Reflecting the strength of global economic growth has been rising equity markets where the MSCI World index has risen 13.60% in the last 12 months. The main disappointment has been Japan where the broad market had risen but 5.84%, a number masking devastation among small and micro caps. Where investors were cautious and somewhat negative there has been a measured advance, the S&P500 rising 10.79%. European markets where there had also been some caution rose 13.77% on average. The healthier UK market managed to lag rising only 7.62%.
The highlight of the year was Asia ex Japan. Philippine and Indonesian markets gained over 40% but Asian quality markets such as Singapore and Hong Kong also managed returns of over 28%. Despite some extreme volatility in May, India rose nearly 45%. It was China that stole the show, however, as China listings in Hong Kong gained 54% and Shanghai and Shenzen listings rose by over 120%. Here an artificial construct – listing A shares at discount to H and then awaiting convergence- has been responsible for the outperformance. The market price of risk has diminished, itself a warning sign. In addition the price of insurance, implied volatility has also sunk back to levels not since for 12 years, despite a short spike in May 2006.
The prognosis for equities is favourable. While equities have risen against caution, it is the caution that makes the rise measured and sustained. Valuations are slightly stretched in the US but in Europe remain within historical limits. In Asia ex Japan, even Hang Seng valuations are undemanding. In China, however, valuations have run ahead of themselves and risk is no longer well priced. The extent of over valuation is by multiples of multiples and is indicative of an asset bubble. Lessons can be taken from Japan at the end of 2005 when a healthy market began to run ahead of itself. Japanese equities started the year in high expectations yet managed to underperform most of the major developed markets as well as Asian and other Emerging Markets as well. 2007 could well spell the same for China.
In US fixed income, as in the UK, anti-inflationary measures have lifted the short end of the curve. The long end has lagged as demand from liability matching investors has competed for yield. That said, inflationary pressures and expectations are likely to build. The US Fed has returned real rates into their 1990s neutral band and is unlikely to move any more in either direction, thus a steepening curve is to be expected. In the UK, however, real rates remain relatively low, near 2002, 2003 levels and further rate action may be expected and the curve is unlikely to steepen.
Inflation is expected to rise from 1.9% current to 2.1% for 2007 in the Euro area and from 0.3% to 0.4% in Japan so curve steepening is also likely in EUR and JPY. ECB policy remains hawkish but is unlikely to go too much further as real rates have returned unto mid 1990s range. In Japan, the BoJ is unlikely to raise rates soon given past history.
Credit spreads actually tightened through 2006 and continue to compress. Demand for yield, healthier corporate balance sheets and robust earnings growth underpins the credit markets. The level of caution resulting from the immense growth in the CDS market has also worked to focus attention on risk and prolong the credit bull market.
On almost every front, the outlook is benign. In the absence of some major disruption on the geopolitical front, current trends are likely to continue. Any changes in direction are likely to be smooth. It is a feature of major trend reversals that they are unforeseen and that the reasons for their happening are not well understood until well after the fact. What risks are at the forefront of investors attention rarely precipitate substantial disruptions. Let’s list some of them.
• Imbalances in US current account versus the rest of the world but particularly with China and Opec.
• The state of the US housing market and the impact on consumption.
• The size of the credit derivatives market.
• The impact of hedge funds on financial markets.
• The weight of capital flowing into private equity.
• The rich poor divide which cuts between but increasingly across countries.
• The eerie calm that greets geopolitical events of late
Wednesday 31 January 2007
Monday 29 January 2007
A word about the global economy.
There is considerable uncertainty regarding the state of the US economy. For the better part of 2006 the US economy was thought to be under inflation risk. The Fed Funds rate has, however, been left unchanged in 4 of the last FOMC meetings, this since a sharp correction in energy prices has taken pressure of CPI which peaked at 4.3% in June 2006 and is currently running a comfortable 2.5%. Indeed sentiment has shifted in favour of easing. This is predicated on current growth staying below the unobserved long term equilibrium growth rate. There is a risk that this rate of growth has as real investment has sought higher returns in developing economies and that even a lower current growth rate my be at risk of inflation. This remains to be seen.
Both new and existing home sales have seen a sharp slowdown but appear for the moment to have consolidated. Given the importance of the consumer in the US economy and the reliance on the consumer on extracting home equity to finance consumption this is an area of concern.
On the labor market front, data continues to be volatile. Late 2006 data indicated a robust labor market but the dynamics of restructuring an economy away from manufacturing towards services expects some volatility. The January initial jobless claims number was higher than expected.
Retail sales have actually softened through 2006 indicating weaker consumer demand. US economic growth is firmly supported by the corporate sector, as evidenced by the increasing proportion of profits as percentage of GDP. The marginal product and hence the price of labour, it would appear continues to slow.
Indicative of the state of health of the US economy is the USD which has been weak against EUR and GBP throughout 2006. Seasonal year end effects should be discounted which would discount weakness against JPY and other Asian currencies.
All the signals point toward a soft landing in the US economy. What remains are large scale imbalances which need time to work out. Global inflation is under control, growth rates are healthy and there is a healthy trend of active diversification taken by all quarters from China and India directing their engagement towards Europe and Africa and away from the US and Europe reciprocating. This results not in a marginalization of the US economy, which would be unrealistic given its size and importance, but a diversification of systemic risk on a global scale. The re-emergence of Japan as a global economic force reinforces this diversification. Eurozone GDP grows at 2.7%, unemployment continues to fall for a second year running, and inflation is running at 1.9%, within ECB tolerances. The Japanese economy is running at 1.6% growth, revised down but healthy nonetheless for an economy just recovered from a long depression. Asia ex Japan, remains highly leveraged to the US economy but is also actively diversifying exposure by increasing inter-Asian trade. Commodity driven economies within Asia ex Japan will find increasing exposure to the Chinese economies while service economies will find increasing dependence on India.
The price of this stability and growth is active management of inflation and inflation expectations, which has led to an almost concerted effort of central banks from China, to the EU and England and the US, to restrain liquidity. Only the Bank of Japan keeps policy fairly benign.
More later about the impact on Markets.
Both new and existing home sales have seen a sharp slowdown but appear for the moment to have consolidated. Given the importance of the consumer in the US economy and the reliance on the consumer on extracting home equity to finance consumption this is an area of concern.
On the labor market front, data continues to be volatile. Late 2006 data indicated a robust labor market but the dynamics of restructuring an economy away from manufacturing towards services expects some volatility. The January initial jobless claims number was higher than expected.
Retail sales have actually softened through 2006 indicating weaker consumer demand. US economic growth is firmly supported by the corporate sector, as evidenced by the increasing proportion of profits as percentage of GDP. The marginal product and hence the price of labour, it would appear continues to slow.
Indicative of the state of health of the US economy is the USD which has been weak against EUR and GBP throughout 2006. Seasonal year end effects should be discounted which would discount weakness against JPY and other Asian currencies.
All the signals point toward a soft landing in the US economy. What remains are large scale imbalances which need time to work out. Global inflation is under control, growth rates are healthy and there is a healthy trend of active diversification taken by all quarters from China and India directing their engagement towards Europe and Africa and away from the US and Europe reciprocating. This results not in a marginalization of the US economy, which would be unrealistic given its size and importance, but a diversification of systemic risk on a global scale. The re-emergence of Japan as a global economic force reinforces this diversification. Eurozone GDP grows at 2.7%, unemployment continues to fall for a second year running, and inflation is running at 1.9%, within ECB tolerances. The Japanese economy is running at 1.6% growth, revised down but healthy nonetheless for an economy just recovered from a long depression. Asia ex Japan, remains highly leveraged to the US economy but is also actively diversifying exposure by increasing inter-Asian trade. Commodity driven economies within Asia ex Japan will find increasing exposure to the Chinese economies while service economies will find increasing dependence on India.
The price of this stability and growth is active management of inflation and inflation expectations, which has led to an almost concerted effort of central banks from China, to the EU and England and the US, to restrain liquidity. Only the Bank of Japan keeps policy fairly benign.
More later about the impact on Markets.
Wednesday 24 January 2007
Correlation and risk
We would like to know what risk we are running in our portfolio which consists of a clutch of hedge funds. To do this we measure the individual volatilities of each hedge fund. We also need to know how these funds relate to one another.
Question: Do we measure the correlation of returns of each fund with another? Or should we find out what each fund has in its portfolio and measure the relationships between portfolio components?
Question: Do we measure the correlation of returns of each fund with another? Or should we find out what each fund has in its portfolio and measure the relationships between portfolio components?
