Saturday, July 23, 2011

Sorry, your return is too high for us

I enjoyed reading Richard Wilson's The Hedge Fund Book (Richard also runs the Hedge Fund Blogger site). To be clear: it is purely marketing-oriented. It doesn't tell you how to find a successful trading strategy, but its focus is to tell you how to market your fund to investors once you have a successful strategy. To that end, it does a pretty good job in conveying what might be conventional wisdom to seasoned fund managers. (For e.g., don't bother to market to institutional investors if your AUM is less than $100M.) The book is filled with quite engaging interviews with fund managers, fund marketers, and other fund service providers (including our very own administrator Fund Associates). If Scott Patterson's The Quants is about the gods of hedge funds, this book is for and about the mortals.

One paragraph in the book stood out: "I've worked closely on the third-party marketing and capital introduction/prime brokerage side of the business, and I often see both types of firms deny clients service [to funds with high returns and high risk] ... Nobody wants to be associated with a manager aiming at 30 percent a month returns."

Maybe not aiming at, but what's wrong with achieving a 30 percent a month returns? I have actually met institutional investors who don't want to look at a fund that actually achieved double-digit monthly returns. Presumably that's because they believe that a high return automatically implies high risk, and also presumably a high leverage as well.  I would argue that there are 2 reasons not to completely dismiss such funds out-of-hand:

1) Leverage should not be determined arbitrarily, but should be based on the minimum of what's dictated by half-Kelly (see my extensive discussions of Kelly formula on this blog and in my book) and what's dictated by the maximum single-day drawdown seen historically or in VaR simulations. And if this minimum still turns out to be higher than what most institutional investors are comfortable with, one should be bold enough to adopt it in your fund.

2) As an investor, there is an easy way to control leverage and risk: just apply Constant Proportion Portfolio Insurance (a concept also discussed elsewhere on this blog). For example, if the fund manager tells you the fund employs a constant 10x leverage (as dictated by the risk analysis outlined in 1) and you are only comfortable with 5x leverage, just invest half your capital into the fund, and keep the other half as cash in your bank account! Going forward, if the fund loses money, your effective leverage would have decreased to below 5x. Say you invested $1M into the fund, and kept $1M in the bank. And say the fund lost $0.5M. Your total equity is now $1.5M, and the fund manager is supposed to trade a $0.5M*10=$5M portfolio. Your effective leverage is now only 3.33x, well within your tolerance. Now if instead, the fund made money, you can immediately withdraw some of the profits to keep your effective leverage at 5x. So, say the fund made $0.5M. Your equity is now $2.5M, and the fund manager is supposed to trade a $1.5M*10=$15M portfolio. If you don't withdraw, this would increase your effective leverage to 6x. But if you immediately withdraw $0.25M, then the fund manager will trade a $1.25M*10=$12.5M portfolio, giving you an effective leverage of the desired 5x.

If you are an investor in hedge funds, please let us know what you think of this scheme in the comments section!

30 comments:

Anonymous said...

Hi Ernie,

Aren't you mixing buy side with sell side in your post? Working for a PB I can see a reason or two on our PnL why we don't want to have such guys ;-)

Regards,

Richard Wilson said...

Thank you for posting a review of my book. I think it is most helpful and valuable to those who may be experts in quant trading or modeling but need advice on capital raising and the hedge fund industry as a business.

Take care and lets keep in touch!

- Richard Wilson
Hedge Fund Group (HFG)

Ernie Chan said...

Hi Anon,
My direct experience is with buy-side investors, but Richard says that even some PB would refuse such funds with high returns. My guess is that they are both afraid of the high leverage. As a PB guy, do you have other reasons to refuse them?

Ernie

Anonymous said...

Hi,
Looking at margin financing you are probably right, the counterparty default risk is the main concern.
However, in synthetics world (where I sit) you would need to add a risk of HF managers playing risky strategies through swaps.

Steady HF with huge portfolios with algo-managed strategies usually generates nice volumes, aren't to complex to support (clear, settle, report, etc). You usually have risk models for that in place, understand the underlying products (can price accordingly) etc.

Compare that with a few choppy trades in emerging markets on illiquid and distressed stock, for which your quants won't even know how to model currency risk...

I think it all comes down to the commoditisation of PB, no one want to be *#$%&^ ... and somewhere close to PB you would have Delta1 teams and these tend don't to like anyone to clever as well, but that is another story...

Regards,
Stefan

Bernd said...

