Lies, damned lies and hedge fund performance statistics

The shine appears to have gone hedge fund performance in recent years, at least compared to the glory years of the 1990s. Indeed hedge funds have posted negative returns in two of the past four years (2008 and 2011).

Nonetheless according to a new report produced by The Centre for Hedge Fund Research at Imperial College London commissioned by KPMG and the Alternative Investment Management Association (AIMA) hedge funds still outperformed equities, bonds and commodities over the 17 years from 1994 to 2011.  

The report, entitled “The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy”, found that hedge funds generated annual returns of 9.07 percent net of fees over the period, compared to 7.18 percent for global stocks, 6.25 percent for global bonds and 7.27 percent for global commodities. Moreover, hedge funds achieved these returns with considerably lower risk volatility as measured by Value-at-Risk (VaR) than either stocks or commodities. Indeed, hedge funds’ volatility and VaR came in at level similar to bonds. The research also demonstrated that hedge funds were significant generators of “alpha”, creating an average of 4.19 percent per year from 1994 to 2011.

“This research is powerful proof of hedge funds’ ability to generate stronger returns than equities, bonds and commodities and to do so with lower volatility and risk than equities,” said Andrew Baker, AIMA’s chief executive. “The most interesting point to come out of this research is that it disproves common public misconceptions that hedge funds are expensive and don’t deliver. The strong performance statistics, showcased in our study, speak for themselves,” added Rob Mirsky, KPMG’s UK head of hedge funds.

Or does it? Mr Baker’s claim may be somewhat disingenuous because on this writer’s reading of the report The Centre for Hedge Fund Research are not comparing like with like. Hedge funds typically employ leverage, which can magnify returns. The market indices used to measure the performance of global bonds, equities and commodities do not.

Leverage levels have probably fallen considerably in the wake of 2008’s global financial crisis. But according to Credit Suisse, for example, global hedge funds were still 2.52 times leveraged at the end of 2010. And this would almost certainly have had a significant impact on returns. It could easily more than explain account for the return differential, especially relative to global commodities and equities.

   

This is certainly the case for private equity, another “alternative” investment. At first sight returns from a typical private equity appear to outperform equity indices, such as the FTSE All Share Index. Lever the index to the same level of private equity fund and the situation is reversed.  

A lawyer’s paradise

“The United States has fiver percent of the world’s population, 25 percent of its incarcerated people and 50 percent of the world’s lawyers. The legal profession takes about 10 percent of the country’s GDP, approximately $1.5 trillion, a sum close to entire GDP, depending on exchange rates, of Russia, India or China.”


Conrad Black, The Spectator, 21 April 2012.   

Career Risk: The ultimate investment fundamental

Yorkshiremen have a reputation for plain speaking. So it should come as no surprise that it takes a Yorkshireman, in the form of Jeremy Grantham, the co-founder and chief investment strategist of Boston, Massachusetts-based Grantham, Mayo Van Otterloo (GMO), a big investment management firm, to get down to the realities of investing. Forget about putting client interests first. For virtually all investment professionals the real fundamental that drives behaviour is keeping their job.

“The central truth of the investment business is that investment behaviour is driven by career risk,” he writes in the lastest GMO Quarterly Commentary. “In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes  knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially.”

The problem, is, however, that this creates “herding”, or momentum. And this results in prices deviating from “fair value” by a considerable margin.

“There are many other inefficiencies in market pricing, but this is by far the largest,” he continues. “It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market.  

“This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1 percent of its long-term trend. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19 percent two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!”  

Market prices tend to revert back to their mean, however, a phenomenon that underpins Mr Grantham’s - and GMO’s investment management philosophy. Unfortunately, as he is the first to admit, this is not always a comfortable position to take. Market prices can take a very long time to revert back to the mean even if they appear very expensive or very cheap.  

“Ridiculous as our market volatility might seem to an intelligent Martian, it is our reality and everyone loves to trot out the “quote” attributed to Keynes (but never documented): “The market can stay irrational longer than the investor can stay solvent.” For us agents, he might better have said “The market can stay irrational longer than the client can stay patient.””

But how long can a typical client remain patient before demanding action or taking his business elsewhere?

“Over the years, our estimate of “standard client patience time,” to coin a phrase, has been 3.0 years in normal conditions,” says Mr Grantham. “Patience can be up to a year shorter than that in extreme cases where relationships and the timing of their start-ups have proven to be unfortunate.

“For example, 2.5 years of bad performance after 5 good ones is usually tolerable, but 2.5 bad years from start-up, even though your previous 5 good years are well known but helped someone else, is absolutely not the same thing! With good luck on starting time, good personal relationships, and decent relative performance, a client’s patience can be a year longer than 3.0 years, or even 2 years longer in exceptional cases. I like to say that good client management is about earning your firm an incremental year of patience. The extra year is very important with any investment product, but in asset allocation, where mistakes are obvious, it is absolutely huge and usually enough.”

As Keynes pointed out in The General Theory of Employment, Money and Interest funds overseen by investment committees and boards tend to be the most critical of fundamental value, driven investors.