Monday 22 January 2007
The Importance of Track Record in Hedge Fund Investing
Let’s do a little experiment. Lets take 1000 fair coins. Let’s give them names and flip them to see which ones come up heads and which ones come up tails. Now let’s take another 1000 fair coins and do the same, given them unique names and flip them recording which ones come up heads and which ones tails. While we are flipping this second batch, flip also the first batch and record their results. Now add another 1000 coins naming them, flipping them and recording their results. Do this for the previous batches as well. Continue doing this until you have 8 batches of 1000 coins.
Using simple rules of probability, of all the coins that have been flipped 8 times, that is from the first batch of course, how many would one expect to have come up heads precisely 8 times? Being fair coins, the number would be 0.5 raised to the 8th power X 1000, or roughly 4 coins. Of all the coins that have been flipped precisely 7 times, that is from the second batch, one would expect the number of coins to have only ever come up heads in every toss to be 0.5 raised to the 7th power X 1000, or roughly 15.
8 heads out of 8 tosses: 4 coins in 1000
7 heads out of 7 tosses: 8 coins in 1000
6 heads out of 6 tosses: 15 coins in 1000
5 heads out of 5 tosses: 30 coins in 1000
Thus, out of 8000 coins there are 57 coins who have never come up tails. Now supposing we loosely defined heads as the ability to generate good returns in a given year and tails the complement, and if we gave the coins strange names like ABC Capital, DEF Capital, GHI Partners, JKL Asset Management and so on…
Here in our database of 8000 coins there are 57 who have never had an unsuccessful year. Because we stopped our count at 5, you could compare this to searching a hedge fund database for funds with at least years of track record and have been successful in every year of their operating history.
The thing about the coins though is that the probability that one chosen from that 57, would have no more than an even chance of coming up heads next flip.
The above example is just an illustration. The definition of successful in a given year has not been clearly made. What is a successful year for a hedge fund? It depends on the level of risk they take. It depends on conditions in the markets. Depending on how demanding you are, success could be a very tough condition and the probability of being successful could be significantly less than 50%.
Let's do some calibration. Let us say that 5% of all managers have a good 3 year track record. We are thus defining success. This implies that success occurs with 37% probability. Using this probability we go through our calculation again and find that there are
0 managers with 8 years of unblemished track record.
1 with 7 years
2 with 6 years
7 with 5 years
18 with 4 years
Thus 28 with at least 4 years of unblemished track record. That's still quite a lot. And on the information we have, any one of these 28, thus chosen would have a 37% chance of being successful in the next year.
Using simple rules of probability, of all the coins that have been flipped 8 times, that is from the first batch of course, how many would one expect to have come up heads precisely 8 times? Being fair coins, the number would be 0.5 raised to the 8th power X 1000, or roughly 4 coins. Of all the coins that have been flipped precisely 7 times, that is from the second batch, one would expect the number of coins to have only ever come up heads in every toss to be 0.5 raised to the 7th power X 1000, or roughly 15.
8 heads out of 8 tosses: 4 coins in 1000
7 heads out of 7 tosses: 8 coins in 1000
6 heads out of 6 tosses: 15 coins in 1000
5 heads out of 5 tosses: 30 coins in 1000
Thus, out of 8000 coins there are 57 coins who have never come up tails. Now supposing we loosely defined heads as the ability to generate good returns in a given year and tails the complement, and if we gave the coins strange names like ABC Capital, DEF Capital, GHI Partners, JKL Asset Management and so on…
Here in our database of 8000 coins there are 57 who have never had an unsuccessful year. Because we stopped our count at 5, you could compare this to searching a hedge fund database for funds with at least years of track record and have been successful in every year of their operating history.
The thing about the coins though is that the probability that one chosen from that 57, would have no more than an even chance of coming up heads next flip.
The above example is just an illustration. The definition of successful in a given year has not been clearly made. What is a successful year for a hedge fund? It depends on the level of risk they take. It depends on conditions in the markets. Depending on how demanding you are, success could be a very tough condition and the probability of being successful could be significantly less than 50%.
Let's do some calibration. Let us say that 5% of all managers have a good 3 year track record. We are thus defining success. This implies that success occurs with 37% probability. Using this probability we go through our calculation again and find that there are
0 managers with 8 years of unblemished track record.
1 with 7 years
2 with 6 years
7 with 5 years
18 with 4 years
Thus 28 with at least 4 years of unblemished track record. That's still quite a lot. And on the information we have, any one of these 28, thus chosen would have a 37% chance of being successful in the next year.
Performance of Hedge Funds in 2006. How did the Big Name Hedge Funds do?
2004 and 2005 were terrible years for hedge funds. If the HFRI Index is anything to go by, the average hedge fund returned 9.05% in 2004 and 9.27% in 2005. Performance in years 2001 and 2002 were worse but those years saw equity markets in free fall. 2003 was a recovery year in equities and 2004 and 2005 while wobbly, were good years on the whole where markets both equity and fixed income found their feet. 2006, however, was a pretty good year. The HFRI Index rose 12.85% for the year.
Despite the good performance on average, in 2006, many investors continue to be disappointed with hedge funds. There are several reasons for this. One is of course the high profile demise of Amaranth, a 10 billion USD hedge fund that quickly became a 3 billion USD hedge fund by way of losses in leveraged bets on natural gas (and hence indirectly, the weather!) The robust performance of equity markets and to a lesser extent bond markets around the world. A third and less obvious reason is that many of the big names, with whom the bulk of the money in hedge funds is invested with, did poorly. Among the large multi strategy macro managers, Moore Global and Moore Fixed Income returned 9.53% and 2.57% respectively for year to November 2006. Tudor managed 10.70% in the same period. Blue Crest Capital returned a mere 6.40% and Bridgewater Pure Alpha only 3.19%. Even when returns were higher and into the low to mid teens, performance lagged previous track record. 11.75% is poor for Perry Partners, as is 11.32% for Brevan Howard.
So who did well? Quite a few. Tewksbury continued to prove that a systematic mathematical approach can work consistently. 27.93% for year to November 2006. CQS in the mid teens was consistent with previous track record and steady as she goes. GLG Market Neutral was another good performer. Where Lansdowne stuck to stocks they performed well. Some of the big winners of 2006 were behaving out of character and should have triggered alarm bells instead of blissful acceptance.
All the above performance numbers are year to November 2006.
All in all, the winners of 2006 were not the usual suspects. They were the smaller, younger managers. Conversations with managers, prime brokers and industry specialists seem to indicate a certain sense of disarray among the big macro and multi strategy fund managers. Perhaps the world has become a more complex place, perhaps we are at another one of those inflexion points we only recognize three years hence. For now, the safer strategy would be to be specific, to be technical and to focus on managers operating in particular areas. For example, dedicated stock pickers be it in Asia, Europe or the US, or sector specific equity managers but where macro factors don’t complicate matters. Event driven and distressed securities managers for example are sufficiently specialized away from the vagaries of macro policy and geo politics.
Some argue that the big names have had their day and are never coming back. Some say that the last year was a temporary lull and that the experience and resources of the big name hedge fund will return them to glory. It’s a difficult call and certainly not one I can make.
Despite the good performance on average, in 2006, many investors continue to be disappointed with hedge funds. There are several reasons for this. One is of course the high profile demise of Amaranth, a 10 billion USD hedge fund that quickly became a 3 billion USD hedge fund by way of losses in leveraged bets on natural gas (and hence indirectly, the weather!) The robust performance of equity markets and to a lesser extent bond markets around the world. A third and less obvious reason is that many of the big names, with whom the bulk of the money in hedge funds is invested with, did poorly. Among the large multi strategy macro managers, Moore Global and Moore Fixed Income returned 9.53% and 2.57% respectively for year to November 2006. Tudor managed 10.70% in the same period. Blue Crest Capital returned a mere 6.40% and Bridgewater Pure Alpha only 3.19%. Even when returns were higher and into the low to mid teens, performance lagged previous track record. 11.75% is poor for Perry Partners, as is 11.32% for Brevan Howard.
So who did well? Quite a few. Tewksbury continued to prove that a systematic mathematical approach can work consistently. 27.93% for year to November 2006. CQS in the mid teens was consistent with previous track record and steady as she goes. GLG Market Neutral was another good performer. Where Lansdowne stuck to stocks they performed well. Some of the big winners of 2006 were behaving out of character and should have triggered alarm bells instead of blissful acceptance.
All the above performance numbers are year to November 2006.
All in all, the winners of 2006 were not the usual suspects. They were the smaller, younger managers. Conversations with managers, prime brokers and industry specialists seem to indicate a certain sense of disarray among the big macro and multi strategy fund managers. Perhaps the world has become a more complex place, perhaps we are at another one of those inflexion points we only recognize three years hence. For now, the safer strategy would be to be specific, to be technical and to focus on managers operating in particular areas. For example, dedicated stock pickers be it in Asia, Europe or the US, or sector specific equity managers but where macro factors don’t complicate matters. Event driven and distressed securities managers for example are sufficiently specialized away from the vagaries of macro policy and geo politics.
