Some financial equations do work. Good hedge fund + bad quarter = buying opportunity. As I expected, many hedge funds have performed well so far in 2009. It is no surprise that market dislocations, misvaluations and panic-selling hysteria created fantastic opportunities for skilled managers. Inevitably performance was bound to be strong when so many "experts" even recommended to avoid hedge funds! Redemptions by those that didn't understand true diversification have benefited investors who reduced risk by having lots of good hedge funds in their portfolios.

Even more impressive are the hedge fund managers that made money in both 2008 and 2009. Market timing is difficult but some have the talent. A good way to evaluate any investment strategy is its return on risk. Even with the recent stock and credit market rally, the return on risk of long only funds has been very low. Is the equity risk premium zero or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve their capital. Invest in managers with the skills to make money when things go pear-shaped - when markets or economies go bad.

Bernie Madoff was a stock broker "managing" client accounts. He was never part of the hedge fund industry. His firm was "regulated" and fraud is already illegal. He did not charge 2 and 20 and had no prime broker, proper auditor or independent administrator. Few sophisticated investors invested directly with so many red flags. Due diligence ITSELF is an alpha source. Diversification with NUMEROUS strategies and fund managers is MANDATORY.

Despite his "performance" Bernie was not a billionaire. With those "returns" on that asset size he should have been a stalwart of the Forbes 400. The chart below (click to enlarge) is the Madoff feeder, Fairfield Sentry, versus Gateway, GATEX, a mutual fund running the same strategy. Suspicious outperformance in the 1990s went from bad to worse in 2001.

Risk management Rule No.1: if it can happen then it will happen. Hope for the best but plan for the worst. Recent events have provided good returns for some hedge funds, hard times for other hedge funds but harsher times for long only. Skilled absolute return managers don't make money every month but they do have milder and shorter duration drawdowns than index funds. I wrote back in January that the Dow and Nikkei would likely fall below 10,000 this year as a result of the credit crisis and owning stock index option puts has indeed been the top performing strategy this year. But those were just lucky guesses. I can't time markets so personally I'll be focusing on funds that can preserve capital, control drawdowns and generate alpha no matter what happens.

Flight to quality? Some real hedge funds are positive for the year even when the aggregate returns for the industry are negative. Performance dispersion is enormous in such a diverse universe. Several strategies have not been affected by prime brokers imploding, changes in short selling rules or the leverage lockdown. The best managed futures CTAs, global macro and options traders have been generating absolute returns throughout the equity and credit mayhem. Strategy diversification is so important since forecasting is difficult. Transitions from one market regime to another often requires a financial revolution.

Best hedge fund? Recently I visited the home of the world's best-ever hedge fund manager and I often re-read his writing on investment topics. On my way to his house I saw some black swans on a lake which seemed appropriate and later ate at a restaurant that had run out of rice which appeared even more significant. It is sometimes the minor data points that lead to major opportunities.

How does one define "best" in the fund manager universe? I have looked at lots of funds, both traditional and alternative. Here is the performance chart of one I analyzed a while back:

Warren Buffett, the world's richest person, seems to prefer security selection to asset allocation. He searches for alpha because he doesn't expect beta to deliver enough. Ye olde split of simple 60/40 stock and bond beta driven asset allocation is just not going to cut it and is needlessly risky anyway. Fortunately for investors there is a solution - adding to the portfolio the absolute returns generated from the security selection, risk management and market timing abilities of the world's best and most "expensive" fund managers. Diversify away that systemic risk and stagflation damage with new investment strategies.

With the separation of alpha and beta there is less attention to the fact that beta itself splits into PRICE beta and DIVIDEND beta. And alpha comes from the RELATIVE alpha of good traditional funds and the much more valuable ABSOLUTE alpha produced by quality hedge funds. As Warren points out, both betas are unlikely to provide the performance of the past. Hopefully beta might contribute one day but in the meantime investors need a triple portion of absolute alpha in their portfolios:

Happy and Prosperous Lunar New Year. I met a lot of interesting people and heard about many new technologies and innovative products in New York last week. Navigating the future financial landscape requires making use of optimal ways to access information, deploy investment capital and manage risk. We can't rely on beta so it is alpha we need to identify for absolute returns. There is no asset allocation; it is how different strategies are applied to those assets that matters. There is also no passive investing; only active investing exists in the real world. And the notion of long term gets shorter term every year.