“What Keynes definitely did say in the famous chapter 12 of his General Theory is that “the long-term investor, he who most promotes the public interest … will in practice come in for the most criticism whenever investment funds are managed by committees or boards,” “ continues Mr Grantham. “He, the long-term investor, will be perceived as “eccentric, unconventional and rash in the eyes of average opinion … and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”

Mr Grantham and GMO have certainly experienced considerable criticism from investors, not least for calling the collapse of the technology bubble of the late 1990s two to three years early, (although GMO’s performance during the deep bear market of 2000 to 2003 more than made up for the opportunities apparently foregone)..

“Reviewing our experiences of being early in several extreme outlying events makes Keynes’s actual quote look painfully accurate in that “mercy” sometimes was as limited as it was at a bad day at the Coliseum, with a sea of thumbs down,” he concludes. “But his attribution, in contrast, has proven too severe: we appear to have survived.”

Proactive risk management in the personal pensions market: Buy a pub and a gun

Saving for a pension often seems to be a mugs game given minimal investment returns and falling annuity rates (although pension providers probably still continue to do quite nicely).

Of course there are alternatives, although the often favoured strategy of using the family home as an alternative to a personal pension fund seems a little misguided. Notwithstanding all the periodic hyperbole residential property is not a particularly good investment. At best it probably keeps in step with the cost of living - but little more. Moreover, unlike pension fund investors house-owners no longer get any tax relief.

Investors could try something more exotic. You could always buy a pub. One local resident disillusioned with the current UK private pensions regime decided to go down this particular route. He also bought a gun to protect his investment.

“I lost faith in pensions so I bought a pub for the value of the property and business carried on in it,” he says. However we all know that ownership is only guaranteed by laws, and if laws break down, you can be dispossessed by anyone with enough force. So that’s why I bought a gun.”

Happy New Year everyone!

Here is a guest article from Tim Price, the director of investment at PFP Wealth Management, a Harrogate and London-based wealth management firm. Here Tim provides some insights on long-term investing as well his current investment strategy. Happy Reading.

Ian

A short quiz, beef and revisited Koo

“Like a Hitchcock film. You did not need to see the blood and gore and violence . the hint of it and the menace that pervaded the office was worse”. Theo Zemek cheerily describes the atmosphere at New Star Asset Management.

Just as there are said to be no atheists in foxholes, try finding a long-term investor during a Crash, or even amid fears of one. We extend this thesis and welcome in the New Year by means of two Buffett-related behavioural anecdotes; one from the great man himself, the other courtesy of Sanlam's Kokkie Kooyman.


From the 1997 Chairman's Letter to the shareholders of Berkshire Hathaway: “A short quiz. If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.


“But now for the final exam: if you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?


“Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying.


“This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

There is one caveat to Mr. Buffett's otherwise excellent analogy. For those investors who are reliant 
upon a fixed pot of capital - call it permanent capital, if you will - and who have no means of “topping up” that pot by way of further earnings from employment or income from other sources, then the hamburger metaphor is no longer entirely valid. Savers drawing upon a fixed pool are right to be wary of bear markets if they face the realistic possibility of outliving that capital pool. But for investors with the luxury or flexibility to add to their pool, Buffett’s analogy holds.


What follows now is a thought experiment that again addresses the aspiration for long-term capital growth and how comparatively quickly that aspiration can fail upon contact with a bear market.

Imagine you had invested $10,000 in shares of Warren Buffett's legendary holding company, Berkshire Hathaway, at the end of 1971. Then imagine you (or better yet, a sibling or friend) had invested $10,000 into the S&P 500 stock index at exactly the same time. The table below shows how your investments would have fared:



Year            Value of Berkshire Hathaway holding    Value of S&P 500 holding

1971                        $10,000                                                 $10,000
1974                          $5,708                                                   $7,456
1975                          $5,422                                                 $10,229
1976                       $13,392                                                  $12,643
1991                  $1,361,805                                                  $92,940
2008                $14,387,737                                                $259,068
Source: Berkshire Hathaway / Sanlam Investment Management.


The raw data alone show that Buffett endured a miserable Crash. By 1974, the broad market had fallen by a quarter, but Buffett’s business had lost almost half of its value. Worse still, by 1975, the S&P 500 had recovered its losses, but Berkshire was even further in the hole. Try and answer this question honestly. If you were holding Berkshire stock, and were keeping an eye on the broader market, would you have bailed? Even if you might have not, many undoubtedly did.

The subsequent returns show how bitterly the hypothetical Berkshire sellers of 1975 would have regretted their abandonment of the longer term. This may not seem like a fair comparison, given the extraordinary outperformance of the market by Buffett and Berkshire over the longer term. The point remains that (at the time) the world’s most successful investor lagged the market over a four year period. If nothing else, this thought experiment suggests very strongly that assessing portfolio performance for a period as subjectively short or long as a calendar year has limited use versus the real long run. So are you a long term investor now ?

