Ten Seconds Into The Future

The Case for Funds of Hedge Funds

Bryan Goh — Mon, 06 Sep 2010 13:52:11 +0000

The performance of funds of hedge funds has apparently underperformed that of direct investments in hedge funds even after correcting for fees. Why is this?

Performance Table April 2003 to July 2010. A comparison of FOF, HF and a sample FOF

*HFRXGL is an investable hedge fund index, HFRIFWI is the HFRI hedge fund index, HFRI FOF is the HFRI fund of hedge funds index and Fund X is an actual FOF.

Data issues are a big source of the measured underperformance of FOF to their underlying hedge funds. Many hedge fund databases suffer from survivorship and self reporting biases. This means that hedge fund indices like HFRI will show inflated returns compared with funds of funds indices like HFRI FOF even after correcting for the additional fees charged by FOF. HFRI FOF is a more representative benchmark for what is achievable in reality since they show the performance of actual portfolios of hedge funds.
HFRX GL is an investable hedge fund index. It is difficult to be truly representative of hedge fund performance since hedge funds value proposition lies in the individual unique edge of each manager.
Investors have become disenchanted with funds of funds due to their underperformance relative to direct hedge fund exposure, especially when measured by indices.
As in all things, not all funds are the same. Some funds of funds are better than others and consistently outperform their peers.
Size is an issue for funds of funds. It is difficult to manage funds of funds beyond 2 to 3 billion USD in assets under management. There are many reasons for this; being forced to invest in larger, less nimble hedge funds one of the more serious problems.
Expertise in hedge fund manager selection and portfolio construction is also highly varied. The divergence of performance between funds of hedge funds is high. It is important to select the right funds of funds manager.

Performance Table April 2003 to July 2010. A Selection of Actual Funds of Funds, compared with MSCI World Index

Funds of funds remain an efficient means of investing in hedge funds. Selecting the right funds of funds manager can result in consistent absolute returns which are important for long term compound returns.
Hedge funds remain a superior investment compared to passive long only equity investments. Even superior long only investment managers have to contend with volatility which imposes the issue of timing the investment correctly. Hedge fund investments exhibit low volatility and so timing of entry and exit is less important.
Despite losing some 22% on average in the financial crisis of 2008, the value of hedge funds is clear in the context of the drawdowns of long only indices like the MSCI World which fell 56% in the crisis.
Take a look at the Sharpe Ratios

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Equity Strategy and the Economy

Bryan Goh — Wed, 01 Sep 2010 10:36:09 +0000

At the beginning of 2010 equity markets had benefited from almost a year of positive returns. At the beginning of 2009 it was clear that it would be fairly easy to make money in the market given the degree of pessimism in the market at the end of 2008 and how much equity markets had been sold down. The market unexpectedly turned around in March 2009 and began an almost year long rally. At the beginning of 2010 market direction was a lot less clear. Equities which were cheap in early January 2009 were no longer cheap given the sharp rally in 2009.

MSCI Earnings Yield Gap, Jan 2010.

Equity markets have been volatile in 2010 falling sharply in early 2010 then rallying hard into the Spring before falling sharply again on fears of sovereign default in Europe and renewed economic weakness in the US. Valuations, however, have improved, as corporate earnings improved while markets traded sideways with volatility.

MSCI Earnings Yield Gap, Sep 2010.

The prospects for equities remain attractive. Investors do not dispute the robustness of growth in the emerging markets, particularly in China, India and Brazil. Germany has been a bright spot in Europe relying on its export industries to support economic growth. The big question is once again economic growth in the US. Employment numbers have been poor and housing data has been dismal. Economist fear a double dip recession in the US, fixed income markets are pricing in Japan style deflation and markets have sold off once more. However, ISM data is indicative of economic recovery and there are reasons to be optimistic about this. ISM PMI data while softer in July remains above 50, indicative of expansion. More importantly, the data is supported by strength in exports. A similar pattern is exhibited in the ISM NMI (non-manufacturing).