Is it really possible to get 2 digit monthly returns in a consistent way? I would avoid a fund offering that, because,unless their strategy is amazingly good ( and it could stop working at any time ), it probably means they are using a very high leverage or a very agressive martin-gale system. A 10% monthly would mean around 3X your capital yearly... Sounds too good to be true to me. What is your opinion about this Ernie? Could it be possible with an acceptable risk?

Ernie Chan said...

Bernd,
I believe that any strategy could stop working at any time, or for some period of time, whether it has high or low return. Just because a strategy has high return doesn't make it more likely to stop working.

As for the high risk associated with high leverage, investors have the option of picking whatever effective leverage level they like via Constant Proportion Portfolio Insurance, as I explained in my post. There is little reason for a fund to lower its leverage just to please certain the risk-averse investors, since the risk-seeking investors who like higher leverage won't be able to increase the effective leverage, while the risk-averse ones can lower theirs.

Again, I believe leverage should not be set based on marketing needs, but on the intrinsic statistical properties of the strategy.

Ernie

Anonymous said...

Hi Ernie,

I'm a long time lurker and I've often wondered about the kind of issues you discuss in this post.

Am I correct in thinking that if anyone comes up with an extremely profitable trading model (100%+ return per year with low risk) then it's not in their interest to hedge fund trade it, instead just build up your capital or get in with a prop shop?

Am I right in thinking that for these same reasons you rarely see quant funds making phenomenal returns because if they were they wouldn't offer the strat to the public?
I hope you get my drift, it's getting late for me
cheers, keep it up!
Rob

Ernie Chan said...

Hi Rob,
Actually, you seldom see high returns strategies offered by hedge funds because they typically have low capacity, so they only have enough room for the trader's own capital!
Ernie

Anonymous said...

Ernie,

I've been following your blog for quite a bit, I think your book is quite solid and can't deny that I've read a fair amount of intelligent comments from you.

The one thing I never agreed with your book, blog & posts, is your view on leverage (including using half Kelly).

CPPI is not that safe and e.g. in an Investment Bank, whenever a client buys CPPI, it is the treasury that makes sure the clients will actually have principal protection, not the awesomeness of the algo.

Anyhow each to his own and everybody is free to leverage his positions according to his own analysis & general attitude towards trading. Personally, I'm much more conservative regarding leverage.

Anonymous said...

just a quick note, I'm a different anon, not the anon at post 1.

Ernie Chan said...

Anon,
Indeed, each investor has her own estimate of risk, and should set her own optimal leverage according to that estimate.

However, as I suggest in this blog post, when the risk estimates and thus desired leverages differ between a fund manager and investor, there is an easy way to resolve the difference. If the investor employ CPPI, it is a mathematical certainty that the investor will get a drawdown below her maximum desired drawdown and a leverage below her maximum desired leverage. Hence I am not sure what you mean by saying that principal protection is just insured by the bank and not by the awesomeness of the algorithm. The algorithm provides 100% certainty with no probabilistic elements at all.
Ernie

Anonymous said...

if by cppi you mean what the client gets then, yes the bond floor never gets hit.

However, nobody that sells cppi atually does exactly this (get some bonds+risky asset, the bond part is usually skipped) and its a bank's treasury that guarantees to clients they'll have principal protection, as if bonds+risky_asset was bought, no matter how desks handle the cppi baskets internally.

In any case, I think you're referring to simply buying less shares in leveraged funds. This makes sense, but you can use this argument with any asset, just mix risk-free bonds (may be harder to find them these days) with the risky asset and pick a portfolio according to your risk preferences.

However, it is not the client's job to build portfolios, it's the asset manager's job. Unless the client is e.g. a Fund of Funds, what you suggest is not feasible from a practical point of view.

Quant1 said...

I have tried reporting my system's performance on both a minimal-capital and CPP basis simultaneously, the performance characteristics at maximally supported leverage and the performance scaled back to an institutional-grade risk level, for comparison. The feedback that I get from prospective investors is that this is confusing, and they are not comfortable. It feels like this is an opaque disclosure that they will regret accepting.

Any idea how to present CPP to prospective investors.

Ernie Chan said...

Anon,
You are right that this scheme does require active rebalancing by the client at every month's end, or more frequently if possible. But given the increasing enthusiasm of many institutional investors to demand transparency and monitoring of intraday P&L, you would have thought that they would be eager to engage in daily or monthly risk management/rebalancing on their part as well!
Ernie

Ernie Chan said...

Quant1,
Indeed it will be confusing, if the investor is not actually using CPPI!

I think a comparison of performance at the high and low leverage levels will be clear enough. But of course you can also explain how the client can archive whatever leverage and drawdown they desire by doing a monthly capital reallocation.
Ernie

rental mobil said...

