Lessons from the Best-Ever Hedge Fund Manager

by: Veryan Allen

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:

Seems pretty good. It is a real fund and you could, if you want, invest in it. No lemon apparent with this product; the fund exists and that chart and performance numbers have been audited many times. A 20% compound annual return with ten consecutive winning years. Heavily regulated and open to investors everywhere. Zero management and incentive fees - 0 and 0 is better than 2 and 20. No leverage, no lockup and no valuation risk. The manager can accept $100 or $100 billion without damaging performance or capacity and offers full position transparency. The fund only invests in listed common equities on the world's largest stock exchange by market capitalization.

Sounds like an ideal fund but after thorough research I concluded this fund was not a suitable candidate for investment. I decided to try to figure out who is the best fund manager ever. The criteria for an investable fund are complex but necessary to identify the "best". If we were to define the top hedge fund as that which extracted the highest percent amount of absolute alpha over several decades, the wealth accumulated by the portfolio manager from his trading acumen, the consistency and repeatability of that performance, the existence of clearly defined protectable edges in fundamental and quantitative analysis and a legacy of investment theory, then the best ever hedge fund manager is pretty clear.

That person was of the great Munehisa Honma who managed a long/short commodities hedge fund during the 18th century. His house is well designed and much larger than most hedge fund managers, but his book "Fountain of Gold" is brilliant. Probably the best investment book ever written. His trading ability enabled the Honma family to go on to become the largest land owner in Japan for over a century. In today's money, his likely net worth was much more than $100 billion. Some years he would have "taken home" the equivalent of $10 billion so it is curious that there are those excited about John Paulson's "record" pay of $3 billion; fair compensation for the $12 billion absolute alpha he generated for investors that they would not otherwise have.

But Honma's returns were higher. Back in 1755 he knew that it was psychology and the irrational actions of market participants, not economic logic that drove markets. The study of behavioral finance isn't new, it's over 253 years old. Also he didn't buy and hold rice and wait to be compensated for its high risk. He did not "expect" a commodity risk premium. And even though rice futures were heavily traded and analyzed back then, the liquidity did not produce an efficient market. Like good traders today, he worked out that if he worked hard to develop competitive informational and analytical advantages, he could extract absolute alpha out of other rice traders, regardless of whether rice prices themselves were rising or falling.

Munehisa Homna had many insights that paved the way for the absolute return managers of today. Translated adages from his main book: - "Market action is more important than news." "Prices do not reflect actual value." "Buys and sells are decided on emotion not logic." He discovered the truth all that time ago and without the computers and communication systems we have. His fund's results speak for themselves. The Swedish Central Bank should retrospectively give him one of those "Nobel" prizes that the efficient, equilibrium economists still have as they continue their fruitless search for a rational, random market.

Honma wrote of the returns to be made buying when all others are selling and shorting when everyone is buying. Consult the market about the market. Even today so many spend time on Fed, ECB and BoJ-watching when they could be watching what the market is saying. The market told us we were entering a recession several months ago. It also clearly implied the credit crisis was not "contained". Mr. Market informed us that rice, oil, gold and sulphuric acid were going up while the pundits claimed inflation was under control.

However Honma did spend a lot of time on fundamental analysis, what moved rice prices, who was buying or selling and why. He also had detailed historical weather data and analyzed it to predict a key factor driving rice crop yields. His trading required good execution latency so, despite the pre-electricity era, he established a signaling system all the way from Sakata to the Dojima Exchange in Osaka to get orders in and prices back as quickly as possible. He developed many quantitative techniques to maintain his competitive advantage; some simple ones, like candlesticks, have entered the public domain but many others he kept to himself. Honma was the original black box algorithmic trader and system developer. As his impact on the markets grew, he evolved from market-taker to market-maker. He leveraged his informational advantages and adapted to the situation as needed.

Many techniques can be traced back to Honma. It is interesting how sometimes Western investors get caught out trying to trade Japan. I've seen more than a few "star" bond or treasury traders get blown away by JGB futures. Some fixed-income hedge funds got hurt by Japanese bonds recently. The yen carry trade has damaged some that didn't realize that a low interest rate doesn't mean a weakening currency. And of course there are equity strategists and some beta dependent Japan "hedge funds" who have been saying "Japan is cheap" since the Nikkei was at 16,000 but now it is down in the 12,000s. As Honma said, the cheap can get much cheaper.

Some investors might be skeptical of technical analysis and know nothing about Japanese technical analysis. Fair enough. There are plenty of fundamental ways to make money. But if another bigger investor with lots of yen to put to work does believe in Dojis, Harumis, Ichimoku, Kagi or Rengo, that may impact the markets and lose money for those who do not keep up with such methods. As Honma knew and John Maynard Keynes succinctly implied, the key is working out what others will do and how they value securities, not your own estimate of its value. The market may never value it "correctly" as some activist investors in Japan have found out to their cost. Equity analysts visiting companies is useful in many countries but I have seen little evidence of its utility in Japan.

Honma was probably the first successful quant in finance. Isaac Newton's earlier market forays weren't very good but then gravitation modeling is easier than financial modeling. The sun will rise tomorrow but the motion of the markets is less predictable. It is interesting how today more scientific method and new math is being applied to the markets. But then the old math and old economic theory have not coped well with reality. Assets classes affect each other and the ways they interact change over time. The equity market neutral crowd will be keeping a close eye on credit traders from now on and vice versa but they should have been doing that all along. Honma kept an eye on many things even if they had no apparent connection to rice prices. Everything is related and nothing is independent.

Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic was a trend in Japan for quite a while though it was first developed in the US. It is disdained by those who think we live in an orderly bivalent world of right and wrong and 0s and 1s. Many years ago I developed a fuzzy model to measure the bullishness or bearishness of the market. It used to give nice projections for the daily ranges for the JGB, Nikkei and yen fx markets. Given the inappropriateness of Ito's stochastic integral for pricing derivatives, I also tried adapting Sugeno's fuzzy integral to derive a more accurate option trading model. Isn't the world itself fuzzy, so fuzzy logic could be of use? Subways run on time in Japan.

That some hedge fund strategies are short volatility - and can be modeled as effectively short sellers of options and hoping a black swan won't show up to transform the fund into a lemon - is old news. Fortunately there are many other hedge funds run by managers who are fully aware of potential "rare" event tail risks, carefully hedge and maintain a long volatility profile. Some hedge funds are indeed lemons but there is lots of other quality "produce" in the investment grocery aisle.

So Japan had the world's best ever hedge fund - Honma's long short rice trading hedge fund managed from the 1740s to the 1790s - but also surprisingly the world's best performing index fund over the long term of 50 years - still the Japanese TOPIX. The fund chart above is the fund performance from 1980-1989. Below is the full performance chart from 1980-2008. Past performance was not very indicative for future performance.

Things haven't been too good since the high water mark of December 1989. Interestingly the 1980s weren't the best period; the 1950s compounded at a 25% CAGR and returned 10X investors' money plus even more in high dividends. Even now, 18 years into the bear market, the TOPIX remains the best index performer in the post war period. Would I therefore invest in it? Absolutely not.

I prefer the manager risk, security analysis and trading skills of today's Munehisa Honmas, not the market risk of every stock that happens to be listed on the Tokyo Stock Exchange. Ditto for other countries and asset classes. Honma would have thrived in current market conditions and with three billion people eating rice as a staple, the recent rice price rises are potentially very important. Possible recession and inflation are going to make the absolute alpha generated by the best fund managers important to portfolios and they have Honma, among other great traders, for inspiration.

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