The US is shaping up as an export economy. Current account as a percentage of GDP has recovered in the wake of the 2008 financial crisis. One thing to note here is that this series will be volatile in recovery as import volatility is higher than export volatility on account of the US being a more open economy than her trading partners. The trend in the current account is clear. Recovery.

US Current Account as a percentage of GDP

Economic growth is cyclical and this is a consequence of any dynamic system. Within the broader long term cycle there are shorter term gyrations. It is likely that the current weakness in employment data is volatility along a longer term trend of recovery. The ISM data is a very strong indicator of economic performance, more so than labour data. The current account data provides some insight into the source of that growth, namely, a newfound export competitiveness in the US.

In terms of the relative performance of markets, we see the largest yield gaps in the US, followed by HK and H shares. Europe, Australia, Canada and India look like the least value. The risk to this approach of valuations is of course that the basis of earnings calculations is course and open to gaming. Also, the yield gap is boosted by treasury yields which are at historical lows. A spike in inflation or higher rates could change the picture significantly. Putting these aside we have the following picture:

Experience tells us that you can have a rising equity market when economic growth is weak or even in recession. Conversely, it also tells us that equity markets can fall when the economy is growing. The lags and autocorrelations are not stable enough for us to measure econometrically, but it is sufficient to understand that fundamentals drive markets through psychology.

Markets have been driven by macro factors since the great financial crisis of 2008. They will likely continue to do so. Weak economic data is likely to precipitate further economic stimulus which the market is likely to take positively. On the other hand the underlying economy is healing and will drive longer term returns going forward. What presents today is a convex payoff to the intrepid equity market investor.

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Hedge Funds versus Equities

Bryan Goh — Fri, 13 Aug 2010 04:04:51 +0000

Forget about correlations.

Since Jan 1998, over 159 months,

Hedge funds were positive when equities were positive 80 months or 50.35% of the time.

Hedge funds were negative when equities were negative 47 months or 29.6% of the time.

Hedge funds were positive when equities were negative 25 months or 15.7% of the time.

And

Hedge funds were negative when equities were positive 7 months or 4.4% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 47 out of 72 or 65.3%.

When equities are up, the chances of your hedge fund losing money are 7 out of 87 or 8.1%

However:

Since Jan 2008, over 31 months,

Hedge funds were positive when equities were positive 15 months or 48.4% of the time.

Hedge funds were negative when equities were negative 14 months or 45.2% of the time.

Hedge funds were positive when equities were negative 2 months or 6.5% of the time.

And

Hedge funds were negative when equities were positive 0 months or 0.0% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 14 out of 16 or 87.5%.

Post 2008, the markets have begun to behave in a very volatile and erratic fashion that has confounded many hedge fund managers who had previously navigated market crises such as 1998 and 2001 successfully.

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Equity Markets. Wait. Worry.

Bryan Goh — Thu, 08 Jul 2010 13:15:00 +0000

Most hedge fund managers waited too long when the markets corrected sharply in May, preferring to stay long of the market. As European sovereign default risk rose in the eyes of the media and investors, investors began to revise their views. The popular press and newspapers like the Economist began to write about the tight spot that governments are in, caught between fiscal stimulus and having to pay for it. Many hedge fund managers turned bearish and reduced their long bets.

Markets are in their third day of positive territory. This is likely a technical rebound from a heavily oversold position at the end of June. However, there is another risk. Its all too easy to be a bear when markets are falling but the weaker the economic data, the more governments will have to abandon fiscal austerity and return to priming the pump. It may be a disastrous policy in the longer run but human beings are very short term in their outlook.

I would expect markets to carry the rebound through for at least another 2 weeks purely based on the technicals. If the economic data is sufficiently poor, I would expect policy noises to lean towards stimulus again. I would expect investors who previously penalized governments for profligacy to change their tune and look to them for fiscal support. This is likely to sustain the market rally into a multi month rally.

