Hedging Investments: Strategy Alpha Diversification Is the Way to Go

Hedge Fund began five years ago today. It's been great meeting and dialoging with many interesting people I might never have connected with. Initially I posted daily but outside the blogosphere I was helping investors make money and reduce risk. Developing portfolio rescue strategies and pension liability solutions also takes time. Despite vastly superior performance, hedge funds continue to be misunderstood. Some still blame them for downturns. Causality is cloudy: did EWP have a good month due to "stress tests" or soccer success? Stocks might eventually go up (or down) but why wait decades to find out?

Could individual and institutional investors afford another severe bear market or credit cataclysm? There is no need for retirement savings and personal net worth to suffer the unreliability and volatility of long only stocks and bonds. Better alternatives and uses of capital are available. Some still bet on risky beta - the unskilled returns from asset classes. I prefer alpha - absolute returns from market skill. The only financial certainty in the future is a substantial increase in investment in skill. Major stock markets are lower than 5 and 10 years ago. Good for alpha but bad for beta. Don't let beta behemoths crush your portfolio, again, prudent man. Fiduciary duty implies attempting to preserve client capital.

I don't predict but can prepare. It's called "hedging". Industry inertia stops many from being allowed to access better risk-adjusted returns. Strategy evaluation and manager due diligence require specialist expertise but it's cheaper than the damage wrought by "simple" portfolio construction. I don't know how longer failed ideas like "strategic asset allocation" and "time in the market" will exist. I do know that smart investors accept that safer strategies, radical restructuring and portfolio triage are required if long term returns are to be achieved irrespective of the economy. Below are the most read Hedge Fund posts.

Hedge fund blog? I wrote this after flying to New Zealand for a beauty parade. Investors should remember the sole reason to hire any manager is for real absolute returns. Relative return funds emerged out of "Modern" Portfolio Theory. Managers were asked to beat a benchmark, not make money! To add insult to injury, "asset allocation" required funds to fully invest regardless of market conditions or valuation. Asset allocation even meant risk management was claimed to be "unnecessary"! Evaluate products for their return on risk and alignment with clients. Don't get caught out by tail risk. Hedge for black swan and purple sheep "rare" events.

Hedge fund test? In the real world, paper qualifications don't help a lot. A PhD in finance is not a PhD in making money. Spend 50 years theorizing at the Ivy League but 50 days on a trading floor delivers more education. Economics Nobel prize winners are infamously negatively correlated with investment acumen and financial expertise. Random walk models, mean-variance "optimization" and CAPM have not aided investors that seek consistent returns. Check out the performance of traditional portfolios obeying ivory tower "advice" and groupthink "asset allocation". It hasn't worked and it won't work.

Private equity IPO? I don't usually recommend specific securities or mispricing opportunities since this is a free blog and it would be unfair to investors to reveal proprietary information. But the hyperbole and paradox of private equity firms going public at ludicrous valuations was a short sell opportunity that couldn't be missed. And some say liquid equity markets are efficient! It is rare to short sell the high (IPO time) and cover at the low (December 2008) but sometimes the harder you work the luckier you get. Shorting doesn't cause securities to go down of course; that happened when the market figured out the true value of FIG and BX. The insiders were smart people; why buy when they were selling?

2 and 20? Skill costs in all business sectors. With good hedge funds, the after fee return to investors is higher than traditional products. Paying a few basis points for -50% losses isn't cheap. Many long only funds have 90% of returns explained by the benchmark. So the residual 10% explained by active management "justifies" a 1% expense fee? The implied expense fee for many traditional funds is nearly 10% since index tracking costs almost nothing. The 2% management fee and 20% of new profits for a good hedge fund is a bargain by comparison. All alpha strategies are capacity constrained and in most cases the 2% is not a profit center. The more clients make the better "pay" for the manager. Incentives work over time.

