Hedge Fund Technology, Wealthcare and Innovation

Davos news seemed rather subdued this year but then the action was elsewhere, especially Paris. Hardly any hedge fund managers were away from their desks but then they had investment opportunities to exploit and risks to deal with. Making money or cutting losses takes precedence over hanging out with celebrities.

Occasionally the World Economic Forum yields a nice end-of-party short sale signal like private equity a year ago or internet stocks in 2000, but this time around it didn't seem overly exuberant about anything. Maybe things aren't so bad after all.

I'm heading over to New York next week for, among other things, the Money: Tech and Battle Of The Quants events. It is always useful hearing about using new technologies to figure out new ways to safely put capital to work. Successful investing is difficult enough so it makes sense to know about financial innovation. Data-driven prediction and market anomaly detection are necessary for future performance and you need to keep up with the times. Past performance is usually not predictive for future performance and perhaps market evolution means prior reliance on rogue economic assumptions may not be effective going forward. Financial technology can help people as much as other technologies have, so why ignore it?

Embrace change or change might overtake you. Long term performance has little to do with long term holding periods. Technology and strategy innovation have changed the game. Lower trading costs, easier shorting, more liquidity, more computational power and globalization have enabled many new investment strategies.

One reason buy and hold looked quite good historically, although very poor on a risk-adjusted basis, is that in earlier decades the cost of trading and cost of information gathering were very high. There also wasn't much else to invest in other than long only but the range of opportunities and range of financial products is now much broader. Stock indices went up over time but will they now that faster creative destruction and shortened product lifecycles are here?

In the past, some informational edges could not exceed the trading costs involved in executing the strategy but now they can. Commissions are much lower, higher trading volumes mean less slippage and free market competition from national and global deregulation have benefited all investors. Data gathering using machines with superior information processing capabilities has helped their human masters. Financial innovation in the form of derivatives, structured products and hybrid securities allows risks to be sliced, diced and hedged as required. New strategies and assets have let those investors permitted to use them to get more diversified.

These benefits come with complexity of course, which creates the need for skilled and "expensive" expertise in trading and managing these risks. Fire was very important to human economic development but fire in the wrong hands can be disastrous. Derivatives are useful trading and hedging vehicles or weapons of financial destruction depending on the competence of who is using them.

Osaka rice futures and Chicago soybean futures have allowed farmers to transfer risk for generations and built several traders' fortunes but have also wiped out lots of unskilled speculators. Equity, interest rate and credit derivatives have been hugely beneficial to end users and competent investors but will do damage if used wrongly.

Societe Generale's futures trader Jerome Kerviel allegedly fraudulently lost $7 billion. I wonder if it would have been revealed if his secret trades had resulted in $7 billion profit? Curious how heavily regulated banks seem more prone to rogue traders than "unregulated" hedge funds. When it is your own money on the line you are more likely to catch unauthorized trading activity by the troops or question gratuitous profits that seem out of line with risk and margin limits. There have been a few hedge fund frauds although the premier meltdowns like LTCM, Amaranth, Bear Stearns (BS) were due to inexperience and lack of skill, not rogue traders. With proper due diligence you can eliminate the risk of fraud or incompetence.

Fraud is worse than negligence just like murder is worse than manslaughter, but from the victim's point of view the result is the same. Reckless regard for risk and model testing lost much larger sums than Jerome Kerviel. Whether it is lax back-office security or poor modeling, hedging or trading acumen, the effect is similar. However, rogue traders and rogue models are billion dollar small fry compared to the rogue efficient market ideas that have wiped out $5 trillion recently from the stock markets. Just like computer passwords and optimistic assumptions, the economic conjecture that equity indices will go up over the long haul requires examination.

Economics is presumably about optimizing scarce resources for the common good. The optimal use and protection of investment capital are key to instilling confidence. It looks like we are going to get some kind of stimulus package though whether it will be the catalyst for a change in sentiment is anyone's guess. Rate cuts help banks with steeper positive carry, assuming credit worthy clients still exist and want to borrow, but the main idea is that low rates are meant to spur spending and incentivize investors to move into riskier assets. In recent history it worked.

The trouble is that when real estate and credit markets are performing even worse than stock markets, risk aversion can increase. If your 401(k) statement shows a much lower number than the previous one and that house nearby just massively reduced its asking price, a money market yield of 2% can start to look attractive compared with heading to the shopping mall or buying into the "stocks are cheap" argument. Not only can stocks get much cheaper, real estate is the leading indicator for many.