Some argue that the big names have had their day and are never coming back. Some say that the last year was a temporary lull and that the experience and resources of the big name hedge fund will return them to glory. It’s a difficult call and certainly not one I can make.
Thursday 18 January 2007
Some evidence that hedge fund managers don't always know what investors want
I was doing the usual rounds in Connecticut visiting hedge fund managers a couple of months ago and I was talking to a convertible arbitrage manager who was seeking to grow his business. The said fund had had a long track record of success in the field of convertible arbitrage chalking up an average performance of nearly 12% p.a. over the last 15 years. In 2004 the convertible market was shaken and investors left in droves. What was a billion dollar business shrank to nearly half. The manager quickly reacted by changing his business by adding a multi strategy credit fund to his product range. The fund did reasonable well and he managed to raise significant capital.
When I spoke to him, he was lamenting that his business had hit a plateau and that assets were not growing. He was pushing his multi strategy fund but unfortunately was not reaching out to new investors. He felt that he had already reached out to all the investors that were interested in his product. This was to an extent true. In the entire hour that we chatted, he only mentioned his old convertible fund but once and only as an afterthought. Performance of the fund had perked up. Convertibles had suffered a very specific problem to do with the dynamics of trading and ownership, a problem which started in 2004 and dragged out till 2005. Since then general conditions had improved significantly, the problem had gone away.
It never occured to the manager that the way to grow his business was to start marketing that old convert fund of his. More astute investors were already moving back into converts and would have loved to invest with a manager of his track record and experience. He was so focused on managing money that he just didn't see the demand.
When I spoke to him, he was lamenting that his business had hit a plateau and that assets were not growing. He was pushing his multi strategy fund but unfortunately was not reaching out to new investors. He felt that he had already reached out to all the investors that were interested in his product. This was to an extent true. In the entire hour that we chatted, he only mentioned his old convertible fund but once and only as an afterthought. Performance of the fund had perked up. Convertibles had suffered a very specific problem to do with the dynamics of trading and ownership, a problem which started in 2004 and dragged out till 2005. Since then general conditions had improved significantly, the problem had gone away.
It never occured to the manager that the way to grow his business was to start marketing that old convert fund of his. More astute investors were already moving back into converts and would have loved to invest with a manager of his track record and experience. He was so focused on managing money that he just didn't see the demand.
Further evidence that hedge fund managers don't always know what investors want
Just yesterday I was talking to a fund manager from Australia. He had launched an equity and equity options fund two years ago, performance had been good and he was on the road to raise capital.
His pitch was to launch immediately into the options trading strategy, which was fairly sophisticated and interesting. He spent nearly an hour talking about his choice of strikes, his decision to take delivery or roll, how he rolled, how he scaled in or out of a trade. At the end of this I asked him a simple question: How do you choose which stocks to execute your options strategy on?
It was only then that he began to tell his story of stockpicking and he turned out to be a good stockpicker. What to him was a matter of course, to an investor was of utmost importance. Here was a stockpicker, someone who analysed companies, their asset value, their cash flows and earnings, their return on investment, the quality of management, the soundness of their business model, and what does he concentrate on? Trade expression. The pitch was back to front. Selling his story as he had done so to many investors would have led them to lose interest or misunderstand and run scared. The diligent investor would have discovered his edge or his fundamental style of investing, but they would have been made to work hard to find it.
This manager was trying to raise capital. Clearly he wanted to impress. But he didn't know what investors want and so went about it in reverse. He could have said, look, I'm a good stock picker, I am an investor, not a trader. Here is how I pick stocks. When I am done picking stocks, I find the best way of expressing my long and short ideas. Here is my option strategy. Instead he would have given a potential investor the impression that here was an options trader, mostly writing options and thus open to tail risk, often getting exercised and thus not the best risk manager, and with little consideration to the quality of the underlying securities...
His pitch was to launch immediately into the options trading strategy, which was fairly sophisticated and interesting. He spent nearly an hour talking about his choice of strikes, his decision to take delivery or roll, how he rolled, how he scaled in or out of a trade. At the end of this I asked him a simple question: How do you choose which stocks to execute your options strategy on?
It was only then that he began to tell his story of stockpicking and he turned out to be a good stockpicker. What to him was a matter of course, to an investor was of utmost importance. Here was a stockpicker, someone who analysed companies, their asset value, their cash flows and earnings, their return on investment, the quality of management, the soundness of their business model, and what does he concentrate on? Trade expression. The pitch was back to front. Selling his story as he had done so to many investors would have led them to lose interest or misunderstand and run scared. The diligent investor would have discovered his edge or his fundamental style of investing, but they would have been made to work hard to find it.
This manager was trying to raise capital. Clearly he wanted to impress. But he didn't know what investors want and so went about it in reverse. He could have said, look, I'm a good stock picker, I am an investor, not a trader. Here is how I pick stocks. When I am done picking stocks, I find the best way of expressing my long and short ideas. Here is my option strategy. Instead he would have given a potential investor the impression that here was an options trader, mostly writing options and thus open to tail risk, often getting exercised and thus not the best risk manager, and with little consideration to the quality of the underlying securities...
Tuesday 16 January 2007
A word about Style Drift and what it means to be a hedge fund
Style drift is when a trader is flexible about their trading strategy and it doesn't work. Nimble is when a trader is flexible about their trading strategy and it works. It isn't style drift if it remains within the experience and expertise of the trader. It's style drift if its out of their comfort zone.
One of the important ways that hedge funds differ from traditional investment strategies is their flexibility.
The concept of the hedge fund bears consideration. Hedge funds are not perfectly hedged, nor do they always hedge, even imperfectly. A more useful characterisation of the hedge fund strategy is that it is an optimal solution in a constrained optimisation where the constraints are a bit more complicated than one finds in traditional long only unlevered investment strategies.
The traditional view is that a hedge fund strategy involves augmenting the traditional long only strategy with short selling and leverage and use of hybrid and derivative instruments. From an economic efficiency perspective, the converse view is that the hedge fund strategy is a less, albeit more complex constrained way of investing. The traditional strategy is therefore a very tightly, and simply constrained (no shorting, no leverage, no derivatives, little cash) investment strategy.
One of the important ways that hedge funds differ from traditional investment strategies is their flexibility.
The concept of the hedge fund bears consideration. Hedge funds are not perfectly hedged, nor do they always hedge, even imperfectly. A more useful characterisation of the hedge fund strategy is that it is an optimal solution in a constrained optimisation where the constraints are a bit more complicated than one finds in traditional long only unlevered investment strategies.
The traditional view is that a hedge fund strategy involves augmenting the traditional long only strategy with short selling and leverage and use of hybrid and derivative instruments. From an economic efficiency perspective, the converse view is that the hedge fund strategy is a less, albeit more complex constrained way of investing. The traditional strategy is therefore a very tightly, and simply constrained (no shorting, no leverage, no derivatives, little cash) investment strategy.
Hedge fund strategies are more flexible and useful since the objective function can be specified to reflect absolute returns (alpha), benchmarked returns (portable alpha), risk adjusted returns (high information ratio), or any number of metrics that best reflect an investors goals over various time horizons.
The feasible set is similarly flexible and can handle the constraints imposed by an investor for reasons of risk management, liquidity or regulatory compliance. By reason of its flexible constraints hedge fund strategies can also be constructed to higher or lower risk tolerances to suit investor appetites. This flexibility allows the investor to define a suitably spacious set within which to express their skill. Too restrictive, and although the risks become more clearly defined, the less room there is to manoevre and the more difficult it is to generate returns. In fact, the more one becomes dependent on certain factors, although such dependence may not be immediately apparent. Too relaxed and the risks become less well defined and the opportunity for style drift and accidents increases.
Thursday 11 January 2007
Investment Process: Investment Committees
Too many cooks spoil the broth. Investment committees don’t work. In fact, I have yet to see an executive committee in any industry. Committee’s are good in an oversight role but in an executive role they tend to fail. If the committee moves forward it is on groupthink. If there is not groupthink, there is no progress. Yet many institutional investment businesses have a sizeable investment committee of which they appear very proud. I recall talking to the head of marketing of a big fund of hedge funds from the US and he was telling me all about his firm, the investment process and how there was a defined and structured investment process involving an investment committee of 6 people which worked by consensus. Every member of the committee held a veto. What was even more surprising was that said head of marketing was also on the committee. One hoped that he had investment experience to match his marketing credentials.