Why does the 12 year cycle in Chinese astrology begin with the rat? Because the alpha rat was smart, small and nimble enough to beat the lumbering beta ox, dragon, horse and others to win the race. A hedge fund manager is an investment rat; able to survive conditions that destroy others, exploit crevices of opportunity amid adversity and outperform the slower and bigger financial fauna. They are often hated by others for their very existence or wrongly blamed for propagating any disease that hits the markets. Much of the investment jungle is inhabited with brainless brontosauruses and preening peacocks strutting around unwilling or unable to do the dirty, hard work of uncovering alpha. If you were an animal, what animal would you be? As far as finding good investments is concerned, look for an alpha rat. Rats figure it out no matter what happens.

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.

Short only equity seems to be working so far in 2008 and stock indices in many major developed markets have erased last year's gains. The S&P 500 is now at 1,400 just as it was 12 months ago AND back in Jan 2000. Investors haven't received their equity risk premium or been compensated for volatility despite what the economics textbooks say but then stocks don't read. Zero index growth century-to-date.

It could be worse; in Jan 1988 the Nikkei was at 24,000 and now, 20 years on, it is at 14,000. With "traditional" assets flat for the decade, investors should be grateful for the hedge fund and venture capital alpha and commodity and emerging market beta that has protected more than a few portfolios.

Hedge funds returns have ranged from -100% to +1000% this year. Most years have a similar spread as a few blow up while someone else bets the house and happens to be right. The average return disguises so much inaccuracy and dispersion that the average is irrelevant. Databases include lots of "hedge funds" that aren't and miss lots of good and bad real hedge funds that don't report.

Since good results are unbounded to the upside but losses are floored at -100%, such a positive skew and the distorting effect of extremely high performing outliers will make the "mean" return higher anyway. But there is the bigger issue of what performance investors are trying to identify, measure and access.

It is after midnight in the hedge fund oasis of Dubai and I am waiting to fly to Osaka. When I arrived here I got long of Dirhams at Citibank and then spent most of them in Abu Dhabi. I was going to exchange the balance back to USD until I came to my senses and bought some more - why does the UAE still have a dollar peg and let Fed decisions export inflation to a booming economy?

Coincidentally it seems the past week there has been a raging discussion on the "high" cost of capital that Citigroup (C) raised from the Abu Dhabi Investment Authority.

Hedge funds "work" because of monetary incentives and checks and balances on managers that closely align their interests with clients. The often cited "heads I win, tails you lose" compensation scheme is a myth. The possibility of investors redeeming for poor performance, high water marks, no lockups and the principals' wealth at risk assures clients of shared downside exposure and motivates managers to try to minimize drawdowns.

Fees for failure have impacted shareholders of corporations where senior management was neither competent nor motivated to prepare for difficult times. While proper hedge funds are structured in ways that provide upside and downside alignment, this is now not always the case with some funds.

Beware of quants? Beware of hedge fund geeks bearing greeks? Some models don't work therefore ALL models don't work? It is curious how fear and hype lead to unjustified generalizations. Semantic pigeon holing is a common response to the unfamiliar. Presumably that's why some think quants are in a quandary, derivatives are dangerous and leverage is lunacy. Black box trading systems are "secret" and ALL the same(!) so better to stay with "human" methods of making money? There are many more bad human investors out there than bad quant models, so beware of the QUALS as well as the QUANTS.

I think investors should beware of everything. Considering the non-quant problems and dire risk management policies on display recently, the faith in the value of human discretion seems ironic. Sure there are plenty of poorly designed and badly tested quant trading systems out there as there are delusional pricing models, but that does not preclude the existence of quality, robust products. A computer making the trading decisions rather than a human does NOT mean an increase in systemic risk or a decrease in the persistence of a good strategy. It just puts the emphasis on ensuring the computer is making decisions in a different way to other computers and turning away investors who require transparency.

Those who ignore history are condemned to repeat it, but those who rely on history are condemned to blow up. Similarly those who believe in the ability of conventional economics or mathematics to model the emotional, non-random and illogical processes underlying financial markets are headed for problems.

Also, insufficient penalties for excessive risk taking often lead to bigger trouble later. Even if stock markets round the world continue to rally, investors would be well advised to have lots of shorts, plenty of puts and a substantial weighting in other truly UNCORRELATED sources of return. It's called hedging or managing your portfolio risk in case you turn out to be wrong.