Time to Cut Tail Risk

by: Veryan Allen

Tail risk for the summer doldrums? The "quiet" month of August is rarely quiet. Triumph of the realists or revenge of the pessimists? Concern over government debt hits markets so "rational" investors buy government debt! Fat tails are getting even more obese. The future is unknown so robust hedging and market neutrality are mandatory. Bear markets and low interest rates don't impact the returns of properly constructed multi-strategy portfolios. It is sad seeing so much of hard working peoples' savings and pensions savaged by the long only lobby. No return for taking so much risk for such a long time.

Time to buy? It's always time to buy alpha - not beta. Volatility is a blessing since forced trading, mispricing and arbitrage situations increase. Unacceptable losses for many years show unskilled long only is for speculators but skilled long/short is for widows, orphans and retirement plans. Time to replace the risky beta bet with better, cheaper alpha solutions. Beta bandits had their chance but the damage they have wrought should now cease. The only fund manager mandate that makes sense is absolute return, not to beat benchmarks. The asset class fixation must make way for superior money making strategies.

How can long only portfolios be considered diversified when codependencies are so obvious? When stocks crash "risk free" yields also drop, doubly worsening pension liabilities. Hedge funds aren't alternatives; they are replacements. 100% in quality replacement investments is the way to reduce risk and secure viable income streams for the long term. Adding commodities and geographic diversification doesn't help since they rely on similar global demand factors.

Emerging and frontier markets offer alpha opportunities, not beta anymore. Real hedge funds are in the business of trading, finding inefficiencies and monetizing volatility for absolute returns. Managers needing bull markets to make money are running closet index funds not hedge funds. Acid tests like now are great for differentiating true ability from random luck.

Hedge funds seek alpha. Across all market participants, alpha sums to zero but the hedge fund industry generates substantial positive alpha. That's despite wide return dispersion and "average" hedge funds aren't skilled. The reason is simple - much investment by non-hedge funds is for non-alpha seeking reasons. All hedge funds try to produce absolute returns but most other funds simply aim to beat or track a benchmark. Securities are bought as they are in an index not because they are good investments. Forced selling from the pressure to be fully invested at all times(!) amid redemptions and forced buying to not stray far from an index (tracking "error") means many trades aren't made in the pursuit of absolute return.

Why buy an equity because it's in an index not because it's growing or cheap? All debt capital markets professionals know the criteria for a bond to be in a fixed-income benchmark. No matter how badly priced or the default probability, passive funds must usually buy. That's the problem of rules-based index construction and beta dominated asset allocation. Dog stocks and dog bonds with fleas gets bought by index and relative return funds while good hedge funds can avoid or short sell them. They can also go heavily to cash when desired. The result is net positive alpha, of which the best hedge funds produce the mother lode.

What beta? The S&P has had no price gains since 1998, FTSE since 1997 and TOPIX since 1983. 28 years! Japan isn't the exception, it's the leading indicator and little has been learnt. Keep to the plan but what if the destination is lower? Smart investors adapt to changing environments. Delta one dinosaurs die. Sophisticated investors don't waste time and capital in unhedged passive products. Stop letting beta "expected returns" destroy wealth. Is your portfolio prepared for the possibility of stocks being lower in 2030 than today? 2040? 2050?

The three decade bull market in "risk free" bonds continues despite "more" default risk, according to the "experts". Last January I must have seen at least 100 presentations on how yields were going to rise in 2011! If you bought 30 year Treasuries in August 1981 you locked in over 14%, outperforming all equity indices but massively underperforming recent hedge fund "retirees" George and Warren. Soros and Buffett had outstanding track records from the disastrous (for beta) 1970s but were ignored by allocators even then. Today the 30 year yields just 3.57%, woefully inadequate for anyone looking to preserve wealth, fund retirement or beat inflation.

There's not much safe haven in bonds at these rates. The Fed says it's keeping rates low till 2013 but it'll be much longer than that. Bank of Japan has had "temporary" zero interest rates for many years. The record of credit rating agencies is bad but more importantly ask yourself are current yields worth the trouble? I don't care if a bond is rated C or AAA, only how wrongly priced it is to its value. There are no toxic securities only the toxic prices the unskilled pay because it's in an index.

Bonds don't yield enough, stocks aren't reliable. The answer is long short security selection and tactical market timing; better known as alpha. If your portfolio needs a higher consistent return over the long term, you need to be able to analyze securities and time markets yourself or hire dedicated managers who have proved they can and whose personal cash is invested alongside yours. All I do everyday is analysis and due diligence to find the next Georges and Warrens.

Skill at long short security selection and market timing are the only drivers of consistent return. How can index funds be "low cost" considering the wealth destruction they wreak. I'm too conservative to take beta risk. Even if I was certain of a bull market I could never advocate a long only portfolio. I just try to make +10% each year at the lowest risk whether the Dow and Nikkei go to zero or 50,000. If your portfolio isn't stress tested for any eventuality you have the wrong portfolio.

I'm glad brilliant managers make their skills available for such bargain fees as 2 and 20. It would be simpler for them to just trade family and friend money. The sooner pension plans are 100% invested in hedge funds the better for society. No need to cut benefits or raise retirement ages and capital contributions. Pay those absolute liabilities from absolute returns. Avoid "average" hedge funds by doing sensible manager selection and portfolio optimization. Access consistent returns and eliminate tail risk with replacement investments. There are no alternatives.