Alas, in an industry paradoxically driven by information yet where information is burdened with massive search costs, popular misconceptions are perpetuated by interested parties. And so even small investment firms are sometimes lured into the labyrinth of process. Investing is a lonely game. Yes, we talk, we network, we trade ideas endlessly, but at the end of the day, when the time for execution is upon us, our decisions are ours alone. These decisions are of course influenced by the information and opinion of those around us, but they otherwise play no direct part in the final decision. The investor who second guesses his own decisions is soon whipsawed and confused. The investment committee ruling by consensus is sclerotic, arthritic, inflexible. It acts too late, it acts too little, or too much, but never just enough and never in time.
I once advised a friend at a good sized US fund of funds. They had an investment committee which ruled by consensus and they were finding difficulty moving forward. Moreover the team consisted of consummate professionals. I presented the following example:
Alas, in an industry paradoxically driven by information yet where information is burdened with massive search costs, popular misconceptions are perpetuated by interested parties. And so even small investment firms are sometimes lured into the labyrinth of process. Investing is a lonely game. Yes, we talk, we network, we trade ideas endlessly, but at the end of the day, when the time for execution is upon us, our decisions are ours alone. These decisions are of course influenced by the information and opinion of those around us, but they otherwise play no direct part in the final decision. The investor who second guesses his own decisions is soon whipsawed and confused. The investment committee ruling by consensus is sclerotic, arthritic, inflexible. It acts too late, it acts too little, or too much, but never just enough and never in time.
I once advised a friend at a good sized US fund of funds. They had an investment committee which ruled by consensus and they were finding difficulty moving forward. Moreover the team consisted of consummate professionals. I presented the following example:
For the sake of illustration, say each individual makes good decisions 80% of the time and poor decisions 20% of the time. The team consisted of 8 people. This meant that when a good investment was put before them, the committee would make the investment only 16.8% of the time and would make a mistake and turn the investment down 83.2% of the time. Of course the converse was also true. Faced with a bad investment the committee would turn it down nearly 100% of the time, making the right decision, and make a mistake only once in 390,000 times.
What happens if we reduce the number of members?
- 8 members:
What happens if we reduce the number of members?
- 8 members:
Accept good investment: 16.78%, Reject bad investment 100.00%
- 5 members:
Accept good investment: 32.77%, Reject bad investment 99.97%
- 3 members:
Accept good investment: 51.20%, Reject bad investment 99.20%
- 2 members:
Accept good investment: 64.00%, Reject bad investment 96.00%
One might ask how sensitive the above analysis is to the quality of the committee members. My comment is that if the quality of members was questionable then they should not be on the committee in the first place. If the error rate of the individuals rises to say 40%, a committee of 8 almost never makes an investment since it will reject a good proposition 98.32% of the time and reject a bad investment 99.93% of the time. The only rationale for having large investment committees ruling by consensus appears to be a paranoid fear of accepting a bad investment. This hardly shows faith in the abilities of the members.
An interesting combination is one where there are two decision makers and they both have to agree. Assuming that each one made an error 30% of the time, the collective decision would accept a good investment 50% of the time but reject a bad one 91% of the time. Unfortunately, if faced with 100 investments where 10 are good and 90 are poor, which is a fair distribution in certain quarters of the investment universe, such a team would accept 5 good investments, reject 5, accept 7 dud investments and turn down 83. That means 5 good versus 7 duds in terms of what will impact the portfolio. Not very encouraging. If the individual error rate is 20%, the good versus dud ratio improves to 6 is to 3. Much better.
The moral of the story is that the most efficient mechanism will not save you from a bunch of monkeys. And, if you have a bunch of good people, don’t let them get in each others’ way.
Warning: The analysis assumes independence, a condition too strong to be found even in the most professional investment firm.
Economists point at emergence of dual economy in Singapore
Today on Channel News Asia, Pearl Forss writes about an emerging dual economy in Singapore.
http://www.channelnewsasia.com/stories/singaporelocalnews/view/251935/1/.html
It makes for some very interesting reading. Having spent 2004 - 2006 in Singapore, I have seen first hand the effects referred to in the article. The article basically reports that:
I agree with most of what the article says. However, I perceive that there is a deeper dynamic that is going on. Singapore's outreach to the global economy is not a general one but a very specific one. Certain industries are being favored and actively courted to some very specific aims. See my earlier post on Singapore property:
http://bgyl.blogspot.com/2007/01/singapore-real-estate.html
Why this lot? Don't ask me. Why don't you come up with some plausible reasons yourselves?
One of the consequences of a dual economy in which one diminishes in relevance while the other grows is on the labour market. I don't know how quick one can re-train oneself to seek employment in a sector of growing relevance but it seems to me that a lot of people will find themselves obsolete if they cannot do so quickly. This has already been happening for a number of years. I think many Singaporeans can see that their relevance is being threatened. I'm not sure they know what to do about it.
I think that policy from on high has profound implications for Singapore and in particular for what it means to be Singaporean. It appears that Singapore now belongs to whoever can take the economy forward. There will be no sentimentalities, no asymmetric treatment for incumbents. Quite how things will work out, I don't know, but if I was resident in Singapore, I would certainly hope I was adding value.
http://www.channelnewsasia.com/stories/singaporelocalnews/view/251935/1/.html
It makes for some very interesting reading. Having spent 2004 - 2006 in Singapore, I have seen first hand the effects referred to in the article. The article basically reports that:
- There is a dual economy.
- A domestically focused economy that is languishing.
- A globally reaching economy that is flourishing.
- The global facing economy is exposed to cyclical factors in the global economy.
I agree with most of what the article says. However, I perceive that there is a deeper dynamic that is going on. Singapore's outreach to the global economy is not a general one but a very specific one. Certain industries are being favored and actively courted to some very specific aims. See my earlier post on Singapore property:
http://bgyl.blogspot.com/2007/01/singapore-real-estate.html
- Wealth management - private banking, hedge funds, family offices,
- Education - attracting talent from the region and schools from across the globe
- Gaming - what was that about hedge funds? I meant punters of course
- Anything catering to the rich - Hospitality, F&B,
Why this lot? Don't ask me. Why don't you come up with some plausible reasons yourselves?
One of the consequences of a dual economy in which one diminishes in relevance while the other grows is on the labour market. I don't know how quick one can re-train oneself to seek employment in a sector of growing relevance but it seems to me that a lot of people will find themselves obsolete if they cannot do so quickly. This has already been happening for a number of years. I think many Singaporeans can see that their relevance is being threatened. I'm not sure they know what to do about it.
I think that policy from on high has profound implications for Singapore and in particular for what it means to be Singaporean. It appears that Singapore now belongs to whoever can take the economy forward. There will be no sentimentalities, no asymmetric treatment for incumbents. Quite how things will work out, I don't know, but if I was resident in Singapore, I would certainly hope I was adding value.
Wednesday 10 January 2007
Watch Out!
A quick comment here. The prices of luxury Swiss watches languished in the early to mid 1990s. That was when I started collecting, small and unimportant pieces, mind. Stainless steel sport watches, divers watches, some classic three hand watches. The later part of the 1990s saw a renaissance for the Swiss watch industry. Companies who in the mid 1990s had consolidated and pared down their product offerings began to expand their product range. Weird and wonderful watches were brought to market.
The recession of 2000 put a dent in the bull market in luxury watches, but only a minor dent. The last 6 years have seen a further surge in interest in horology. Prices have been skyrocketing. All manner of complicated watches have been produced to fulfil needs and requirements nobody knew they had.
As prices have risen, so too has production. Companies that used to make several thousand watches today make several tens of thousands of watches. Many watch buyers have seen the prices of their watches double or more in 5 years. Prices of certain watches considered hot and in demand have risen even more quickly and many trade at a premium to list price. But here's the thing. Demand and supply. Clearly wealth creation and the successful marketing efforts of watch companies has led to a surge in demand. Supply has been adjusted to meet demand. Or at least that's what the watch companies have tried to do. The supply of hand made watches can't just be cranked up like some production line. And so prices rise as watches become relatively scarce. However, supply is not entirely constrained either and production capacity certainly has increased significantly in the last 5 years.
Nothing goes up or down in a straight line, and nothing lasts forever. When the economy slows down the next time, I wonder if it would be wise to count on that hot watch holding its value. A 1960's Patek Philippe perpetual calendar might lose some of its value, but a relatively mass produced 2005 equivalent might not be as resilient.
The recession of 2000 put a dent in the bull market in luxury watches, but only a minor dent. The last 6 years have seen a further surge in interest in horology. Prices have been skyrocketing. All manner of complicated watches have been produced to fulfil needs and requirements nobody knew they had.