The risks are: economic data comes out more positive and therefore policy becomes increasingly hawkish, individual earnings miss estimates.

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Stress Testing the European Banks

Bryan Goh — Thu, 08 Jul 2010 12:11:14 +0000

As Europe’s banks undergo so-called stress tests, an old adage comes to mind. Every failed trade becomes an investment. Every failed investment becomes a strategic holding.

Apart from specifying the nature of the stress, what is being assumed in each stress scenario, what probabilities have been assigned to sovereign default, etc etc, the valuation of assets and the assessment of the variability of the valuation of those assets is key in a stress test. Who is providing that valuation? Who is providing the assessment of variability and reliability?

Or is this a take home test?

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Addressing weak output growth

Bryan Goh — Tue, 06 Jul 2010 15:52:53 +0000

Governments are torn between fiscal austerity and stimulating economic growth. Since credit driven growth ceased in 2008 private sector economic growth has been muted. Consumption has been hampered by the need to restore household balance sheets. Such restoration is likely to overshoot as the lessons of 2008 linger, so savings rates are likely to be higher than expected. Corporate investment is likely to be less robust as well as managers risk management is highly autocorrelated and corporates are likely to retain a high buffer of cash on their balance sheets. This leaves exports as the driver of growth. Not every country can be a net exporter.

Governments had been quick to pick up the slack left by private consumption and investment. This fiscal stimulus has left sovereign balance sheets stressed. A balanced budget approach to stimulus is not effective since it is only a reallocation of resources which may or may not be better than the status quo. Also, in the US, it is important to measure the net stimulus taking into account Federal and State policies.

The efficacy of fiscal stimulus is in the details. Should government cut taxes effectively outsourcing its fiscal stimulus to the private sector or should it directly engage in productive activities? The psychology of the consumer will likely drive them to save any additional disposable income they receive. Policy may be better served by government directly engaging in economic activity. It should do this in the form of building infrastructure and capacity for the future productivity of the country. There is the risk that government is a poor allocator of resources and that resource allocation is suboptimal. However, in the face of a private sector that is unwilling to deploy new resources, government is the best available solution.

The problem faced by most governments is paying for the fiscal stimulus. Governments with weak balance sheets may not be able to fund their fiscal plans. Their ability to fund their ongoing liabilities and operations may require them to operate a policy of fiscal restraint or austerity.

Economic policy is not one dimensional. While a government operates fiscal policy, its monetary authorities or central banks operate monetary policy, in the form of market intervention or determination of interest rates. In the acute liquidity crisis of 2008, central banks the world over increased the leverage on their balance sheets in an effort to prevent the failure of the financial system. They continued to print money in 2009 in an effort to compensate for the sharp decline in the velocity of money in circulation. This strategy works by inflating the nominal output of the economy but is unable to ensure that the nominal output increase is evenly distributed across all segments of the economy, and can thus be highly inflationary in certain sectors or industries, and is also unable to ensure that real output will increase, i.e. can lead directly to inflation. This strategy has worked to a certain extent and failed in others. In capacity constrained markets it has created inflation while in non capacity constrained markets it has increased real output. In particular it has caused asset price inflation in financial assets, which have now become acutely sensitive to monetary policy.

Monetary policy has its limitations. In developed markets, interest rates are already close to zero. In the absence of inflation, it is not possible to induce negative real interest rates. Fiscal stimulus needs to be brought to bear. The current issue is how to fund that stimulus. Since the beginning of May, Europe has focused on the ability of Greece to repay its debts. Similar concerns arose about Portugal and Spain. The likely outcome will be that developed market central banks will have to purchase sovereign debt thus inflating money supply substantially and accelerating the debasement of fiat currency. This is highly inflationary. High debt to GDP countries will likely favour this type of inflationary policy since they have few options and this option is least worst.

