Investing Thoughts

I stumbled across this just now – I wrote it over a year ago but its certainly not out of date. I wouldn’t say its timeless as investing constantly changes but i wouldn’t see the need to change much. I know an awful lot more about risk management now in my current role as a partner in RiskSystem (www.risksystem.com):

 

My personal views on investing:

MARKETS:

• Diversification is about the best free lunch there is
• Value has proven to be the best long term risk adjusted investment strategy (though it will at times severely underperform eg TMT/Nasdaq bubble)
• Re the tortoise and the hare I am most definitely a scared tortoise – “get rich slowly”
• A 50% drawdown requires a 100% return to get back to your starting position so avoid large drawdowns at all costs
• Well run hedge funds can add alpha but many do not – FOHFs are even worse (due to fees, and inability to invest in the best managers). Some strategies offer genuine uncorrelated returns and will work when you need them eg CTA’s in 2008
• Volatility is not the same as Risk. Risk is not the same as uncertainty. Risk can be quantified e.g. roll of a dice, uncertainty cannot eg S&P at tomorrow’s close. But risk and uncertainty can lead to permanent loss/impairment of capital if not managed
• Equities beat bonds over the long term, but not always. Cash can be king, occasionally. It’s an option – to buy at distressed prices when all are selling
• Equities and GDP growth are not well correlated
• Earnings will match nominal GDP growth over the long term (r=0.93) – eps emanate from revenues
• There are only three sources of returns from the stock market: earnings growth, dividend yield, and the change in P/E
• Figure out the direction of PE’s and you can largely predict equity returns
• Key unknown is inflation – a driver of PE’s. Equities like stable inflation; rising or falling away from stability is not generally good
• Stocks are a long term claim on a stream of income (long duration). Forward earnings models do not have a good long term track record. CAPE and Q-ratio are better Shiller/Hussman/Smithers).
• Profit margins are mean reverting (the average rarely happens!)
• Future US and world GDP likely to be lower going forward – Grantham/Gross/El Erian “new normal” (1-2% pa not 3% long term average)
• There are times to buy and hold (starting PEs low) and times when you need to be active (high PEs, high profit margins)
• For buy and hold periods index funds (passive) are good enough (though tactical overlays can further add value); for active periods use combinations of cash, alternative strategies, active managers, options and more frequent rebalancing
• Beware the folly of forecasting! Analysts are rubbish at it, economists worse. Prepare instead. Analyse don’t forecast. “analysis should be penetrating not prophetic” Ben Graham. Too many “unknown unknowns” – black swans (Taleb)
• Beware “recency bias” and reading only material that confirms your view
• Stability breeds instability – Mises
• Remember what is signal (eg Fed, ECB) and what noise (politicians!) is. Simple is better.
• Investing is simple but not easy.

 

SELECTING FUND MANAGERS:

• Selecting good fund managers is both an art (qualitative – ex ante) and a science (quantitative – ex post). The science bit can be done at computer – the art bit involves interrogating the fund manager – ideally in his/her office
• Quantitative analysis at best gives you 50% of the story – similar to a desk-top valuation on a property (Madoff had a great Sharpe ratio, as would a simple strategy of writing put options, collecting the premia until…)
• Due diligence is an ongoing process – it never ends

Thinks to look for in a good fund manager:

• A process/methodology that can be explained in about two minutes
• Process, Process, Process
• Good process /good outcome = ultimate aim
• Can’t control return, hard to control risk but can control process
• Look for persistence of investment process in different economic/market periods
• Manager must have a good track record over a reasonable period (min three years) using a consistent style/strategy that is his/her own track record – not inherited or spliced together by the marketing guys
• No fund manager outperforms all the time eg Buffet in late 90’,s so don’t expect them to and don’t eliminate the good guys – you won’t if you understand their process
• Process must be scalable
• Process must not simply take advantage of anomalies that could be arbitraged away
• Style drift is a no-no – there are NO exceptions to this
• Manager must be well resourced (in-house or outsourced?)
• The manager’s investment philosophy must make sense e.g. no astrology
• Really good fund managers understand optionality
• Fund managers should have a significant part of their net wealth tied up in the fund
• Separation of custody/valuation/trading. Independent administrator a must – manager must not mark own book under any circumstances. Who are the sub-custodians? Who are the PBs? What banks do they deposit with?
• Operational due diligence is underrated
• Read and understand the constitutional documents of the fund – know the obvious: Gates/swing pricing etc
• Bottom line – this is a people business – the fund managers integrity is key

Simon O ‘Sullivan

December 18^th 2012

 

Hedge funds

reposted directly from Josh Browns blog:

Some thoughts on the equity long / short hedge fund segment from reader and industry insider Jaeson Dubrovay.Jaeson has been involved with the hedge fund world since 1990, here’s why he believes the bloom is off the rose for ELS funds and what the challenges are going forward. Enjoy!