As prices have risen, so too has production. Companies that used to make several thousand watches today make several tens of thousands of watches. Many watch buyers have seen the prices of their watches double or more in 5 years. Prices of certain watches considered hot and in demand have risen even more quickly and many trade at a premium to list price. But here's the thing. Demand and supply. Clearly wealth creation and the successful marketing efforts of watch companies has led to a surge in demand. Supply has been adjusted to meet demand. Or at least that's what the watch companies have tried to do. The supply of hand made watches can't just be cranked up like some production line. And so prices rise as watches become relatively scarce. However, supply is not entirely constrained either and production capacity certainly has increased significantly in the last 5 years.
Nothing goes up or down in a straight line, and nothing lasts forever. When the economy slows down the next time, I wonder if it would be wise to count on that hot watch holding its value. A 1960's Patek Philippe perpetual calendar might lose some of its value, but a relatively mass produced 2005 equivalent might not be as resilient.
Tuesday 9 January 2007
Skill and Luck 2
One time I was with a colleague in Japan interviewing managers. My colleague Patrick knew his way around Tokyo, well, somewhat, so we only spent 25% of the time lost instead of the usual 50%. This was early 2006 when Japanese hedge funds were facing a particularly horrible time. The January and February losses on the broad market were about 7% each on each downleg. Taking into account some upside volatility the market actually only lost slightly over 5% from the beginning of the year till mid February.
Hedge funds trading Japan from Japan had mostly sustained double digit losses and were facing tough questions from their investors. In the latter half of 2005, the fund of funds community, that is the people who invested on behalf of investors into hedge funds, had been very bullish about prospects for Japanese hedge funds. They had piled into Japanese hedge funds rather exuberantly.
At the annual Goldman Sachs Asian hedge fund conference usually held in November in Tokyo, the mood was upbeat and investors outnumbered hedge funds by several multiples. Some 600 over people showed up, some uninvited, hedge funds and investors both. Times like this I get nervous. I have no reason to be. No good reason at least. But human beings are like lemmings sometimes. In November 2005 we were being told that the smart money was already invested but that the party would continue. I was and am of the view that this was the correct view to take and this story is not one about contrarian investing. This story is about a particular hedge fund.
(Throughout this Blog names of people and companies are changed, so are particular circumstances so don't bother trying to figure out who I am talking about. Usually the characters are composite characters, sometimes reflecting the schizophrenic nature of some managers, but more often because it makes for more colorful description.
John was the manager of a Japan equity long short fund. In Asian markets, equities are the most liquid and visible of markets. The dominance of bank lending has stifled the growth of corporate debt although this has changed considerably since the 1990s. Still, the majority of hedge funds in Asia will be involved in trading equities. Local currency debt is a growing market. Emerging market managers trading in Asian markets but sitting in London or New York mostly participate in the hard currency soveriegn and sometimes corporate market for debt but these rely more on macro economic analysis than bottom up stock selection.
Anyway, John was an experienced trader who had cut his teeth trading at such intitutions as HSBC, Citigroup and Merrill Lynch. He had grown up in Asia despite his African American / Japanese ethnicity. He spoke fluent Japanese and he had an excellent network in Japan.
Following a pretty good career at Citi, John joined a hedge fund launched by a big name trader who had come off the proprietary trading desk of Deutsche Bank. The fund launched with some fanfare and raised 500 million USD in capital. It traded for a year and then came unstuck. Prop desk traders are in hot demand when it comes to hedge fund start ups, but there are risks. There are always risks. With prop traders the risk is that the guy was never a very good fund manager to begin with. Maybe he was just a psychotic risk taker and his success at some investment bank was down to the quality of risk management and not to his own skill. Any prop trader leaving to set up his own fund will tell you that this is not the case. They will tell you how risk management in an investment bank is stifling and does not understand the true nature of risk, does not understand the structure of the market, or the intricacies of trading. Success at Goldman Sachs, Morgan Stanley or JP Morgan on the prop desk does not automatically translate into success at one's own hedge fund. In any case, John's new venture collapesed in a cloud of redemptions as investors sought to cut their losses and exposure to further losses.
When I went to see John, he had just completed his separation from the ill fated hedge fund and started his own firm. In the course of the interview I began to suspect that John was actually a very good investor. Having traded Japan myself I was in a position to discuss at the position level, his current portfolio and understand his rationale for each position. Subsequent reference checks in the days following allowed me to confirm that the damage at his previous shop was due to poor risk management on the debt side of the portfolio. John was good and the implosion of his old shop was not his fault. It was bad luck that he had saddled up with the wrong posse and got burned.
Unfazed, John picked himself up, dusted himself down and re-launched himself with his own capital. The investment in the business totalled over a million USD and he had another 3 million USD to invest in his own fund. Unfortunately for John, he launched his new business at the end of 2005. His first 3 months were horrible and saw losses totalling 17% by March. Losses do strange things to people. His natural instinct told him to stick to his knitting and he would recover but as he was at the stage of raising capital, courting funds of funds as investors, he changed the way he managed money. By June the losses were nearly catastrophic.
I kept in touch with John throughout and followed his investment strategy through the months. They were sound and would eventually turn his way. Unfortunately, as the great Lord Keynes said, the markets can stay irrational longer than one can stay solvent. I have lost track of John now and he may have thrown in the towel. I hope he hasn't because he was a skilful investor on a bad roll. At least that was my opinion.
The first question is, how do you distinguish between bad luck and poor skill? If one has traded the same markets or strategies one can empathize with the manager. What if the strategy is alien and one is learning about it for the first time. Technical competence and skill are very different things. Competence can be learnt. Skill takes experience to learn, sometimes painful experience. Here again, skill could be discerned if one knew enough of the strategy and had sufficient information (transparency) to understand the rationale behind the positions.
A more difficult question as an investor is how long do you tolerate bad luck?
Hedge funds trading Japan from Japan had mostly sustained double digit losses and were facing tough questions from their investors. In the latter half of 2005, the fund of funds community, that is the people who invested on behalf of investors into hedge funds, had been very bullish about prospects for Japanese hedge funds. They had piled into Japanese hedge funds rather exuberantly.
At the annual Goldman Sachs Asian hedge fund conference usually held in November in Tokyo, the mood was upbeat and investors outnumbered hedge funds by several multiples. Some 600 over people showed up, some uninvited, hedge funds and investors both. Times like this I get nervous. I have no reason to be. No good reason at least. But human beings are like lemmings sometimes. In November 2005 we were being told that the smart money was already invested but that the party would continue. I was and am of the view that this was the correct view to take and this story is not one about contrarian investing. This story is about a particular hedge fund.
(Throughout this Blog names of people and companies are changed, so are particular circumstances so don't bother trying to figure out who I am talking about. Usually the characters are composite characters, sometimes reflecting the schizophrenic nature of some managers, but more often because it makes for more colorful description.
John was the manager of a Japan equity long short fund. In Asian markets, equities are the most liquid and visible of markets. The dominance of bank lending has stifled the growth of corporate debt although this has changed considerably since the 1990s. Still, the majority of hedge funds in Asia will be involved in trading equities. Local currency debt is a growing market. Emerging market managers trading in Asian markets but sitting in London or New York mostly participate in the hard currency soveriegn and sometimes corporate market for debt but these rely more on macro economic analysis than bottom up stock selection.
Anyway, John was an experienced trader who had cut his teeth trading at such intitutions as HSBC, Citigroup and Merrill Lynch. He had grown up in Asia despite his African American / Japanese ethnicity. He spoke fluent Japanese and he had an excellent network in Japan.
Following a pretty good career at Citi, John joined a hedge fund launched by a big name trader who had come off the proprietary trading desk of Deutsche Bank. The fund launched with some fanfare and raised 500 million USD in capital. It traded for a year and then came unstuck. Prop desk traders are in hot demand when it comes to hedge fund start ups, but there are risks. There are always risks. With prop traders the risk is that the guy was never a very good fund manager to begin with. Maybe he was just a psychotic risk taker and his success at some investment bank was down to the quality of risk management and not to his own skill. Any prop trader leaving to set up his own fund will tell you that this is not the case. They will tell you how risk management in an investment bank is stifling and does not understand the true nature of risk, does not understand the structure of the market, or the intricacies of trading. Success at Goldman Sachs, Morgan Stanley or JP Morgan on the prop desk does not automatically translate into success at one's own hedge fund. In any case, John's new venture collapesed in a cloud of redemptions as investors sought to cut their losses and exposure to further losses.