Recession or not, stock markets anticipate problems and equity drawdowns change the economic outlook. Bear markets are "defined" as a drop of 20% but does it matter? A 20% fall is a huge loss already and needs a 25% rally just to get back to breakeven. So whatever economic scenario ultimately transpires, a fall of that magnitude for long only equity portfolios is not only unacceptable but also unnecessarily risky. The appropriate use of hedging instruments and new investment strategies ought to have made such portfolio volatility obsolete by now.

Whether we are in a bear market or a recession is just semantic debate. What matters is that traditional equity investors have lost money and that will change behavior. The Fed has been criticized for "panicking" last week with a 75bp cut after heavy selloffs in Asia and Europe after the Societe Generale debacle, but they probably had no choice given the circumstances. If Ben Bernanke had not cut, the USA stock market would likely have lost 7-8% that day or 1,000 points on the Dow. Such a drop in a single day would have had a very negative impact on investor psychology. Central banks try to protect the economy and stock market fluctuations have a direct and immediate effect on economic well-being.

Doubly damaging is that not only have traditional equity strategies failed to preserve investors' capital, but inflation is raising the cost of living at the same time. Reduced savings and less spending power is not a recipe for growth. Many analysts like to focus on a questionable metric called "core inflation" which excludes rising food and energy prices. So according to some economists, as long as you don't eat, don't use any form of transportation and don't heat your home in the winter inflation is indeed "contained"! For those of us outside the ivory tower, let's hope stagflation is avoided. Six months ago credit contagion was supposedly also contained and we now know how that assertion turned out.

I've written several posts about LBOs and CDOs but the products themselves are not to blame for losses anymore than derivatives or hedge funds. LBOs, pioneered by KKR, were a brilliant financial innovation. The issues that bothered me in recent years was their dependence on cooperative credit buyers, the strategy now being too well-known and too much money in the "taking public firms private" arbitrage. Similarly CDOs are a great invention but it was junk math and dubious pricing and risk management that were the problems, not the products themselves.

Even if someone avoids new assets and hedge funds, I don't think anyone can dispute they have impacted market dynamics. You may dislike dark pools, derivatives, decimal point increments, deregulated commissions and day traders as well, but they have changed how securities fluctuate. A buy and hold investor is effected by new products, strategies and trading technologies whether they want to be or not. I am sometimes accused of being a hedge fund apologist or shrill for the industry which is interesting, considering that I think so many hedge funds are no good. But just like there are amateurs and quacks in medicine, there are plenty of good doctors in healthcare and talented fund managers in wealthcare.

Financial and medical technology have some other parallels. There was once a time when innovative surgeons were ridiculed for their "radical" ideas of washing hands and using anesthesia before operating. Technological innovation in HEALTH management has benefited everyone. Why then in WEALTH management do so many personal financial advisors remain in the stone age world of Prehistoric "modern" portfolio theory? Hedge funds and derivatives are not fads and can assist in reducing market exposure before bad things happen. Portfolio immunization and vaccination can prevent economic diseases like recessions and inflation sickening investors.

"Hedge fund" is a loaded term these days so rebranding them simply as "diversifying strategies" might help. New investment technologies seek, but do not guarantee, to produce absolute returns even if underlying asset classes fall apart. A few will deliver and many others won't but all investors need strategy diversification in their portfolios. As for "derivatives", they enable "portable" risk transfer from those who don't want an exposure to those that do or can hedge it away in some way. Derivatives may be dangerous in the wrong hands but are very useful and investors need them also.

Quant models and systematic strategies are also in the news again because a few weaker ones weren't tested for bearish conditions. Maybe it would be better to rebrand quantitatively driven investing as carbon-based lifeforms outsourcing the more boring aspects of security analysis, data gathering and trade execution to silicon-based lifeforms.

Lifeform? Alan Turing didn't have financial markets in mind when he did his work but systematic computerized trading can mimic and often perform better than human traders, thereby satisfying the Turing Test with respect to trading. It may be quite a while before computers can pass for a human in natural language processing or many other endeavors but as far as investing is concerned the singularity isn't near, it is probably already here.

Comments

[floatyerboat:]

"Embrace change or change may overtake you."
Its going to overtake someone every time, where else does the money come from. You always have to ask the question, for who is this going to work and not work.

2008 Jan 29 08:46 PM