, always be long a basket. Clearly, we have monetary authorities who are focused on growth. What else do you have?”
The bartender replies, “Well, we have a section that is private, exclusive and based on fundamental research, so I’m told. We have to put these away for 20 years and then find out the value. If we open them sooner, it’s a bad Christmas. Everyone swears that this is a superior strategy, but it’s a long time baking these cakes and the world could change 5 times in the interim. It’s really a bet that the world and its economic engine won’t be disrupted. Valuing it is tough but there seems to be a bit of a mania for these at the moment. The one’s we’ve opened have tasted ok to date. But 20 years from now?”
The investor says, “Well, I do like wine and I plan to be around for a long time….. I can outwait small downturns…, as long as there’s an upturn on the way and the world doesn’t change dramatically.”
The bartender sighs, leans forward and whispers to the investor, “without the Fed and easy global credit, your investments would have had a very different path; just a bartender tip.”
“Ah” says the investor. “I hear you saying that excess returns are dependent on credit availability and asset inflation. If only we can anticipate future central bank activity.”
The bartender adds, “Second tip: Baby boomers and their children are running the show.”
About Sigma Analysis
A firm of market professionals, mathematicians and data scientists. Sigma delivers investment solutions to Pension plans via custom built cash efficient, liquid and cost-efficient vehicles.