When I went to see John, he had just completed his separation from the ill fated hedge fund and started his own firm. In the course of the interview I began to suspect that John was actually a very good investor. Having traded Japan myself I was in a position to discuss at the position level, his current portfolio and understand his rationale for each position. Subsequent reference checks in the days following allowed me to confirm that the damage at his previous shop was due to poor risk management on the debt side of the portfolio. John was good and the implosion of his old shop was not his fault. It was bad luck that he had saddled up with the wrong posse and got burned.
Unfazed, John picked himself up, dusted himself down and re-launched himself with his own capital. The investment in the business totalled over a million USD and he had another 3 million USD to invest in his own fund. Unfortunately for John, he launched his new business at the end of 2005. His first 3 months were horrible and saw losses totalling 17% by March. Losses do strange things to people. His natural instinct told him to stick to his knitting and he would recover but as he was at the stage of raising capital, courting funds of funds as investors, he changed the way he managed money. By June the losses were nearly catastrophic.
I kept in touch with John throughout and followed his investment strategy through the months. They were sound and would eventually turn his way. Unfortunately, as the great Lord Keynes said, the markets can stay irrational longer than one can stay solvent. I have lost track of John now and he may have thrown in the towel. I hope he hasn't because he was a skilful investor on a bad roll. At least that was my opinion.
The first question is, how do you distinguish between bad luck and poor skill? If one has traded the same markets or strategies one can empathize with the manager. What if the strategy is alien and one is learning about it for the first time. Technical competence and skill are very different things. Competence can be learnt. Skill takes experience to learn, sometimes painful experience. Here again, skill could be discerned if one knew enough of the strategy and had sufficient information (transparency) to understand the rationale behind the positions.
A more difficult question as an investor is how long do you tolerate bad luck?
Skill and Luck 1
In the investment business, the need to distinguish between skill and luck is very important. But why?
I am in the investment business. My job is to find and invest with fund managers whom I consider to be good investors. But what makes a good investor? This is a lengthy subject which has been dealt with by others. Matthew Ridley, who manages a fund of funds at Consulta has written an excellent book entitled How to Invest in Hedge Funds which goes into great depth what makes a good investor.
My interest is in separating skill from luck and even before that, asking if it is important at all to distinguish between the two.In my search for investment managers I once visited a manager in New York who was reputed to be an excellent investor. As someone responsible for investing with managers it was my job to figure out if this guy was going to be able to make us money. Phil, let's call him Phil, was a distinguished guy in his late 40's or early 50's, it was difficult to look beyond his perma tan. We met at his office in Midtown Manhattan with a view over Central Park. Phil was clearly a successful manager. The fund he ran had over 1 billion USD in assets and he was generating good returns for the last three years.
Phil began by rattling off his CV. So many years at Drexel with Michael Milken and his group, that's how you really learn the business, so many years at Morgan Stanley, that's how you understand the institutional business, so many years at XXX Capital, one of the largest hedge and most respected hedge funds... It was very impressive.
Next, Phil launched into his investment strategy. He was always long volatility, he had a team of analysts who took a bottom up approach to investing and understood the portfolio companies as well as the CFO's of the companies did. He had a network of fellow investors whom he hob-nobbed with. Risk management? A Russian PhD in mathematics ran risk management.
Phil and his fund were very impressive but they would not discuss positions or the current or even a slightly outdated portfolio. He would not discuss example trades but spoke very generally of being long volatility, never taking tail risk, monitoring correlations, being long convexity, buying cheap optionality etc etc. Without going into some of the details of the portfolio, without access to his traders and without the opportunity to understand the motivation behind old successful or losing trades, all I had to go on was the track record of the fund. Phil was saying, trust me, look how much I have made for others before, I can do the same for you.
I was very impressed by the numbers, the CVs, the presentation, Phil's bespoke suit and expensive address. I told him I would take some time to think about it and that I would have follow up questions. Phil was all sweetness and light. In this crazy industry he was doing us a favour by taking our money. Call me any time, he said. Anything you need, just let me know. Yet all he would give me were sweeping generalities, not an insight into how he thought and how he invested. The number he was printing looked fantastic. 20+% returns every year in the last three years was good performance. I just couldn't tell if it was luck or skill.
Here's my problem with making money by accident. First of all, investing in hedge funds is expensive business. Fees are typically 2% of assets per annum plus a 20% share of profits. Find a skilful manager and that's cheap. Find a flukey one and 1% is expensive. When I invest with a manager who is skilled, they, and I, know why they made money at a given time. They also know why they lost money. That means that when things go wrong, they know how to react. Flukey Luke Capital who makes money by accident is risk because if they don't know how they make money, they certainly don't know why they lose it, and they don't know what to do when they are in a losing streak. When in a winning streak, its easy. Stand on your position or increase it.
So how do you tell skill from luck? Well, I know when I have no chance of telling between them and that is when the manager is not willing to talk to me about their investment rationale in some detail. Transparency is a concept that has been discussed ad nauseum in our industry. Transparency has its uses. Understanding the strategy is one of them. It should be used wisely, however. Trying to make sense of a 15000 position portfolio list of ISINs is not helpful.
Also, it involves a lot of homework. I can usually conduct a coherent interview with an equity trader. Imagine if I was interviewing the manager of an Art Fund that invested in Asian Tribal Art. One has to know a bit about the particular industy in which the manager is involved in order to conduct a coherent discussion. If you don't know, very soon the manager knows you don't know and you are quickly at the mercy of their goodwill. Commonsense goes a long way. Whenever I can't understand a particular strategy I go back to basics. There are limits, however, to the interviewee's patience and good charity, and to one's own professional reputation. Manager's welcome intelligent questions. Don't expect a tutorial on the dividend discount model or on discounted cash flow valuations.
Even after all this, its bloody difficult. Until today, the assessment of skill is more art than science. Very often it is a hunch that demands corroboration and evidence. Sorry I don't have a recipe for distinguishing between skill and luck. Besides the obvious one: they did not know how they made or lost that money... It would make life so much easier if I had a checklist that I could fill that at the end said, this here manager has skill, or this here manager is just plain lucky, but alas, life is just not like that.I would like to add one further thought: How do you tell poor skill from bad luck?
I am in the investment business. My job is to find and invest with fund managers whom I consider to be good investors. But what makes a good investor? This is a lengthy subject which has been dealt with by others. Matthew Ridley, who manages a fund of funds at Consulta has written an excellent book entitled How to Invest in Hedge Funds which goes into great depth what makes a good investor.
My interest is in separating skill from luck and even before that, asking if it is important at all to distinguish between the two.In my search for investment managers I once visited a manager in New York who was reputed to be an excellent investor. As someone responsible for investing with managers it was my job to figure out if this guy was going to be able to make us money. Phil, let's call him Phil, was a distinguished guy in his late 40's or early 50's, it was difficult to look beyond his perma tan. We met at his office in Midtown Manhattan with a view over Central Park. Phil was clearly a successful manager. The fund he ran had over 1 billion USD in assets and he was generating good returns for the last three years.
Phil began by rattling off his CV. So many years at Drexel with Michael Milken and his group, that's how you really learn the business, so many years at Morgan Stanley, that's how you understand the institutional business, so many years at XXX Capital, one of the largest hedge and most respected hedge funds... It was very impressive.
Next, Phil launched into his investment strategy. He was always long volatility, he had a team of analysts who took a bottom up approach to investing and understood the portfolio companies as well as the CFO's of the companies did. He had a network of fellow investors whom he hob-nobbed with. Risk management? A Russian PhD in mathematics ran risk management.
Phil and his fund were very impressive but they would not discuss positions or the current or even a slightly outdated portfolio. He would not discuss example trades but spoke very generally of being long volatility, never taking tail risk, monitoring correlations, being long convexity, buying cheap optionality etc etc. Without going into some of the details of the portfolio, without access to his traders and without the opportunity to understand the motivation behind old successful or losing trades, all I had to go on was the track record of the fund. Phil was saying, trust me, look how much I have made for others before, I can do the same for you.
I was very impressed by the numbers, the CVs, the presentation, Phil's bespoke suit and expensive address. I told him I would take some time to think about it and that I would have follow up questions. Phil was all sweetness and light. In this crazy industry he was doing us a favour by taking our money. Call me any time, he said. Anything you need, just let me know. Yet all he would give me were sweeping generalities, not an insight into how he thought and how he invested. The number he was printing looked fantastic. 20+% returns every year in the last three years was good performance. I just couldn't tell if it was luck or skill.
Here's my problem with making money by accident. First of all, investing in hedge funds is expensive business. Fees are typically 2% of assets per annum plus a 20% share of profits. Find a skilful manager and that's cheap. Find a flukey one and 1% is expensive. When I invest with a manager who is skilled, they, and I, know why they made money at a given time. They also know why they lost money. That means that when things go wrong, they know how to react. Flukey Luke Capital who makes money by accident is risk because if they don't know how they make money, they certainly don't know why they lose it, and they don't know what to do when they are in a losing streak. When in a winning streak, its easy. Stand on your position or increase it.
