Hedge Fund Blog by Veryan Allen

ヘッジファンド 代替投? ??? ??? ????? ??基金 对冲基金 ?? ?? Хеджевые фонды
???????? ????????

Add to your Blogroll

function pop_window($id) {

window.open('http://www.feed2podcast.com/player/podcast_player.php?url=http://www.feed2podcast.com/podcast/' $id '.xml', 'popup', 'width=320, height=300, top=50, left=650, menubar=0, scrollbars=0, location=0, toolbar=0, resizable=0, status=0'); }

Hedge Fund Podcast

Tuesday, January 15, 2008

Alpha or beta?

Bear market or bull market but there is always an OPPORTUNITY MARKET for alpha. Short selling seems to be working, so far, in 2008 and stock indices in most major markets have erased last year's gains. Investors have not received the alleged equity risk premium for eight years but then stocks don't read the textbooks. Not everyone can afford to wait around for REALITY to catch up with economic THEORY. The "panic of 2007" is continuing into the new year. It just snowed in Baghdad and Maui; unlikely events can and do happen.The S&P 500 is now at 1,400 as it was 12 months ago AND back in January 2000 but it could be worse; in January 1988 the Nikkei was at 24,000 and 20 years on the index has "grown" to 14,000. With equity benchmarks mostly flat for the decade investors can be grateful for the alternative sources of return like hedge fund and venture capital alpha and commodity and emerging market beta that have helped diversify portfolios and preserve capital. Investing and trading have important roles in portfolio management but it is no place for gambling. Prudent investing surely requires acknowledging the possibility of an extended bear market and constructing a portfolio that can grow, if necessary, no matter what happens. Bills accrue and liabilities grow regardless of what stock and credit markets do. But risk free yields are far below required actuarial return targets.Much worse is the dually damaging impact of lower discount rates at the same time as the stock market drops significantly. Many investors cannot wait long enough for traditional beta bets to pay off and why should they when they can allocate to funds with the edge to generate reliable absolute returns? The trades to make and the managers to pick are those with positive expectation and favorable odds.What is the difference between investing, trading and gambling? With the first two it is the holding period; seconds to months is trading and years is investing. Investing and gambling are quite similar at first look; putting money at risk in the hope of making more money. Decision making under uncertainty. But most investors would balk at the idea of being called a gambler even if the markets often resemble a casino.Surely the difference is that investing is deploying capital when you DO have the edge while gambling is when you DON'T have the edge. To make consistent absolute returns it is necessary either to have an advantage or identify someone else with one. That does not eliminate the possibility of small, manageable losses but it does mean persistent and predictable performance. By definition there is no edge in beta and it is not very reliable over most relevant time frames.Strategies make money out of asset classes. In implementing a strategy the fund manager must either have a protective moat of a talent-based barrier to entry or keep it secret. Many things in the public domain do NOT work anymore but is that surprising? "Sell in May" timed the market brilliantly in 2007 while "3rd year of Presidential cycle" didn't but then both are just statistical flukes. The Dogs of Dow, the January effect, the "Magic formula" of value investing are also much too well known. Those anomalies, among others, are gone. I hope for the sake of the long only crowd that the "First 5 days in January" is NOT predictive for 2008. But I would be pleasantly surprised if the Dow and Nikkei don't dip below 10,000 sometime this year. And if the two largest economies have problems so will many others.There are reasons to be bullish but then there always are. The mythical "private equity put" and "Bernanke put" evaporated to be replaced by the "Sovereign Wealth Fund put" and that sell-side delusion called "global decoupling". Many economists are predicting a recession which, given their track record, means there is a good chance there won't be one. Several large US banks will report earnings this week and with new CEOs and new stock options the temptation to write down doubtful CDOs, SIVs, CMBSs and real estate loans to very conservative levels and adopt a kitchen sink approach to disclosing bad news must be high. LAST quarter can be blamed on former management but not the NEXT quarter. Ben Bernanke promising substantial rate cuts was clearly preparing the market for bad news. Short sell the rumor, buy the fact? Or is a 50bp cut ALREADY priced in?Monetary policy isn't quite the economic rudder many would like to rely on. Some central banks think raising interest rates will curb inflation and lowering interest rates will avoid recession. Maybe but not necessarily anymore as global capital flows and new, non-obvious relationships between assets and geographies may have changed the rules of the game. High rates in Iceland or New Zealand or low rates in Japan or Taiwan haven't had quite the effect that central bankers anticipated. Situations change; western investors helped out Asian banks and now Asian investors help out Western banks. Asset classes shouldn't be looked at in isolation as they all have varying effects on each other. Commodities move stocks, currencies impact bonds and vice versa. Last year showed how long-biased credit strategies could hurt everything from private equity LBO funding to some of the more crowded "market neutral" equity strategies.One of the hedge funds that profited from the subprime CDO meltdown, Magnetar Capital, did NOT contribute to "astronomical" losses for the street; some counterparty banks simply didn't know how to price or hedge structured credit tranches properly. As with caveat emptor, caveat venditor or seller beware - if a sell-side firm can't manage the risk in a product, don't sell it to clients in the first place. You can dress the credit crisis up with the exotica of Klio and Norma CDOs but basically it was poor quality financial engineering and fictitious capital rearing its monstrous Cetus-like head. Casinos are now using something called NORA or Non-Obvious Relationship Awareness in their surveillance work. Successful investing is now very dependent on monitoring non-obvious relationships between securities. It was the key to doing well in 2007 and will be more so in 2008. This is where many err; looking at