Why True Diversification Is Important

Includes: BPT, EWJ, FXY, MSB, SPY
by: Veryan Allen

Which alternatives are really alternatives? Every investor's portfolio is a fund of funds so the key decision is who chooses the managers. Replacing long only with long/short only works if skill is evident. People with rare talent tend to work where incentives are best. Forecasting alpha and identifying good managers is difficult but not impossible. After much due diligence, predictive analysis and multifactor modeling, I've found the main traits for future superior track records are innovation, hard work, great teams, aligned interests and exclusive focus. Seek alpha, avoid beta.

Value-added alpha comes from selecting the right securities or the right managers. It's a similar process. What I look for in any investment is new ideas and asymmetric returns. Sadly, conventional "wisdom" favors old products with low returns at high risk and dire margins of safety. Despite investors needing consistent performance, traditionalists resist innovation and even dispute after-fee alpha exists! According to most economists, it's luck but I do get most manager and security selection decisions correct. It's not rocket science. Just common sense, mathematical rigor and tracking the world for opportunities.

Luckily 2010 was good for my retirement plan. Not as great as 2008 or 2009 but still above assumed returns. Most external alpha vendors did better than +10% after fees - the minimum acceptable target. I directly manage a few special situations if I have an edge and the time to analyze properly. Emerging market alpha was a major contributor if only because volatility and mispricing are so prevalent. As I expected a year ago, my VUPPS position delivered nicely with Peru and Sri Lanka especially strong. Ukraine, Venezuela and Pakistan also did well. The long Colombia/short China and long Bangladesh/short Brazil trades worked perfectly against the overhyped BRIC. Don't overweight bigG securities; overweight the best ones.

My largest USA holding, Mesabi Trust (NYSE:MSB), went from 14 until by luck I sold at 56 which was near the high. The second biggest position, BP Prudhoe Bay Royalty Trust (BPT), having been ignored after years of double digit dividends, finally got attention and I reluctantly took profit at 122. Why waste time in SPY when stock picking is safer? Japan and China were terrible sources of beta but fantastic for alpha. I love it when managers who know nothing about either say they are about to implode. Watching those JGB and yen bears get trapped in short squeezes was fun and lucrative. FXY for the yen but no ETF for the largest government bond market? Long new Japan/short old Japan positions like long Skymark Airlines 9204/short Japan Airlines 9205 did fine. Making over 200% on the long and 120% on the short was even better than long Southwest (NYSE:LUV)/short Northwest a few years ago. Avoid those claiming you can't make more than 100% on shorts.

Someone told me that "everyone" is bearish on the Japan stock market. Odd comment considering its cheapness and Warren Buffett is heavily short billions in Nikkei puts. A bullish outlook which few BRK.A watchers have followed. I just think that like anywhere there's lots of inefficiencies for long/short alpha capture. Hedge funds are called "substitute investments" in Japanese. Why wouldn't you want your cash in "substitute investments" when bonds don't yield enough and "recoveries" notoriously give back their gains? Dow 12,000 again is almost as boring as the many previous Nikkei 12,000s. I prefer manager skill than risky buy and hold. Constant improvement - kaizen - and revolutionary innovation - kakushin - are essential for absolute returns in bull and bear markets. "Everyone" is usually wrong so now I own some TOPIX futures and EWJ, for a while.

Just weeks into 2011 and reminders from Tunisia and Egypt (NYSEARCA:EGPT) that long/short security selection with innovative research and risk management is the best route to absolute returns. And short selling whatever groupthink says is "hot". There's lots of money to be made in China but it won't come from a "passive" China index fund. Maybe it's better to border BRICs than be a BRIC. Unsurprisingly, Mongolia was the top market in 2010 - all those natural resources sandwiched between Russia and China. I just bought my first Laos stock EDL, years after the initial visit. Of course I also made a few mistakes last year, which is why true diversification is important. Small losses are the cost of doing business. Large drawdowns mean there is something very wrong.

All good strategies innovate to keep performing. Alpha is extracting returns out of other market participants. Beta is too risky and unreliable to gamble on for the long term. The best managers make use of the latest financial products and drive the invention of new ones. Style drift is not bad; it may even be preferable in a good manager. Paulson & Co. was a merger arbitrage fund but now does everything from CDOs to commodities. Berkshire Hathaway is wrongly considered a buy and hold shop but Warren Buffett has used alternative strategies and hybrid securities throughout his career. Convertible bond arbitrage, derivatives trading, value investing, event driven were all "new" once. A style not adaptable to changing market regimes is obsolete. Abnormal returns requires keeping ahead of copycats.

Semantic arbitrage? Despite the name of this blog, in my professional life I long ago stopped using the term "hedge fund" when referring to skill-based strategies. Even "alternative investments" has become a catch-all for any manager not doing long, only relative return stocks and bonds. Alpha is available from many sources in public and private markets, in numerous countries over many time horizons. In assessing a fund I strip out any betas and luck to calculate the proportion of returns due to the manager. Skill is persistent, luck isn't. I now use "innovative strategies" as a better term than the overworked and often misleading moniker "absolute return". That was almost as misleading as "market neutral". Every fund I look at that says it is market neutral isn't.

There is still massive scope for innovation in portfolio construction and wealth management. Many investors have weak manager selection methods and fail to reap the full benefits of modern investment methods. New strategies and financial products are being developed all the time. Blame credit derivatives for the recession and GFC - Global Financial Crisis - is like blaming match manufacturers when a house burns down. John Paulson's net worth rose by $5 billion in 2010. Warren Buffett was "paid" $10 billion from also eating his own cooking and making clients far more. Their strategies have little in common other than thorough security analysis and working harder than the "crowd". How "hard" does a passive "manager" work? Be proactive not reactive. And definitely not passive.

Variant perception drives alpha. But portfolio optimization remains mired in the suboptimal mean variance world of Markowitz and Sharpe. Policy asset allocation still dominates thinking while successful investors pay it little attention and instead focus on security selection and strategy diversification. John Paulson, Warren Buffett and many others aim to put 100% capital to work in good opportunities. They are not concerned with the defeatist and often deadly 60% in stocks and 40% in bonds. I find this unrewarded, unhedged faith in unskilled asset class returns rather than skill-based strategies very strange. Currently it appears we are in a bull market but that will change soon enough. Passive funds end up getting crushed.

Good managers that can make money in any conditions have to be incentivized for the hassle of accepting outside capital and undergoing exhaustive evaluation and monitoring. It's great for investors that so many still make their services available for such low fees of 2 and 20 and often cheaper. The crowd fears "exotic markets" and "exotic strategies" but smart investors enjoy spending the returns. Forget about alternative investments and focus on "innovative investments". Construct robust portfolios that grow and preserve capital no matter what happens. That takes hard work and it's worth paying for. Invigorate portfolios with substitute investments using the five factor model.