Jack Bogle versus hedge funds? Jack Bogle is brilliant. A brilliant salesman of beliefs but the index crowd doesn't like being confronted with facts. Another 3 years on and "stocks" are even lower while "bonds" don't pay enough yield. While the S&P 500 has lost money, some component stocks dropped -100% whereas others have risen massively like AAPL, GOOG, PCLN, ISRG and CRM. Equities are opportunity sets for long/short alpha capture, not buy and hope beta. Security selection can't be done? Market timing is impossible? Hold every stock regardless of price or prospects? George Soros, Warren Buffett and Jim Simons were just lucky flukes? 3,000 hedge funds making money in 2008 wouldn't have helped cushion the crash for Bogleheads? There are no arbitrages? Avoid black boxes?

Hedge fund quant? Curiously quant hedge funds are reviled even more than non-quant strategies. Even some "professional" hedge fund investors won't go near systematic trading. Bizarre considering the outperformance and diversification benefits. Almost everything has been blamed recently on a "new" quant strategy - high frequency trading. Humans are slow at large data set analysis, complex event processing and trade execution, so faith in only carbon-based managers seems quaint. The "random" markets are full of anomalies and computational intelligence is often the first to spot them. Anyone that avoids quantitative strategies does not have a diversified portfolio. Why ignore new ways of making money and reducing risk?

Hedge fund arbitrage? Those dollar bills are still being dropped on streets all over the world and being scooped up by the quick and nimble. Why take unhedged directional risk when the markets offer so many inefficiencies. The experts hate this notion because it goes against the house of cards theory that no securities are ever mispriced and so arbitrages cannot appear. Risk and return have no connection. Some arbitrages offer a good return for low risk. Meanwhile long only funds in major stock markets have delivered negative returns on very high risk. Finding lucrative arbitrages does take talent and expertise. Fortunately this is available for the low fees of 2 and 20.

Rich enough for hedge funds? Retail hedge funds. Absolute return strategies on 401(k) menu options? Why can't investors of any net worth be allowed to invest in skill-based strategies? In some countries they can but in many they still can't. UCITS may help in certain geographies. There is no correlation between being an accredited investor and a sophisticated one. Whether you have $1 trillion or $1,000 to put to work, everybody needs as much alpha and strategy diversification as possible. The regulatory wealth test seems incompatible with personal freedom. Why "protect" Mom and Pop from products that perform and diversify portfolios? Or is it actually to protect "passive" pushers?

Portable alpha? Don't add alpha to beta. Get rid of the beta and isolate the alpha. The portable alpha fad was weird. Now thoroughly discredited, I've always advised any institution that asked against this crazy concept. Why waste alpha by "porting" it back onto a beta. It nullified the absolute returns of hedge funds by transforming it into relative returns! Shocking that it ever got traction but some promote it even today. As we saw in 2002 and 2008 and will again soon, don't let beta drown the alpha. Strip out beta factor exposures by shorting derivatives and only invest in alpha. Strategy alpha diversification, not strategic beta asset allocation, is the way to go.

Hedge fund definition? Uncorrelated? One of the problems with the "hedge fund" industry is that it is not rigorously defined and only a subset actually are hedge funds. The number of good hedge funds is even less. As a rule of thumb I have found that 80% of "hedge funds" are unsuitable. Thorough manager due diligence, heavy qualitative and quantitative analysis permits the separation of the skilled from the lucky. Skill persists, luck runs out. Managers that make money in up markets and lose it in down markets are running mutual funds, not hedge funds. Fortunately there are currently over 2,000 open hedge funds globally that do have skill. And the number grows every month.

The tipping point from beta-centric to alpha-centric portfolios is here. Most mainstream commentary on hedge funds is uninformed and therefore negative. Those who criticize hedge funds have never invested in one. Few that take the time to understand skill-based absolute return strategies revert back to long only. Other industries embrace innovation but improvements in investment technology are still fiercely and often successfully resisted. Sad for those that urgently need access to new sources of return. Whether the Dow is on its way to 50,000 or 500, the growth of the hedge fund industry is guaranteed. Smart investors demand acceptable risk-adjusted returns on capital. Long only stocks and bonds don't meet the standard.