Nice article, thanks for the information.

Issy said...

hi Ernie,

this scenario happened to Mark Cook (market wizard) when his broker offered him to manage money. His returns of 80% in the first month of managing funds; caused his investors to worry :)

Issy

scottc said...

nice article... my firm makes +100% annual returns with very low risk taking but one prime broker said possible investors would view this very doubtfully...something like a possible nigerian investment scam. they said to lie and show a 30% return instead!!
I think the reality of the hedge fund industry is that 90% of players have no absolutely no market advantage, they simply leverage up 3-4 times and hope for a 5% market return on carry trades...and in any downturn most of the profits are given back.

Almost all high volume HFT firms are privately capitalized anyways, no reason to share high returns.

Anonymous said...

I have always been fascinated by that kind of stories. If anyone can make such return at the level of 80% per month, then it would get you a billionaire in less than a year with an initial investment of 10,000. Even a 40% per month would still give you a 56+ times of the origina return. So "congrats" there.

I was surprised to see that an algo trading blog would attract so many fairy tale lovers.

Ernie Chan said...

Anon,
I don't think commenter Issy above claimed that Mark Cook is able to generate 80% every month. That was just a first-month result, which is quite possible if he uses high enough leverage.
Ernie

smartrs said...

Why not dilute the returns? If you are showing 30% a month, just ask for 5x as much capital as required and stick 80% of it in a bond portfolio, so that the returns are diluted to 6%. That ensures your clients are taking less risk, as you know they have the diversification/capital to survive the inevitable blips of geometric investing.

Ernie Chan said...

smartrs,
Certainly one can delever a fund to suit one investor, but what if the other investors prefer the high return and risk of the higher leverage? My point is this: if an investor prefer lower leverage than what the fund employs, it is easy for this investor to lower her own effective leverage using the method I described here. However, there is often no easy way for an investor to increase the effective leverage she is exposed to in a fund, unless she is able to borrow money somewhere else to invest in the fund.
Ernie

nonpareil said...
This comment has been removed by the author.
Anonymous said...

Ernie,

I think you may be forgetting something extremely important- minimum investment levels. As you suggested, a client may want want to reduce leverage via a lower investment level and leave the rest of his bankroll in cash, but that might just not be possible.

Ernie Chan said...

Anon,
My suggested scheme may be impractical to implement for certain funds due to lockup periods, since it depends on the investor being able to withdraw profits on a monthly basis. However, I don't think minimum investment level is relevant though, since the scheme would require the investor to withdraw only when there is a profit. Obviously, the initial investment must already have met this minimum level.
Ernie

smartrs said...

Hey Ernie, my understanding is that its the prime brokers who are not keen on 30%+ returns...not the underlying investors. The prime brokers are just a conduit for pension funds or whatever to invest in you. I guess the statistics alone "30% per month" are insufficient. A track record of 30% per month for 5 years would be more interesting, but would mean 1 USD in the beginning would be worth USD 7.10^6 today. You'd be front page news! A geometric average of Thorp's original fund would have been something like 2% per month, over 20 years.

More explicitly, in case it was missed in my original suggestion, when you dilute the investors funds by a factor of 5, you 2% fees actually turn out to 10% upfront on your active capital. Nice.

Jose Miguel said...

Hi Ernie,

I have recently bought your book. I am currently reading the chapter 2 and it is being very useful for a beginner like me. It is best suited for me by far.
However, I am working as java developer for the last 4 years and I would like to know if you have read any other book which deals more about programing details, full-automated systems,tech infrastructe, intraday operations, high-frecuency trading, etc...
What book would you recommend to an IT professional with little knowledge about stocks?
Best Regards

Jose

Jose Miguel said...

By the way....among several platforms you mention at your book, I do know why it is not tradelink on it. I have read possitive reviews about it.
Have you ever tried tradelink, the open source trading platform? what is your opinion about it?
Regards

Jose

Ernie Chan said...

Hi Jose,
I am not a professional programmer anymore, so I don't read books on implementing HF systems. However, you can check out maxdama.com which is more focused on programming issues.

Regarding tradelink, it does look pretty useful. Thanks for mentioning it. I will refer to it in my next blog post, which talks about 2 other open-source backtest/trading platforms as well. One advantage of a professional platform such as QuantHouse or Alphacet over these open-source free platforms is that historical data is typically integrated into a professional platform, which makes it much easier to backtest.

Ernie

futures trading said...

30% per month is considered quite high. Per year would be more likely, as market don't always have large moves. To achieve that every month, the fund manager got to master scalping and long term trading.