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!

Monday, July 18, 2011

The social utility of hedge funds

There is an article in the New Yorker magazine profiling Bridgewater Associates, the world's biggest global macro hedge fund. Inevitably, we come to the awkward question: "If hedge-fund managers are playing a zero-sum game, what is their social utility?"

I thought about this question a lot in the past, and I used to agree with many others that the social utility of hedge funds, or trading in general, is to provide liquidity to the markets. And a good economic case can be made that the more liquid a market is, the higher the utility it is to all participants. However, based on recent experience of flash crash and other unfortunate mishaps, we find out that traders typically do not provide liquidity when it is needed most! So this answer becomes quite unsatisfactory.

In trying to come up with a better reply, I though it is curious that few people asked "What is the purpose of having a Department of Defence?" since wars between nations are typically also zero-sum games, yet we greatly honour those who serve in the armed forces (in contrast to our feelings for hedge fund managers).

To me, clearly the answer with the best moral justification is that, in both cases, there is great social utility in defending either your clients' comfortable retirement from financial meltdown (e.g. due to governmental or corporate mismanagement), or in defending your country from foreign aggression. More specifically, the purpose of hedge funds is to reduce long-term volatility in your clients' net worth. (I would like to say "reduce risks to your clients' net worth", but that would be a bit too optimistic!) 

I emphasize long-term volatility, because of course trading generates a lot of daily or hourly volatility in your clients' equity. But I do not believe that such short-term volatility affects ones' life goals. On the other hand, a 3-or-more-year drawdown in a typical buy-and-hold portfolio can wreck havoc with many lives.

If one day, the markets become so quiescent that few hedge funds can generate higher Sharpe ratio than a buy-and-hold portfolio (as indeed seems to be the case with the US equities markets these days), then yes, most hedge fund managers should just quit, instead of hogging intellectual resources from our best universities.

Sunday, July 03, 2011

Hedge fund transparency and "barometers"

Jim Liew of Alpha Quant Club recently posted an interesting article about the increasing demand for transparency of hedge fund strategies by institutional investors, so much so that they are essentially willing to invest only in managed accounts with real-time trades and positions updates. This is, of course, bad for fund managers, since not only can the investor reverse-engineer the simpler strategies from such knowledge, they can also piggy-back on the trades, thus paying a much smaller portion of their profits as performance fee. One might be tempted to think that since the investors are going to reverse-engineer the product anyway, why not just make it as simple and as generic as possible, and charge a much lower fee than the usual 2-20 (which hopefully will attract a much larger investor base), so that the main value to the investor is just convenience and not the originality of the strategy?

In fact, Jim wants to do just that. He proposes to construct hedge fund "barometers", essentially prototypical hedge fund strategies running in managed accounts. This would work well if these barometers have large enough capacities such that the performance can hold up even when a large number of investors sign up. From the investors' point of view, this is a trade-off between investing in a truly outstanding, high-performance strategy while paying a large fee and losing "transparency", versus just investing in a generic strategy that may still outperform the broad market. For some institutional investors, this might just be the bargain they are looking for.