a single stock, pair of securities or one asset class when it is the ENTIRE interrelated macro puzzle that needs analyzing as well. Sometimes a stock, bond, commodity, currency or any other security goes up and other times it goes down. Predicting those moves is difficult but some can do it. Their changing relationships opens up anomalies and inefficiencies that can be exploited if you work hard enough to identify them.Around New Year I spent a few days in that bastion of statistical arbitrage, Las Vegas, the only city in the world named after a volatility metric. I am always long vega and long Vegas. The usual opinion on casinos is you can't beat the house just like conventional "wisdom" in finance is that you can't beat the market. In general that is true since the sweat equity, concentration and aptitude required to perform such a difficult task on a consistent basis is rare. Difficult yes, impossible no. Like others I've taken the time to try to find an edge in picking managers and picking securities. And some people have an edge in Vegas.As in financial markets there are slight advantages that can be developed in a few casino games to change the negative expectation of gambling to the positive expectation of investing. But it requires dedication, insight and research. Many people are aware Blackjack can be beaten but disclosure of the techniques and changes in the rules have reduced that edge. The first time I visited Vegas I had mastered basic strategy and the probabilities almost as well as Ed Thorp and could memorize cards as well as Dustin Hoffman and I did reasonably well; nowadays I am content to break even. But others have greater skill and can do better than that. Despite the increased sophistication and monitoring at casinos there are still professional blackjack players making good money from innovating their strategy and developing their talent. Just like a proper hedge fund keeps refining and adapting its edges and finding new ones. Perhaps even roulette and dice games can be "beaten" if beaten is defined as having a small probabilistic bias that reduces the house's advantage; it just takes high ability AND years of practice to do it. Skeptics can read the book Eudaemonic Pie or dice control for some basic introductory tips though what works NOW is not going to be written about or easy to implement for obvious reasons. Poker is a game of luck over one hand but skill over many hands. And when I looked up at the casino's sports book I saw potential mispricings and arbitrages on the board just like on a futures exchange or page of stock quotes; but it does take hard work, an informational advantage and domain knowledge of the teams, players and horses to identify them. I've written before that a sports gambling hedge fund would make sense although there are larger edges available in financial markets than in casinos.Slot machines are interesting from a risk/reward perspective. The house has the edge but that does NOT mean they should never be played. The POSSIBILITY of an enormous payout for a very low capital outlay is a different value proposition. "Experts" say that the odds of hitting a $10 million jackpot are so remote (1 in 100 million or so) as to make them a loser's game. But as with a national or state lottery, the probability that the jackpot will be won is 1.00, i.e. a certainty. Someone WILL win it. If you don't play you have ZERO chance of winning but if you DO play you have an unlikely but NON-ZERO chance. Since any number divided by zero is infinity the act of risking a few bucks RAISES the probability of winning by an infinite multiple! The optimal algorithm with a lottery or a Megabucks slot machine IS to play but with small cash. Similar to buying far out of money options; even if most expire worthless, you only need one to pay out. By complete fluke I happened to put $20 into a machine one evening and won $1,000. Deducting "fees" of 5?d 50?at is a "return" of 2,400?o now you know what the "highest" performing non "hedge fund" was last year - the Nevada Slot Machine Fund. A stupid statement of course but sadly such unrepeatable luck has been used to market many a fund. Naturally that return was "pure alpha" as I had the "skill" to pick the right machine in the right casino at the right time. NOT. But I have seen even sillier contentions from some fund marketing materials.Suppose I had then lent the $1,000 to someone who promised to pay back $2,000 if they won speculating on local real estate. What if I assigned an overly optimistic default probability to this "trade" and launched the Enhanced Nevada Credit Opportunities Fund on the back of this "amazing" mark-to-model yield? Sounds ridiculous but that is what Merrill Lynch, Citigroup, Bear Stearns, Northern Rock, Sowood and Dillon Read among several others were effectively doing in their credit businesses. Subprime borrowers weren't "obeying" the Moody's KMV model any more than stock markets have been recently rewarding investors for their "risk".The cold winter of the real world has not been kind to the warm summer of academic conjecture. Zero passive equity index growth century-to-date! I'll take different strategies applied to assets rather than the "reliability" of the asset classes themselves every time. That very long term security called Gold may be around $900 today but remains far below its inflation-adjusted high set nearly 600 years ago. Gold traders and gold miner shovel makers - yes, long only gold - no. Take the long view? On what?What if in 2020 or 2030 major equity indices are LOWER than today? Lost year, lost decade, lost...? High yield only makes sense if it is higher than the risk. Volatility and extended drawdowns do NOT always compensate with performance. Whenever I hear the case for long term passive investing I wonder what temporal era is meant - geological or cosmological time. Over holding periods of importance to humans I'd rather invest in alpha than gamble on beta.

© posted by Veryan Allen at 1/15/2008 01:43:00 PM

Email: hedgefundblog@gmail.com

Please enter your email address

About Me

Name: Veryan Allen

Welcome to Hedge Fund Blog where I write about alternative investing. I help investors and portfolio managers identify robust sources of absolute return. Mostly I research new strategies and performance analytics and also advise on due diligence and portfolio construction. My background is in emerging markets, computational intelligence and option pricing though I've either invested in or traded most hedge fund strategies and asset classes. You can email me at: hedgefundblog@gmail.com
View my complete profile

Recent posts

标签： commodity trading