The world of “professional” economists has not acquitted itself well during the Financial Crisis. This may be because economics is a false science, and most of its practitioners are charlatans, and it may be because economists are more concerned about maximising job security by peddling conventional wisdom supportive of the banking sector than by issuing objective counsel about the state we’re in. Nevertheless, some economists deserve at least a mention in despatches, and 
Richard Koo is among them.

Mr Koo, chief economist of the Nomura Research Institute, argued in “The Holy Grail of macro-economics: lessons from Japan.s great recession” that it was pointless to fight the Japanese recession of the 1990s with conventional policy tools because it was not a conventional recession.

Economists tend to refer to “business cycle” recessions, where central banking tightening of monetary policy suppresses inflation following a boom. Yes, there was once a time when central
banks were actually capable of raising interest rates rather than simply cutting them. There was indeed a time when central banks actually gave a stuff about inflation, though those times are obviously long gone. In order to save banks and bankers, the rest of the economy can go hang.

Mr Koo’s point was that Japan was not suffering from a typical common-or-garden “business cycle” recession, but rather from an economic contraction caused by balance sheet restoration . hence his phrase “balance sheet” recession. In a “balance sheet” recession, companies and households have amassed too much debt, and are more concerned with paying it down than with borrowing more. 
Amid such deleveraging, it doesn’t matter how low you drive interest rates, because the vast mass of the private sector has no real interest in borrowing.

Mr Koo was rightly sceptical about the role of quantitative easing (for want of a better phrase: money printing), a monetary experiment first made by the Bank of Japan. He called it the twenty-first century’s greatest monetary non-event. His analogy was with a shopkeeper nursing a store of apples he is simply unable to shift. When he cannot sell more than 100 apples at 100 yen each, he then tries filling his shelves with 1,000 apples, and when that has no effect, adds 1,000 more.

“As long as the price remains the same, there is no reason consumer behaviour should change . sales will remain stuck at about 100 even if the shopkeeper puts 3,000 apples on display. This is essentially the story of quantitative easing, which not only failed to bring about economic recovery [in Japan], but also failed to stop asset prices from falling well into 2003.”

Now Mr Koo is back. His latest piece is rather ominously entitled “The world in balance sheet recession.”

In his original book, Richard Koo makes the fair point that the Japanese government - by abandoning all fiscal restraint and amassing an extraordinary debt load - stepped in to the void left by a deleveraging private sector and managed to prevent a Depression in Japan. The point often lost by observers of Japan’s “lost decade” is that it could have been so much worse if not for massive government borrowing.

But the point insufficiently understood by Richard Koo this time round, we think, is that the other governments of the west no longer have the approval of the markets to expand their balance sheets further by issuing yet more debt. Japan itself may be the first truly major economy to encounter a bond market explosion.

In a recent letter to investors titled "Imminent Defaults" hedge fund manager Kyle Bass alluded to countries at risk, including “Greece, Italy, Japan, Ireland, Iceland, Japan, Spain, Belgium, Japan, Portugal, France, and have we mentioned Japan?”

The sobering conclusion is that there is no painless way out of our current predicament. The Keynesians would like the government stimulus bandwagon to roll on, no matter how many bodies get thrown beneath it. 

We incline to the Austrian perspective, which argues that there is no problem so bad that government intervention cannot make it worse. Any Austrian economist will tell government not to interfere with the market.s adjustment process. As Murray Rothbard put it, in “America's Great Depression”: “The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure.”

But we are investors and not policy-makers, and many of our clients are dependent on a fixed pot of capital - so the requirement for capital preservation notwithstanding an environment of acute uncertainty is all the more urgent.

No lessons have been learnt by our monetary leaders. Investors today are effectively passive spectators to a titanic battle between the (market) forces of deleveraging on one side and the increasingly desperate forces of government inflationism on the other. Fiat currency for one is rapidly becoming collateral damage amid the unfriendly fire, which is why we continue to see merit in the paper currency insurance that is gold.

Yes, the gold price has fallen sharply over recent weeks, as expressed in nominal dollars (of dubious intrinsic value). But it still ended 2011 up a little over 10 percent from where it started. And its price has risen by, on average, 15 percent per annum over the past decade. Stocks (as expressed by the MSCI World Index) have, by comparison over the period, generated total annualised returns of less than 1 percent in nominal terms, and one dreads to think what in real terms. And it has been fairly typical, despite the strength of its rally, for gold, every year, to have incurred double-digit percentage corrections, along the way.

But gold does not form the totality of our savings and investments. Despite (or more fairly, because of) the economic and political uncertainties of our time, we also see merit in the most creditworthy and yieldy bond investments (hint: not in the supposed safe havens of the US or UK government markets, with their negative real yields and bubbly price characteristics); in high quality defensive equity investments, and in managed futures investments whose investment returns are not precisely forecastable but whose ongoing lack of correlation to traditional assets is a racing certainty.

Like many we have little overarching conviction but unlike many we see little point in trying to predict the hopelessly unpredictable. As in 2011, the twelve months ahead, for us, will remain a search for safer havens and dry powder.

Tim Price
Director of Investment
PFP Wealth Management