So how do you tell skill from luck? Well, I know when I have no chance of telling between them and that is when the manager is not willing to talk to me about their investment rationale in some detail. Transparency is a concept that has been discussed ad nauseum in our industry. Transparency has its uses. Understanding the strategy is one of them. It should be used wisely, however. Trying to make sense of a 15000 position portfolio list of ISINs is not helpful.
Also, it involves a lot of homework. I can usually conduct a coherent interview with an equity trader. Imagine if I was interviewing the manager of an Art Fund that invested in Asian Tribal Art. One has to know a bit about the particular industy in which the manager is involved in order to conduct a coherent discussion. If you don't know, very soon the manager knows you don't know and you are quickly at the mercy of their goodwill. Commonsense goes a long way. Whenever I can't understand a particular strategy I go back to basics. There are limits, however, to the interviewee's patience and good charity, and to one's own professional reputation. Manager's welcome intelligent questions. Don't expect a tutorial on the dividend discount model or on discounted cash flow valuations.
Even after all this, its bloody difficult. Until today, the assessment of skill is more art than science. Very often it is a hunch that demands corroboration and evidence. Sorry I don't have a recipe for distinguishing between skill and luck. Besides the obvious one: they did not know how they made or lost that money... It would make life so much easier if I had a checklist that I could fill that at the end said, this here manager has skill, or this here manager is just plain lucky, but alas, life is just not like that.I would like to add one further thought: How do you tell poor skill from bad luck?
Alpha and Betas
A word about alpha and betas in investment returns
The Math
In mathematics, half the problem is giving things names. The investment management industry has borrowed a naïve model, applied it to very complicated problems and then expect to make sense of the results.
What is alpha and what are betas?
The terms alpha and beta come from the linear model of statistical modelling.
yi = b xi + a + ei
Where yi is the dependent variable, xi is the independent variable, a is an intercept term and ei is an error term which by construction has a mean value of zero.
The standard example is where yi are the returns of a particular stock, xi are the returns of the market (using some suitable stock index as proxy). The coefficient b is the beta and represents the systemic risk, the coefficient a is alpha which represents specific risk.
In order to make statistical inferences from the model a distribution needs to be assigned to the error term ei. There is a theorem that says that subject to some assumptions about how ei behaves, not only is it possible to estimate what the betas and alpha look like but we can make inferences from them.
The model is easily extended and generalized to :
yi = sum of (bj xi +a + ei)
Where there is not one market factor but k of them. The industry applies this model to hedge fund returns often with one factor, usually an equity index, and sometimes to several factors. Natural candidate factors are, bonds, yield curve shape, equity vol, swaption vol, credit spreads, interest rates, currencies.
Observations and comments:
An assumption is being made about the relationship between y and the x’s. If the assumptions are wrong, the betas and alpha measured are meaningless. The industry will sometimes apply the model to a credit manager, or a fixed income arbitrageur, or an asset based lender with equity market returns as an explanatory variable, despite the lack of causality.
There has to be sufficient data. The more complicated the model, the more data you need. Hedge funds publish monthly performance numbers. A manager with a 5 year track record has only got 60 data points. Having enough data is the first point. The data has also to be well behaved.
Proper estimation of betas and alpha require that the x’s have certain properties. One of them is that the x’s should not cluster, mean revert or converge. This is clearly a problem. Basically what the methodology requires, in simple terms, is that if you want to measure a manager’s alpha, you need to have all sorts of market conditions from bull and bear trends to choppy sideways markets. It makes sense. A 5 X levered position in a rising market looks very much like alpha. What does one call a 0.5X levered position in a rising market? Negative alpha?
The two previous points suggest also that the data has to come from a sufficiently diverse set of states. Enough data and enough variation in data imply that a manager has to be tested over all phases of the cycle in their particular market. Ideally, the performance should be measured over several cycles.
The necessary conditions for meaningful inference make this methodology intractable for hedge fund analysis. Track records are rarely sufficiently long to include several iterations of the market cycle.
Comments about industry implementation:
Seeking to buy alpha is only relevant if one is willing to invest over sufficient cycles for the alpha to manifest.
Beta is cheap. Alpha is not priced. It may be expensive or not, but current performance fees are not directly linked to alpha.
Alpha and beta are thought of as constructive concepts when they are illustrative concepts. Unless one is happy to invest over a sufficiently long horizon.
Alpha can be negative even as returns are positive and outperforming the market.
Alpha and Betas are convenient language for active risk and passive risk as long as we don’t take them too seriously.
The Math
In mathematics, half the problem is giving things names. The investment management industry has borrowed a naïve model, applied it to very complicated problems and then expect to make sense of the results.
What is alpha and what are betas?
The terms alpha and beta come from the linear model of statistical modelling.
yi = b xi + a + ei
Where yi is the dependent variable, xi is the independent variable, a is an intercept term and ei is an error term which by construction has a mean value of zero.
The standard example is where yi are the returns of a particular stock, xi are the returns of the market (using some suitable stock index as proxy). The coefficient b is the beta and represents the systemic risk, the coefficient a is alpha which represents specific risk.
In order to make statistical inferences from the model a distribution needs to be assigned to the error term ei. There is a theorem that says that subject to some assumptions about how ei behaves, not only is it possible to estimate what the betas and alpha look like but we can make inferences from them.
The model is easily extended and generalized to :
yi = sum of (bj xi +a + ei)
Where there is not one market factor but k of them. The industry applies this model to hedge fund returns often with one factor, usually an equity index, and sometimes to several factors. Natural candidate factors are, bonds, yield curve shape, equity vol, swaption vol, credit spreads, interest rates, currencies.
Observations and comments:
An assumption is being made about the relationship between y and the x’s. If the assumptions are wrong, the betas and alpha measured are meaningless. The industry will sometimes apply the model to a credit manager, or a fixed income arbitrageur, or an asset based lender with equity market returns as an explanatory variable, despite the lack of causality.
There has to be sufficient data. The more complicated the model, the more data you need. Hedge funds publish monthly performance numbers. A manager with a 5 year track record has only got 60 data points. Having enough data is the first point. The data has also to be well behaved.
Proper estimation of betas and alpha require that the x’s have certain properties. One of them is that the x’s should not cluster, mean revert or converge. This is clearly a problem. Basically what the methodology requires, in simple terms, is that if you want to measure a manager’s alpha, you need to have all sorts of market conditions from bull and bear trends to choppy sideways markets. It makes sense. A 5 X levered position in a rising market looks very much like alpha. What does one call a 0.5X levered position in a rising market? Negative alpha?
The two previous points suggest also that the data has to come from a sufficiently diverse set of states. Enough data and enough variation in data imply that a manager has to be tested over all phases of the cycle in their particular market. Ideally, the performance should be measured over several cycles.
The necessary conditions for meaningful inference make this methodology intractable for hedge fund analysis. Track records are rarely sufficiently long to include several iterations of the market cycle.
Comments about industry implementation:
Seeking to buy alpha is only relevant if one is willing to invest over sufficient cycles for the alpha to manifest.
Beta is cheap. Alpha is not priced. It may be expensive or not, but current performance fees are not directly linked to alpha.
Alpha and beta are thought of as constructive concepts when they are illustrative concepts. Unless one is happy to invest over a sufficiently long horizon.
Alpha can be negative even as returns are positive and outperforming the market.
Alpha and Betas are convenient language for active risk and passive risk as long as we don’t take them too seriously.
Monday 8 January 2007
Singapore Real Estate
An ex-colleague of mine sent me an email today. He was trying to interest me in investing in an apartment in Singapore somewhere near the Singapore River. This was good news and bad news.
Calling the direction of a market is usually a perilous endeavor. When I moved to London in 1999 I thought that the property market was overheated and due for a sharp correction. It turned out that I was mistaken and due for a sharp correction. The market rallied for another 7 years and is still rising. There have been a couple of hiccups along the way but nothing anyone would call even a mild correction. My opinion on London real estate led me to underinvest in 2000. As a result I have been somewhat 'left behind' by the London property market. Fortunately I did buy a small apartment to live in which has provided me with some exposure to the rising property market. Today I continue to look at the London property market in disbelief. I do not believe it can go any further and I expect a correction but I have been quite wrong in calling this market, so mine may not be the best advice.