Inflation, however, is measured with a CPI or RPI. The mechanical and defined specification of a price index can hide or degrade information. Owner’s imputed rent features significantly in most inflation measures, yet is never paid, and thus has little income effect. It is likely that inflation may be underestimated for some time while eroding real incomes and purchasing power. Inflation can occur not only in goods markets, service markets, but in the market for future claims on goods and services, in other words, the asset markets.

The future direction of asset markets whether equities, credit, commodities or real estate is likely to be highly sensitive to economic policy. While global growth remains fragile and uncertainty is high, economic policy will have a high impact on prices. Only when certainty returns to the global economy will idiosyncratic risk return to markets.

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Macro: Equity Markets and Policy

Bryan Goh — Wed, 30 Jun 2010 13:51:27 +0000

In economic policy there is a difference of view between the US and the rest of the world. As Japan’s largest trading partner the US is especially empathic to the deflation scenario that has plagued Japan since 1990. Therefore, US monetary policy is likely to err on the side of being too loose rather than vigilant on inflation.

Europe has a history of hyperinflation and is therefore likely to tighten sooner than might the US. The current focus on the health of sovereign balance sheets strengthens the case for a retraction of quantitative easing and expansionary fiscal policy.

The flexibility of the CNY is likely to reduce the demand for US treasuries and lead to a de linking between US and China monetary policy. China economic policy will be more hawkish on inflation than before.

All these point to the resumption of de risking that began in May that has led to falling markets and a rise in correlations.

This is all backward looking.

The economy and markets have reacted to the financial crisis of 2008 and the subsequent stimulus policies quite predictably. It rebounded and rallied hard as governments printed money thus debasing their currencies and inflating the value of real assets and future claims on the cash flows expected to be generated by real assets, and quite a little relief and hope.

We have seen in past crises like the one in Asia that post the initial decline, 100% rallies are possible and post those, 50% retracements are also possible. Equity markets are technically weak. They may strengthen over the next few weeks as corporate earnings come in reflecting 2Q financial results, but the trend is down. Earnings, however, are not the driver of markets. Liquidity and policy are.

There are many factors that can drive equity markets over time, but there is usually only one or maybe two factors that drive them at any moment in time. Equity markets are likely to continue to fall until weaker economic numbers prompt policy makers to revise their stance on fiscal rectitude and start printing money again. Who will go first? The US has not tightened policy. Australia, Canada and Norway, for example, have already been running tight monetary policy for some time, since 2009. China has been selectively reigning in leverage in particular sectors of the economy to prevent overheating. The commodity countries and Asia are unlikely to loosen policy again soon. The more likely candidates for reverting to expansionary economic policy are the Europeans on the basis that European economies are likely to be weakest.

Germany is exposed to exports to Asia; a more domestic centric China will impact European exporters. Domestic Europe remains weak and disconsolate. Unemployment remains high, balance sheet repair is slow. Spain is in a depression. Greece is insolvent. The PIIGs face a liquidity crisis. The outlook for Europe is poor. Able or unable, Europe will print money. Interest rates will remain low and if anything head to zero. Fiscal policy is constrained which will put even more pressure on monetary policy.

Europe is likely to be the first to resume printing. And the debasement of currency has as its dual, the inflation of goods and services, and assets.

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China Signals Flexibility in the CNY exchange rate

Bryan Goh — Mon, 21 Jun 2010 16:57:42 +0000

On Saturday, 19 June, China signalled the end of its currency peg which fixed the CNY at 6.83 to the USD and said it would gradually make the its currency more flexible. The CNY appreciated to 6.80 on Monday.

A stronger CNY it was hoped would:

Address the trade imbalances between the US and China.
Address inflationary pressures in China.
Provide impetus to developing a more balanced Chinese economy away from exports towards domestic consumption.
Increase outward overseas investment due to increased purchasing power.
Reduces foreign debt obligations and debt service, China had in 2005 about 180 billion USD of external debt.
Ease the risk of asset bubbles by delinking Chinese monetary policy from US policy.
Keep the Washington trade hawks at bay and reduce the risk of a trade war.
Be a vote of confidence for the global economy in general and the Asian and Chinese economies in particular.