– Josh

***

Equity Long Short Funds

Do They Provide Excellent “Return-Free Risk?”

Contributory factors for ELS underperformance over last 5 years (Jun 2012)
•Meaningful institutional assets continue to be invested in hedge funds
•Institutional investors have lower return/risk expectations than HNW
•Investments are primarily directed to the “Kindred Hundred” (top 100 funds)
•Managers focus on capital preservation and maintain low gross exposures
•This leads to crowding as larger funds deploy capital where they can (due to size)
•Stock ETFs have effectively reduced available float = higher volatility
•Sporadic short selling bans (mostly Europe) add to volatility due to uncertainty
•Larger organizations and AUM dilute the manager’s attention to stock-picking
•Managers less involved in investing/trading due to client servicing demands
•Managers invest in secondary ideas in order to deploy capital and diversify
•Managers go from “running a fund” to “running a business” = capital preservation bias
•Manager’s large investment in fund magnifies capital preservation bias
•Focus is on short-term performance and position-level liquidity
•Tension between capital preservation mindset and one eye on the equity indices
•Prime brokers/leverage providers tighter on financing terms: both pricing and tenor
•Short-interest rebates contribute minimally to performance due to low interest rates
•HF that do well in bull markets have “too much beta”
•HF that don’t keep up with bull markets suffer from redemptions
•2/20 at lower return levels is onerous (2% management fee is fixed/incentive fees minimal)
•Fundamental analysis has not worked in the current “risk-on / risk-off” market
•Macro factors overwhelm idiosyncratic factors
•Lower dispersion among stocks nullifies the benefits from taking idiosyncratic risk
•Current deleveraging inflection point may take longer than anticipated to digest
•Markets generally tend to exhibit irrational behavior during inflection points
•Current market focus is on liquidity and a shorter investment horizon
•Recent “gating1” of FoHF may draw attention to the difficulties managers have in liquidating funds

Reasons why ELS funds may experience challenges going forward
•ELS funds tend to have higher betas than most other strategies (0.60 – 0.80)
•Crowded trades caused by inflows increase correlation among hedge funds
•No separation between alpha and beta makes these funds expensive at 2/20
•Illiquidity, lack of transparency and high fees make long only investments more attractive
•Funds that incorporate technical and/or macro views may do better than those that don’t
•ELS has had flat performance over last five years – investors rely too much on past performance
•Equity markets have reported moderate returns over the last five years – with higher volatility
•Asset allocation studies by large institutional investors may begin to favor equities again ◦Moderate returns/high volatility (equities) preferred over no return/moderate volatility (hedge funds)
◦Sizable outflows will make hedge funds unstable with even more focus on liquidity
◦Manager talent pool may shrink as some successful managers will elect to close the fund and manage their own capital

1 Salient and Morgan Creek (4Q2012

Risk

No posts in July – I was away for the month and blogging on an ipad is too much like hard work. I tried and failed miserably – copying and pasting just aint easy on the ipad. I did read lots of interesting stuff (which I wasn’t meant to as I was on hols but I just cant help myself) which I saved to instapaper so I’ll post it up over the next few weeks. Personally I’ve just joined a new company specialising in risk management for the asset management industry which I am very excited about. It was started by my old boss from my hedge fund days at Pioneer. The system itself is very impressive and will be very helpful to fund managers looking for AIFMD solutions for their risk management – which now has to be “hierarchically and functionally separate” according to the legislation. The implications of this are very far reaching and AIFMD is potentially a game changer as far as risk management is concerned – if the regulators interpret the legislation literally as written by ESMA. Oh and just for fun they are also bringing in remuneration policies into the legislation. Anyway I will be writing a lot more on this in future.

“Risk is not knowing what you are doing”
Warren Buffett