In 1996 I was more fortunate in making the right call. Real estate markets in the Far East, particularly in Hong Kong and Singapore but also in Bangkok and Kuala Lumpur were skyrocketing. My analysis of the nature of demand and supply at the time told me that the market was very stretched. My macro call was to be out of real estate and into cash USD. The timing smacked of luck. I will take a profit attributable to luck or skill or an act of God any day. While many regard the Asian crisis to have been happened in 1997 my view was that this was a a the culmionation of something that happened earlier back in 1994. Asia was heavily in a leveraged carry trade long local currency and short hard currency. When the US Fed raised interest rates in 1994 it signalled the end of the Asian carry trade and cheap funding for Asian corporates. Any leveraged position would have suffered and real estate is a chronically leveraged asset. My recommended position was to go from long to neutral. You didn't want to be short and levered in an illiquid asset.
Singapore has been through some tough times. In 1997 it discovered that for all its achievements, for all its being first in the class (of Asian Tigers), it was vulnerable when Asia as a region stumbled. By 1998 Singapore was in recession with the rest of the lot. 1999 was a year of recovery although few in Singapore felt it. Many were over-levered in real estate and in negative equity. The rebound in real estate was weak and short lived. In 2000 the US equity market bubble burst. Some bear had gone and frightened the living daylights out of Goldilocks. A global recession ensued. On September 11, 2001, planes flew into buildings and it looked as if things could not be worse. Sars was the localized (to Asia) event that made things worse. Further recession for Singapore in 2003. The real estate market sagged further.
At the time (2003), the then Prime Ministed Goh Chok Tong delivered the government's plan for recovery. The plan was simple in principle.
Attract wealth by attracting wealthy people or people who could create wealth. Do this by attracting certain industries such as Wealth Management, Private Banking, Gaming, Education, High value added services. On a capacity constrained island, this makes life a bit difficult for traditional industry and manufacturing. Sacrifices had to be made. The Swiss were being hobbled by the need to integrate albeit informally into Europe. China, the Middle East, India, Indonesia needed a new place to process their newfound wealth.
Execution was another matter. I did not have much faith at the time. The government spoke of creating a cachet like London or New York. That takes decades, centuries if you look in Europe. I did not think it would work.
By 2004 I thought I had better put in some research just in case Singapore succeeded. Never write off the Singapore government. They are possibly the most motivated, deliberate and driven people you will meet. When they set out to do something, expect them to achieve a good proportion of their goals.
Real estate markets as represented by the URA's property price indices bottomed in March 2004. It was difficult at the time to tell if this was another false start in the beleaguered property market. Even today we do not know if it will continue. What we do know is that as of Dec 2006, the index was 15.7% above the March 2004 low.
I could make all sorts of representations about what I believe the market will do. But December 2005 I took a long position. I am revealing my preference. I may be wrong. I hope not but the facts support the hypothesis.
Calling the direction of a market is usually a perilous endeavor. When I moved to London in 1999 I thought that the property market was overheated and due for a sharp correction. It turned out that I was mistaken and due for a sharp correction. The market rallied for another 7 years and is still rising. There have been a couple of hiccups along the way but nothing anyone would call even a mild correction. My opinion on London real estate led me to underinvest in 2000. As a result I have been somewhat 'left behind' by the London property market. Fortunately I did buy a small apartment to live in which has provided me with some exposure to the rising property market. Today I continue to look at the London property market in disbelief. I do not believe it can go any further and I expect a correction but I have been quite wrong in calling this market, so mine may not be the best advice.
In 1996 I was more fortunate in making the right call. Real estate markets in the Far East, particularly in Hong Kong and Singapore but also in Bangkok and Kuala Lumpur were skyrocketing. My analysis of the nature of demand and supply at the time told me that the market was very stretched. My macro call was to be out of real estate and into cash USD. The timing smacked of luck. I will take a profit attributable to luck or skill or an act of God any day. While many regard the Asian crisis to have been happened in 1997 my view was that this was a a the culmionation of something that happened earlier back in 1994. Asia was heavily in a leveraged carry trade long local currency and short hard currency. When the US Fed raised interest rates in 1994 it signalled the end of the Asian carry trade and cheap funding for Asian corporates. Any leveraged position would have suffered and real estate is a chronically leveraged asset. My recommended position was to go from long to neutral. You didn't want to be short and levered in an illiquid asset.
Singapore has been through some tough times. In 1997 it discovered that for all its achievements, for all its being first in the class (of Asian Tigers), it was vulnerable when Asia as a region stumbled. By 1998 Singapore was in recession with the rest of the lot. 1999 was a year of recovery although few in Singapore felt it. Many were over-levered in real estate and in negative equity. The rebound in real estate was weak and short lived. In 2000 the US equity market bubble burst. Some bear had gone and frightened the living daylights out of Goldilocks. A global recession ensued. On September 11, 2001, planes flew into buildings and it looked as if things could not be worse. Sars was the localized (to Asia) event that made things worse. Further recession for Singapore in 2003. The real estate market sagged further.
At the time (2003), the then Prime Ministed Goh Chok Tong delivered the government's plan for recovery. The plan was simple in principle.
Attract wealth by attracting wealthy people or people who could create wealth. Do this by attracting certain industries such as Wealth Management, Private Banking, Gaming, Education, High value added services. On a capacity constrained island, this makes life a bit difficult for traditional industry and manufacturing. Sacrifices had to be made. The Swiss were being hobbled by the need to integrate albeit informally into Europe. China, the Middle East, India, Indonesia needed a new place to process their newfound wealth.
Execution was another matter. I did not have much faith at the time. The government spoke of creating a cachet like London or New York. That takes decades, centuries if you look in Europe. I did not think it would work.
By 2004 I thought I had better put in some research just in case Singapore succeeded. Never write off the Singapore government. They are possibly the most motivated, deliberate and driven people you will meet. When they set out to do something, expect them to achieve a good proportion of their goals.
Real estate markets as represented by the URA's property price indices bottomed in March 2004. It was difficult at the time to tell if this was another false start in the beleaguered property market. Even today we do not know if it will continue. What we do know is that as of Dec 2006, the index was 15.7% above the March 2004 low.
I could make all sorts of representations about what I believe the market will do. But December 2005 I took a long position. I am revealing my preference. I may be wrong. I hope not but the facts support the hypothesis.
- Singapore is an almost centrally planned economy. How can one say that given that it is clearly a market economy? Simple. The central planner outsources to the market when it is optimal to do so. For the most part, it is optimal to do so. Policy is thus exceptionally effective in Singapore.
- The government is a partner to free enterprise. Again this is because it is effecient to be so in a small economy where information is good.
- The government has restructured the economy from a manufacturing focused economy into a service economy. Of late the focus has been on financial services and wealth management, gaming and education.
- Defined policies, strong fiscal incentives and expeditious regulation and legislation stand behind Singapore's position for the future. It is likely to be successful.
- GDP growth has recovered from 2003 levels. Inflation has been benign and there is no reason to expect it to rise. Unemployment is remarkably low. Per capita income is a very respectable 32,000 SGD.
- The economy is now less dependent on the US and more on Asia and Europe.
- Land is in fixed and short supply on an island like Hong Kong and Singapore. Part of the decline in supply in the last 10 years has been led by demand and part by physical constraints but supply has been steadily falling since 1997.
- Vacancy rates rose in 1997 but have held steady at about 8% until mid 2006. It is now in decline. Expect supply to be adjusted through re-development to meet demand.
General conditions are supportive of real estate in Singapore. But there are of course risks. With real estate, leverage is almost always attached and can range from 2 to 10X. The asset is illiquid exacerbating the leverage risk. Prices in certain sectors have risen 30%-50% in the space of 12 months.
This time is not different. Some of the players are different, some of old hands having been taken out for the count in the last dip back in 2003. Nothing lasts forever, neither bull markets nor bear markets. Nothing goes in a straight line. This bull market will see its share of pullbacks, corrections, surging rallies and deadtime.
There were lessons to be learnt in 1997 , 2000 and 2003. Invest with knowledge and not in ignorance. In the earlier half of the 1990s it was easy to make money. Get your maid to stand in the queue at any (and I mean any) new development so you could reserve your unit when the sales office opened. In 1995 even rusty tours looked good. Buy indiscriminately and leverage blindly. (Leverage? What's that? I don't leverage, I only use a mortgage... excellent.) Many people got blindingly rich by leveraging into a raging bull market. Many of these chaps lost faith in 2003 and look disapprovingly at the current bull market. Some of their sons and daughters will be looking to flip a couple of apartments just as mom and dad did in their hey day. There is a fine line between investing and gambling. (Please, no jokes about the Integrated Resorts.) In a world where astute investors can be separated from their wealth, gambling is not very viable, a gamble is precisely what the uninformed investor undertakes.
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