However:

One wonders how prepared China’s companies are for FX volatility, especially smaller and less sophisticated exporters.
A stronger CNY can become a much stronger CNY as capital inflows increase in anticipation of further CNY appreciation. Such capital inflows can exacerbate existing asset bubbles such as real estate.
A stronger CNY will put pressure on the agricultural sector as imports become cheaper. There are some 500 million farmers in China.
What is the PBOC’s objective, is it a stronger CNY or a freely floating one? There are pros and cons of each route. A freely floating CNY would imply independent monetary policy. On the other hand the PBOC might not want to live with the volatility of a market determined exchange rate.
A lot depends on the magnitude of the CNY appreciation. Elasticity of exports and imports takes a long time to adjust and usually adjusts to secular trends, of which it is a circular driver, which by implies that the trade balance will adjust more to larger and more established moves in the exchange rate.
Given the behaviour of CNY when it was allowed to appreciate from 2005 to 2008, it is likely that the PBOC does not intend a floating exchange rate but rather will manage the exchange rate in very tight fashion to achieve a steady and controlled appreciation. This addresses many of the risks of a floating exchange rate that the Chinese economy might otherwise struggle to manage.
Absent a managed float, market forces are likely to encourage a weaker CNY not a stronger one, as the balance of trade swings towards balance with the US.
Allowing more flexibility in the CNY exchange rate is likely to translate into a reduction of demand by the PBOC for US treasuries which is a de facto withdrawal of vendor financing for Chinese exports. Demand for trade settlement is likely to strengthen the USD. The natural pressure on CNY is not clear.

Murphy’s Law:

Forecasts and expectations are often confounded as reality has an uncanny tendency to defy all logic and reason.

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Hedged.biz Downgrades Credit Ratings Agencies

Bryan Goh — Tue, 15 Jun 2010 13:33:41 +0000

Hedged.biz has downgraded Fitch, Moody’s and Standard and Poors from AAA directly to junk.

For downgrading (upgrading) issuers only after price discovery has occurred and being reactive rather than proactive. For downgrading (upgrading) issuers only after bad (good) stuff has happened and been priced in. Downgrading BP over a month after their rig in the Gulf blew up is not very useful.

For operating a conflicted model whereby the issuer pays the credit ratings agency to provide a rating.

For the audacity to rate instruments which they did not fully understand.

For being part of a feedback mechanism of automatic leverage and deleverage.

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The State of The Craft

Bryan Goh — Tue, 01 Jun 2010 12:04:52 +0000

We are not rewarded to bolster the base of the pyramid but to reach for the stars. Too often intermediate levels are built upon a deck of cards. Where the potential to build highest lies, most effort is directed there, often in disregard of the frailty of the supporting levels below.

The engineer knows that they cannot build to the edge of tolerance, there must be some cushion, for often lives are at stake. What better risk management than that lives are at stake, to shake the engineer’s faith in himself and his tools, in the work of his brethren before him.

Danger lies in faith, in comfort in a higher power, in complacency that error will not be catastrophic, that loss is not loss of life for then the engineer builds to the edge of knowledge.

But how many look at the foundations before they build a tower? The Craft has grown in convolution so much that to do so is an uneconomic endeavour. How many understand the Grand Structure we have built? It has grown without design, evolved beyond our comprehension, that now to break the ramparts, one has but to shake the tower.

The Craft now seeks to mend the Structure, but it will take time, generations perhaps. First is to understand and to understand is to deconstruct. This will not be linear. Charlatan will vie with Sage and Jujuman.

In the meantime, what can the body of the Craft do? Reinvent the wheel. Some of us have done this everyday of our lives. The populist Heretics rail against the reinvention of the wheel, but it is in First Principles that we truly understand, and in Knowledge that we have power, if over no one else then over ourselves in the avoidance of an unceremonious and unnecessary suicide.

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